A key attribute common amongst successful businesspeople is financial literacy. You don't need an MBA or to have studied accounting for years. It is however imperative that you understand basic concepts which will allow you to make better decisions, increasing the profitability and value of your business.

A few of those basic concepts are: fixed cost, variable cost, profit (and loss), break-even, gross margin, contribution margin.

FIXED COST

What is it? Your fixed costs (expenses) represent the money that you have to shell out on a regular basis.

How do I calculate it? If you have to pay an expense whether you serve one customer or a million customers, then it is probably a fixed cost. Lease and mortgage payments, insurance, corporate fees and similar expenses are obvious fixed costs. You should also note that regular salaries and wages also have the attributes of fixed expenses (Employees must be on hand to answer the phone and serve customers and they cannot be laid off at the whim of the business owner).

Why is this important? You must have enough cash on hand to meet your fixed costs in plentiful and lean times. This is the 'nut' that you must cover on a regular basis.

VARIABLE COST

What is it? Variable costs (expenses) are the costs that increase relative to the volume of your business' activity.

How do I calculate it? Many costs exhibit hybrid attributes, where they are neither wholly fixed nor wholly variable. An example of a purely variable expense is the expense incurred when outsourcing work to an external provider. Other variable expenses include the inventory used in a retail business or a per client commission paid by a service provider.

Why is this important? Businesses with a greater proportion of variable to fixed costs tend to have a more flexible cost structure and show profitability at lower levels of sales. This cost structure is an attribute preferred by many experienced entrepreneurs.

PROFIT (and LOSS)

What is it? Profit is the financial gain from a business after all of the costs and expenses of bringing in the money have been met. Loss is what you are faced with when it costs you more to produce and deliver your products or services than they bring in.

How do I calculate it? It can be deceptively easy to miscalculate profit and loss, if you fail to consider the whole range of costs (including hidden costs). Once you have done that, the equation comes down to simple arithmetic: Total Revenue minus Total Expenses.

Why is this important? There are countless tales of business people blinded by concepts like 'market share' or 'strength of brand'. At the end of the day, no matter what the hotshot consultant tells you, you must remember that no business can lose money indefinitely - even if you have a line of credit that stretches to the moon, your business can still not afford to lose money indefinitely.

BREAK-EVEN

What is it? Break-even is the state achieved when the money coming into your business (revenue) equals the money going out (expenses).

How do I calculate it? Business owners will want to know how many units of a product / service they must sell, how much they must charge per unit or how much total revenue they must earn to break even.

The key principle to note is that at break-even, total revenue minus total expenses equals zero

Total revenue is easy to calculate - it is the total you expect the business to earn over the period (normally a month).

As discussed earlier, expenses can be fixed or variable. Fixed expenses are right in front of you and easy to estimate. Variable expenses can be estimated by first determining the variable cost of each unit produced (customer served, dollar earned etc as appropriate). Then multiply the variable expense per unit by the number of units.

Total Revenue = Total Costs or Total Revenue minus Total Costs = 0 or (Revenue per unit multiplied by number of units) minus (Fixed costs + [cost per unit multiplied by total units]) = 0

Why is it important? By being aware of your break-even and the factors that influence the calculation, you gain an essential tool for pursuing profitability. You will be able to: i) more effectively price goods and services ii) determine your required volume of production & sales and iii) assess whether or not you have the capacity and required resources to reach that number.

Asgill Post Ltd. provides assistance with Business Valuation, Financial Strategy and the Purchase and Sale of Companies. For comments or queries, contact Kumi Bradshaw MBA, CBA, BVAL via email at kumi@asgillpost.com or phone at 295-3301. Patterson Partners Ltd. provides cross-border tax, estate and investment planning services to dual citizens of the US and Bermuda, their families and businesses. For more information, visit www.patterson-partners.com or contact Jennifer A. Patterson, CFP®(US), CIMA®, TEP via e-mail at info@patterson-partners.com or phone 296-3528.