coststructure

One of the key fundamentals to knowing how to or continuing to finance your business is understanding your cost structure and cash flow. We discuss the role of fixed and variable costs and how to create a model of how you are going to pay your fixed costs.

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Speaker 1:
From his first job flipping burgers at McDonald’s and delivering The Washington Post, Craig Willett counts only one and a half years of his adult life working for someone else. Welcome to The Biz Sherpa podcast with your host, Craig Willett. Founder of several multimillion-dollar businesses and trusted advisor to other business owners, he’s giving back to help business owners and aspiring entrepreneurs achieve fulfillment, enhance their lives, and create enduring wealth. The Biz Sherpa.

Craig Willett:
This is Craig Willett, The Biz Sherpa. Thanks for joining us today on today’s episode. I’m excited to have you with me. You know, as I look back on the guests that we’ve had so far in the last year, I’m grateful for each one of them. Each has a story with examples that really paved the way for us to learn. As we apply the principles that they’ve learned, we can avoid some of the pitfalls that come.

In the last episode that I had with you a month ago, I shared with you some ideas about how to finance the startup of your business or the ongoing operations. And one of the key fundamentals at the base of starting a business and knowing how to finance it, or continuing to finance it, is to understand your cost structure and your cash flow. Today, I’m hoping that we can tackle those issues.

In every business that I’ve ever started or been involved with, there’s a three to five year time horizon that it will take for you to feel that you’re comfortable. I’m not saying profitable, because I think you can hit profitability much sooner than that. But when I say comfortable, I’m talking about successful. That it has an energy in and of itself that is not so dependent on you as the business owner. Now that’s the assumption that you are actively involved in the business. And of course, I think most small business owners are. In fact, I think the pitfall is that many of us find that the business owns us rather than us owning the business.

One of the ways a business can own you is by going into debt. And then you feel the pressure to repay it. I’m not saying debt is bad. I think there are ways and times where you should take on debt to finance some shortfalls or some seasonal needs in the business. As a business owner, you’re the equalizer, though. You are the equalizing force, whether you hire someone or whether you spend the extra hours yourself to get a particular task or job done.

There are dangers in that because you can become distracted and lose focus on what’s important and the money making part. So saving costs at the expense of bringing in profitable business isn’t always the best choice. But sometimes as business owners, we find a way to do both. Now, when you really are looking to understand your costs, you really need to look at two really main factors. One is your fixed costs.

That would be your overhead—commonly referred to as rent, marketing costs, insurance costs, costs to operate an office, utilities, and things like that. And then there’s your variable costs. If you produce a product, then it’s the cost to produce the product, both in labor and materials to do that. And if you’re transactional-based, then there are commissions and those become variable costs because they’re a percentage of the revenue you bring in.

So you really need to understand what those are. Once you understand what your fixed costs are, then you need to develop a model of how to pay for those fixed costs on a recurring basis. Some people call this a break-even model, where you look at what is it going to take to bring in the costs, the revenue I need to cover my fixed costs, including your salary. And once you figure that number out, that will tell you how much in sales you need to have.

Now that doesn’t mean you use that to set your goals, but it certainly gives you an idea to determine whether it’s realistic to incur the costs that you’re going to take on in order to achieve the revenue that you’re aiming for. You know, sometimes we get very optimistic when we start a business, right? And we want to do more and better than we think we can. Often I find that that’s the case. Sometimes we under shoot or under commit to what we think we can do and our product takes off. That’s a good problem to have.

So I’d rather be conservative in the startup stage because it will help you determine the right amount of money that you need to have to finance your startup. I remember that you as a business owner have to really take into consideration those costs. I remember when I started my development business, that I sat down and decided, “If I’m going to tell people they can own their building for less than rent then I truly, personally, needed to make sure I owned our office building in one of our projects.”

So in our very first project, I owned one of the buildings. In the process, though, here’s how I made up for it. I worked out of my living room until the first building was completed. And I worked out of a trailer in our second project until that first unit was completed. Now that building was bigger than what I needed for my young and fledgling development company business, but I built it out to accommodate a lot more people that we grew in to occupy the entire building at one point.

But we rented out the other units as executive office suites, and were able to supplement our payment by the rent that we were able to charge and some of our overhead costs to operate the business, such as a receptionist. And it allowed us to pay for more because people wanted to use our conference room as well.

Now, you need to live the part and you need to look at ways that you can save. One of the dangers is also putting a stress on the business that you demand too much for your own personal living expenses. I think I talked about this once before, and you need to be careful that you are living as economically as possible so that you don’t have to draw as much money out.

That will allow you to own more if you’re offering equity, you won’t have to dilute as much to get more money, or you won’t have to borrow as much in taking on some of that additional risk just to cover your personal expenses. Then there are some costs that, really, you can’t afford not to incur.

I remember when we were into our second project, that I had listed it with a nationally recognized brokerage firm. They were located in Phoenix. My project was located in Mesa, Arizona. They would get phone calls from the sign that they put on it, but rather than meet the people face to face, they would fax them information sheets. And then the people would, or would not get back to them. After a while I got tired of reports of a number of people being interested and inquired and that they had sent information, but had no real follow-up.

I decided that I needed to take marketing into our own hands. This took some of my time and it meant that I had to hire a sales staff. Now some of that sales staff needed to be supported, so there were costs associated with that as well. The lion’s share of the costs were going to be commissions, but as you can imagine, there are still costs and time associated with it. We went from 3 million sales in those first two years to over the next 10 years doing nearly 700 million in sales. It was a great move, a cost I couldn’t not afford because I needed to do that, to get that personal, one-on-one attention that I wanted for the potential buyers of our product, of our buildings.

Now, if you remember, I think I’ve told this story too, but I remember the first sign I got when I took down the brokerage firm’s sign and put up our sign. It was a doctor, he was driving around looking for a new office space. He said, “You know, I just drove by your sign. And I’m looking for new office space I need to be in, in the next four months.” He said, “It says that I can own it. It said own for less than rent. I didn’t know I could own my own office building.”

At that point I knew that if I control their message, rather than just “For sale,” or “For lease,” that we controlled our message with our sign and with a live person who could walk them through that process. Then we could articulate turning those phone calls into buyers who are satisfied and refer their friends. This became a very dynamic decision for us.

So when you’re looking at those costs, look at those that may seem like something you can do, but also look at it as maybe something you cannot not afford to do. You know, it’s really important to understand cash flow. Why? Because you need to understand how much capital it’s going to take for your business and when you need the capital, and when you’ll be able to repay that capital. Having that understanding of being able to forecast your cash flow and understand your cost structure will make the discussions you have with banks when you need to borrow on a line of credit, or with family and friends who you might need to borrow from for a short period of time, that will allow you to set expectations of when it will be repaid.

I shared this before. I had a bank one time that kept asking me to come in every year and meet with their senior loan committee, including some members of the board. And I thought to myself, “Well, why are they having me do this?” Finally, I was so curious that I finally asked a loan officer one time, “I love coming in and making presentations to your bank, in fact, the senior management of your bank. But do you mind if I ask why they have me come in?”

And he said, “Craig, you see, they want to make sure they set aside enough money this coming year to meet your needs because you’ve always paid them back before you said you would, and you’ve always met or exceeded the cash flow projections that you gave them.”

That is very rare, I guess, in many circles. So you want to be sure that you have a good understanding of that. If you don’t, you can hire experts. We’ll have Matt Waller on from Henry and Horne CPA firm. He’ll talk about how you can manage and use outside resources to help you understand and make better forecasts so that you can manage your relationship with your lenders or with your investors, or even just for your own safety and peace of mind.

You want to also be sure you understand your cash flow so you know what kind of commitments you can make. Early on in your business, you’re going to be signing a lease for a store or an office or a warehouse or a factory, and you need to understand what those costs are going to mean, how long of a term you’re going to have to sign for, what that guarantee means in terms of dollars and cents so you know how much you can commit for.

You might also be buying equipment and how you finance that, whether you lease it or you buy it. Those are very important parts that can play a key role in determining in those critical first three years of your business, whether you’re one of the businesses that succeeds or you’re one of the businesses that struggles. Now I understand that costs don’t take a business down. They do make it difficult when they can’t sell.

So you have to articulate with your customers— and we’ve talked a lot about that on niche marketing. We’ve talked a lot about pricing. We’re not here to talk about that today, but as I mentioned in financing your business, a large percentage of businesses—I think it’s nearly 90%, 85% of businesses—when they go to hire an individual, need some sort of financing in order to commit to employees.

So I think it’s important to know your cost structure, so you can understand whether you have adequate cash flow. There’s nothing like having to turn to your first employee and say, can you wait an extra week for your paycheck? I’m sure it starts to make them nervous and may affect their performance at work.

I’ve often talked about being able to relax. I understand that the first three years of a business, and even maybe up to five years, the business does own a good part of your time, and certainly a good portion of your mind. Whether it’s at night or in your quiet time, it still sneaks in and you still try to solve the problems and try to figure out how to make it work. And I admire that. I think that’s very important, but I also think that you need to find ways to set it aside.

I had a client early on in my CPA career that told me I should have a hobby. And I asked him his and he shared with me his two hobbies. And through the years I’ve sought to do different things. One of the hobbies I’ve worked on is watercolor painting. Another one of the hobbies that I’ve worked at is golf. And that doesn’t sound like a hobby, because sometimes it’s very discouraging, but it does allow you to get your mind off of it if you can do it.

But it’s a game that you have to learn to shut down and relax; otherwise, the muscles aren’t going to help you hit the ball in a straight direction and it can be very frustrating. I would say that you need to find what those are and find them early on because you do need to give time for your mind to rest. And when you put your mind at rest, you come back and are able to focus and are able to solve those problems.

When our mind is burned out, we can’t have our subconscious work on helping us solve our problems. So when I’ve hit difficult times, I’ve found it helpful to have had hobbies and other interests and have been able to take vacations so that I have the reserve energy it takes to put in 110% of my time to solve during difficult times. Because they will come. We don’t know what they’ll be. If we knew what they’d be, we’d plan for them in advance and it wouldn’t take any extra of our time, right?

So you want to really understand your cost structure. As you look at your cost structure, consider what kind of profits you need to retain in the business to grow and have longevity. You also know how much you can share with your employees or with your partners. I wouldn’t distribute all profits. I think that’s not a good idea. You do want to set aside money, though, on a regular basis outside the company so that you have a separate stream of income and assets to rely on during the difficult times.

Sometimes you may be called upon to put those into the business, and I think that’s very important. Other times you may be able to lean on those to live off of rather than take money out of the business. So I think they will help build your longevity in business. Now we talked about our profit. We talked about our cash flow. Now we talked about our cost structure, fixed and variable costs.

For each business, those can be a little bit different. I’m not going to go into details, but that’s something you can work on, and I have a worksheet associated with this podcast on our resource page at www.BizSherpa.co. You can go there and look and work out what you’re fixed and your variable costs are. And there’ll be a break-even formula at the bottom for you to calculate what your break-even point is, based on your cost structure.

Now with that in mind, you also need to understand the difference between cash flow and profits. Often it’s really easy for business owners to slip into this and believe me, I understand, and I understand where you are on this. And I’m not making any accusations here, but I don’t know how many times as a CPA I had clients who called me from among the 700 small business clients I had and said, “Craig, you know, we’re running out of cash. We’re just not making money.” And I thought to myself, “Well let’s sit down and look and see how much money you’re making and what’s happening to the cash.” Let me walk you through a very basic scenario and I’ll put up the slide right now so that you can see it.

But the basic scenario is a t-shirt business. Let’s say that you go into business and you sell $15,000 worth of t-shirts that cost you $5 per t-shirt. And that’s a thousand t-shirts. So a thousand t-shirts at $15 is $15,000 in sales in the first month. And then your cost is $5, so your cost is $5,000. So 15,000 minus the 5,000 gives you $10,000 of profit. That’s your gross margin, not your profit.

So now you have to look at your fixed costs. Let’s assume your fixed costs are rent of $3,500, insurance of $3000, utilities $425, advertising $500, interest at $400 and salaries of $4,000, or $9,125 in expenses. You made $875 that month in profit. But your cash flow may not reflect that. Let’s say you had a loan and that you had to produce—because you thought you would sell more than a thousand t-shirts, so you made 5,000 t-shirts or spent $25,000 on t-shirts that month to produce them.

Your sales were $15,000, so you collected $15,000, you incurred a cost of $25,000 just to produce the t-shirts. So you’re in the hole $10,000 before you even get out the door to sell. Now you have $9,000, $9,125 of expenses, so you have negative cash flow of $19,125. Now you might ask, how did you get to a negative balance, it’s because you had cash in the bank when you started. It was either your money or a loan.

But let’s say you drew down $19,000 that month, so you’re feeling pretty weak, but it was your first month in business. And maybe your t-shirts take off and start to sell, and then next month you sell 4,000 t-shirts. That would bring in $60,000. Guess what? They cost you the extra $20,000, $5 a shirt, 4,000 t-shirts, $5 a t-shirt, 4,000 t-shirts. That means $20,000. You brought in $40,000 before your expenses of 9,000.

Now all of a sudden you’re up $31,875 if positive cashflow the next month, if you produce no more t-shirts. So you can see the swings that can take place in cash flow. Your profitability won’t swing that much. Let’s go through that profitability calculation. It’s $60,000 minus $20,000, so you made $875. You won’t always necessarily have a negative cash flow month. Let’s look at why you had negative cash flow.

You made 5,000 t-shirts. They cost you $5 each. There’s $25,000. You only brought in 15. So you’re $10,000 in the hole, and then you incurred $9,125 of expenses. So your negative cash flow was $19,125. But hold on, this was your first month in business. You had cash in the bank so you’re able to cover that, but you don’t want to go $19,000 in the hole every month, right? That’s not a winning proposition in business.

Let’s say the next month you sell all 4,000 remaining of the 5,000 t-shirts and produce no more. At $15 a shirt you bring in $60,000. You incur, from a cash flow standpoint, no more costs to produce because you already paid it the prior month and you incur $9,125 of operating expenses. So you have $50,875 of positive cash flow in your second month of business.

Now it’s probably not prudent to not have inventory to start your third month in business, but great that you sold out. What was your profitability? The profitability would be the $60,000 in sales, less $5 a t-shirt for 4,000 t-shirts or $20,000. So you have $40,000 gross margin, less your 9,125 of fixed costs, to result in $30,875 of profit in your second month of business. Imagine that.

Now if your t-shirts take off, that’s great, but you can see that how you invest your money in inventory and equipment and other costs can determine your cash flow. That’s the key to operating an effective business, understand your cash flow. It’s not always easy to predict sales, but you need to be careful to be not overstocked. You know, the last thing you want to do is have too much invested that you can’t make it productive.

So you need to determine how to start your business and how to grow it so that it becomes productive. The best problem to have is to sell out and not be able to deliver. The worst problem to have is to not get the sales you are expecting, and to have too much money in a product that’s not selling. So these secrets of understanding cash flow and understanding costs together—they harmonize and they allow you to become in charge of your future.

As I mentioned, it’s so often easy for us as business owners to get confused. We work hard and then trying to figure out what the finances look like also adds burden to it. If that’s you, hire someone to help you, but look back and always have a finger on the pulse of where you are on your cash flow and on your profitability. As you understand your cost structure, you’ll make better business decisions.

After all, that’s what it’s about. And when you make better business decisions, you’re in a happier mood. You’re more able to interact with your customers and your employees, and be able to really achieve the friendships and achieve the relationships to mine that emotional reward that comes from owning an effective and successful business. After all, it’s success that we’re after.

Remember, many people start their business to make money, but I say you start a business so that you can exceed other people’s expectations. When you understand that, the money seems to take care of itself. No one ever started a business that really meant to take care of other people, and didn’t really have … No one ever regretted starting a business with the objective to help other people. If we start solely to make money, people are going to sense that, and they’re going to shy away from us because they feel that we’re only after their wallet.

I’m grateful that I was able to get an education in accounting. Now that doesn’t mean that every business owner should be an accountant. I don’t recommend that either, because sometimes we’re too conservative and may miss opportunities. But my education gave me the opportunity to understand those costs and to be able to effectively manage them. I suggest that if you don’t understand those, that you find people who you can surround yourself with who will. As you do so, you’ll make better decisions, you’ll meet the expectations of the people that help you finance your business, whether it’s friends, family, yourself, or a bank.

And the better you do at that, the more successful you’re going to be. They’ll look forward to understanding your situation when you need seasonal borrowing, and be able to lend to you during those times when you need it, because you’ve been able to prove that you know and understand your costs and are able to repay each time you borrow. This is extremely important.

I think part of that’s called integrity, but some of it is just understanding your market and your business. I hope this, combined with niche marketing and pricing, will help you. Pricing is very important in this component. You can always discount, but it’s very hard to raise prices. I think you watch James Stephenson, who talked about that. He started low and got some market share, but he’s found it very hard with some of those initial accounts to raise the price, even though the quality of the service that they give doesn’t even compare to what they originally were doing. And I think that’s important for us to take into heart, that we need to value our own services. Someone once told me if you don’t value it and highly value it, no one else will.

I wish you continued success. Thanks for joining me on today’s episode. This is Craig Willett, The Biz Sherpa.

Speaker 1:
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