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ENTREPRENEURSHIP: Starting and Operating a Small Business, 3/e

Steve Mariotti and Caroline Glackin

UNDERSTANDING AND MANAGING START-UP, FIXED, AND VARIABLE

COSTS

UNIT 3 • SHOW ME THE MONEY: FINDING, SECURING, AND MANAGING IT

Class NameInstructor NameDate, Semester

1. Identify the investment required for business startup.2. Describe the variable costs of starting a business.3. Analyze your fixed operating costs and calculate gross profit.4. Set up financial record keeping for your business.

Performance ObjectivesAfter this lecture, you should be able to complete the following Performance Objectives

7 What Does It Cost to Operate a Business?

To run a successful business, you will need to keep track of your costs and have more cash coming in than is going out.

Economics of one Unit (EOU)-because everything sold has related costs, a business can make a profit only if the selling price per unit is greater than the cost per unit.

7 Start-Up Investment

Seed Capital: one-time expense of opening a business.

Prototype: a model or pattern that serves as an example of how a product would look and operate if it were produced.

Brainstorm to Avoid Start-Up surprises.

Research the Costs.

Keep a Reserve Equal to One-Half of Start-Up Investments. Cash Reserves: emergency funds and a pool of cash resources

Exhibit 7-2 Start-up Investment ChecklistItem Cost Assumption

s

Rent Deposit

Signage

Utility Deposits

Vehicle(s)

Other 1

Other 2

Total Start-Up Assets

Total Start-Up Requirements

Contingency Funds (10%)

Start-Up with Contingency

7 Predict the Payback Period

Payback period: estimated time required to earn sufficient net cash flow to cover start-up investments.

Start-Up Investment

Net Cash Flow per Month

Estimate Value: a tool to determine the current value of proposed investments, of which net present value (NPV) is widely accepted as the most theoretically sound.

7 Variable and Fixed Costs: Essential Building Blocks

Variable Costs – expenses that vary directly with changes in production or sales volume.

1. Variable costs fall into two subcategories: Cost of Goods Sold

(COGS) or Cost of Services Sold (COSS)- The cost of materials used to make the product (or deliver the service).- The cost of labor used to make the product (or deliver the service).

2. Other variable costs: - Commissions or other compensation based on sales volume. - Shipping and handling charges.

Fixed Costs – are expenses that must be paid regardless of whether or not sales are being generated.

7 Calculating Critical Costs

Calculating Total Gross Profit (Contribution Margin)-gross profit per unit-the selling price minus total variable costs plus other variable costs.

Calculating Economics of One Unit (EOU) When You Sell Multiple Products - a business selling a variety of products has to create a separate EOU for each item to determine whether each is profitable.

Inventory Costs-expenses associated with materials and direct labor for production until the product is sold.

7Exhibit 7-4 Manufacturing Business

Economics of One Unit (EOU) Analysis

Unit = 1 Hand-Painted T-Shirt

7 Average Contribution Margin

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

Economics of One Unit AnalysisExhibit 7-5 Retail Business

Unit = 1 Candy Bar

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7 Fixed Operating Costs

Fixed operating costs -expenses that do not vary with changes in the volume of production or sales.

7 Common fixed operating costs: USAIIRD:• Utilities• Salaries• Advertising• Interest• Insurance• Rent• Depreciation

7 Depreciation Makes Records More Accurate

Depreciation – the percentage of value of an asset subtracted periodically to reflect the declining value.

If you buy a computer that will last 4 years, spread the expense out over 4 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.

7 Fixed Operating Costs Do Change over Time

Fixed costs does not mean that costs never changes! For instance:

Advertising or heating and cooling costs

7 Allocate Fixed Operating Costs Where Possible

Net Profit – the remainder of revenues minus fixed and variable costs and taxes.

For example: for every watch you sell, your total cost, fixed and variable, is $6.50. If you receive $15 for each watch, therefore, your profit before taxes is:

$15.00 Selling Price - $6.50 Total Cost per Unit = $8.50 Profit before Taxes

7 The Dangers of Fixed Costs

If a business does not have enough sales to cover its fixed costs, it will lose money!

7 How Inflation Can Hurt Small Business Owners

Inflation: the gradual, continuous increase in the prices of products and services.

7 Using Accounting Records to Track Fixed and Variable Costs

The systematic recording, reporting, and analysis of the financial transactions of a business (keeping statistical records of inflows and outflows) is called accounting.

7 Three Reasons to Keep Good RecordsEvery Day

1. Will show you how to make your business more profitable.

2. Will document your business profitability.

3. Proves that payments have been made.

Audit- a review of financial and business records to ascertain integrity and compliance with standards and laws, particularly by the U.S. Internal Revenue Service (IRS).

7 Suggestions for Keeping Good Records

Accounting Software – There are many excellent computer software programs on the market to help the small business owner keep good records and generate financial statements and analytical reports; Intuit QuickBooks, Microsoft Office Accounting, & Peachtree Accounting.

7 Receipts and Invoices

Receipt = document with date a amount of purchase. Always get a receipt for every purchase you make

Invoice = a bill or statement, shows the product or service sold and the amount the customer is to pay.

7 Keep at Least Two Copies of Your Records

Always keep a copy of your financial records in a location away from your business, preferably in a fire-retardant safe or concrete-lined file cabinet.

If you are using software, back up your data and keep the media (CD, jump drive, etc…) in a different location.

7 Use Business Checks for Business Expenses

Avoid using cash for business. Use checks, get receipts. Keep a paper trail.

Deposit money from sales right away.

7 Cash versus Accrual Accounting Methods

Cash Accounting Method – the procedure wherein transactions are recorded as cash as paid out or received.

Accrual Method – Account process wherein transactions are recorded at the time of occurrence, regardless of the transfer of cash.

7 Recognizing Categories of Costs

Understanding the key categories of accounting data:- Variable Costs- Fixed Costs- Capital Equipment- Investment- Loans- Revenue- Inventory- Other Costs

KEY TERMS

accrual methodauditcash accounting methodcash reservecontribution margindepreciationfixed costsfixed operating costs

inflationinventory costsnet profitpayback periodprototypeseed capitalvariable costs