I recently spoke to a business owner who has been struggling with his business. He told me that his business is doing well and he keeps getting new customers, but at the end of the day, the business keeps making a loss.
During our conversation, I realised that he did not have a total overview of all his costs and expenses. He also told me that he used money from the business to pay for family and personal expenses. This is something that many business owners do. It is not a problem, but it can make you think your business is not doing well when in fact it is doing well by itself.
For example: it is possible that your business is making a profit but the profit is not high enough to cover family expenses. The result will be a loss. Of course, you need to take action to address this situation. But the action you take will be different from the action that is needed if the business itself was making a loss.
So how to deal with this?
I advised the business owner to take the following 5-step approach. If you are facing a similar issue in your business, it would be a good idea to try it too.
- Get a clear understanding of all your expenses and costs
- Separate business and personal expenses
- Divide business expenses into direct and indirect costs
- Determine where to cut costs
- Make adjustments as needed in your business
1. Understand all your expenses and costs
To understand your costs and expenses, you should start with record keeping. In the ideal situation, you will record all money inflows and outflows during the full year. Once you have completed a full year, you will have a good overview of all your expenses.
However, if you have never recorded this business data before, start today. You should record all your expenses for at least three months to get an idea of how much and how often money is leaving your business. Note: you should also record all the money that is coming into the business.
In my post about how to keep records, I gave an example of recordkeeping.
|Jan 2, 2021||Personal||Notebook||– 5|
|Jan 4, 2021||Business||Sale of product A||250|
|Jan 9, 2021||Business||Phone top-up||– 25|
|Jan 11, 2021||Personal||Transportation||– 20|
|Jan 11, 2021||Business||Transportation||– 80|
Note: when you talk to an accountant or auditor, they will tell you that there is a difference between costs and expenses. That is true. This is the definition:
- A cost is a one-time outlay of money acquire something. For example: buying a car or a buying land for a production facility.
- An expense is an ongoing outlay of money. For example: rent, salaries or your phone expenses.
2. Separate your personal and business expenses
If you are already recording this data, your next step will be to separate business and personal (or family) expenses. This is an important step that will help you determine if your business is making a profit or loss.
From the example above, you will see that I recorded the Type as Personal or Business. Sometimes an expense may be partially for your business and partially a personal expense.
For example: you go to town to buy stock for your business and you also use the time to do some personal errands. Your transportation expense is therefore partially for business purposes and partially for personal reasons.
In this case, you can divide the amount you spent between the two types. For an example see my entry for January 11. I recorded the transportation expense of 100 partly as personal (20) and partly as business (80).
3. Divide business expenses into direct and indirect costs
Once you have your overview of all costs and expenses, you will review it one more time. The review you are doing now is to determine which items are linked to which part of your business operations.
Direct costs: any cost that is incurred to produce a product or service. There is no way to produce your product or service if you do not have these costs. Here are some examples:
- Furniture business: the cost of wood, other materials to produce the furniture, and tools
- Manufacturing: the cost of production workers, raw materials, equipment, and rent & utilities (electricity and water) of the production facility, not your office building
- Transportation company or tour operator: the salary of the driver and fuel
- Consulting firm: the billable hours of your consultant(s), staff training to carry out a particular project
- Construction company: the daily wage of workers, building materials
- Retail company: the price of buying the products for resale
Indirect costs: any cost that is not directly related to manufacturing a product or creating a service. These are the expenses you have for any activity that supports your core business. Here are some examples that many businesses will recognise:
- Cost of transportation or distribution
- Marketing expenses
- Packaging expenses
- Salaries of IT support, security and administrative staff
- Office supplies
- Insurance premiums
- Phone cards or phone subscription
- Purchase of business cards
- Rent of your office building (not your production facility) and utilities (water and electricity) at your office building
You will use this to calculate your Cost of Goods Sold (COGS). This can be used to find out if the products you are selling are making a profit. I will explain how to do this in another blog post. For now, what you need to know is that:
- If you are selling retail products, your COGS is the price that you pay to your supplier.
- If you are selling services, your COGS will include your billable hours and anything that you had to buy specifically for this particular contract.
- If you are doing manufacturing, producing goods to sell to customers, your COGS will cover raw materials or ingredients, maybe storage and transportation costs, labour expenses (if you have employees), and – if you have a rented production facility – the rent you pay for it.
4. Determine where to cut costs
Once you have all your costs and expenses, review them carefully.
- If the information is available, use industry benchmarks to determine if you are spending too much money.
- If possible, compare your expenses and costs to your competitors. For example: if you have a similar business, are they spending the same amount of money on insurance or utilities as you?
- If this information is not available to you at all, just take the time to review your total list and evaluate whether there is any area where you can reduce costs without affecting your business.
- Also carefully review your personal and family expenses. Is there any way to reduce some of those expenses? Maybe a family member can also help to bring in additional income to reduce the dependency on the business.
While you may think that it is not possible to cut costs, there are many ways to find creative solutions.
For example: can you rent or lease the equipment you use instead of buying it? Can you introduce a cheaper product at the same or similar quality level? Can you agree long term contracts with your suppliers at a reduced rate? To do this, you need to understand your inventory. I will talk about this later.
You can also do this with regular customers. Can you convince them to buy a package deal or get a subscription? A package deal or subscription could be a monthly package of multiple products that they use. The benefit for you is that you know how much stock you need and you can save on storage, transportation and even marketing.
5. Make adjustments in your small business as needed
Once you have collected this business data, it will give you a lot of information about your costs and expenses. You can now use the information to start looking for ways to reduce your expenses.
Reducing costs and expenses will position your business to generate higher profits. Higher profits will help you to create financial reserves. Financial reserves can be used to invest in your business without having to depend on money from outside. I believe that is a good place for any business to be.