Entrepreneurship and Small Business Management Chapter 12 Understanding and Managing Start-up, Fixed, and Variable Costs

Ch. 12 Performance Objectives Identify the investment required for business startup. Describe the variable costs of starting a business. Analyze your fixed operating costs and calculate gross profit. Set up financial record keeping for your business.

Start-Up Investment Seed capital is the one-time expense of starting a business. Brainstorm every cost to avoid surprises. Consult advisors and research industry business plan models. Include a cash reserve for emergencies.

Predict the Payback Period Start-up investment Net cash flow per mo. This estimate tells investors how long it will take your business to bring in enough cash to cover the start-up investment. = no. of months

Estimate Net Present Value NPV—technique used to determine the current value of a proposed investment Information used to calculate NPV: Initial investment Required rate of return (%) Annual net cash flows If NPV is a positive value, the investment will have a positive return.

Variable Costs Change based on sales and production Cost of goods sold (COGS) or Cost of services sold (COSS) Cost of materials Cost of labor Other variable costs Sales commissions Shipping and handling

Finding the Contribution Margin

Average Contribution Margin A business selling a variety of products can use an average COGS to determine an average contribution margin.

Fixed Operating Costs Do not change based on sales/production USAIDIR (common fixed operating costs) Utilities (gas, electric, telephone, Internet) Salaries (indirect labor) Advertising Insurance Depreciation Interest Rent

Depreciation Makes Records More Accurate If you buy a computer that will last four years, spread the expense out over four years. Subtract 25% of the computer’s cost from gross profit each year, instead of subtracting 100% of the cost from gross profit the first year.

Fixed Operating Costs Can be Dangerous to a Business Fixed costs must be paid whether or not your business has a gross profit. Be careful about taking on additional fixed costs. Change fixed costs to variable costs wherever possible. Keep a cash reserve as a cushion of protection in case of emergencies.

Keeping Good Records Accounting—tracking the inflows and outflows of your business Good records enable you to… Create financial statements Determine how to improve business profits Show investors the firm’s performance Prove that payments have been made Make audits go more smoothly

Good Accounting Practices Use computerized accounting software. Get a receipt for every purchase. Create an invoice for every sale. Backup computer records regularly.

Good Accounting Practices (continued) Keep a copy of financial records in a location away from the business office. Get a checking account for business use only. Use checks instead of cash to pay business expenses. Deposit money from sales right away.

Cash Versus Accrual Methods Cash accounting—transactions are recorded when cash is paid or received Accrual accounting—transactions are recorded at the time they occur, regardless of the payment date

Categories of Accounting Data Variable costs—any costs that change based on the number of units sold Fixed costs—business expenses that must be paid whether or not any sales are made Capital equipment—money spent on equipment expected to last a year or more Investment—money invested in exchange for part ownership (equity)

Categories of Accounting Data (continued) Loans—funds borrowed to start or operate the business Revenue—money received from sales Inventory—items purchased for resale, including suppliers’ shipping costs Other costs—anything that does not fit into the other expense categories