I was watching I Love Lucy last weekend. It was the episode where Lucy and Ethel go into business selling Lucy’s salad dressing. When they realize they’re losing money on each individual jar, Lucy says “We’ll make it up in volume.” She could not have been more wrong, which makes for a great episode, but our businesses aren't sitcoms.
I am always a bit surprised at the number of people who set up their business and start selling, without having a clear picture of their costs. If you don’t know your costs, you can’t know if you’re making a profit. I know I’ve talked about this before, but let’s review…
Revenue (money that customers pay you)
Direct Costs (everything that goes directly into making your product – setup costs, labels, packaging, any materials used in production, production labor, and anything else needed to produce an item)
Gross Profit (Revenue minus Direct Costs)
The Gross Profit is then used to pay your rent, phone, advertising, employees, yourself etc… Whatever is left is your net profit, so hopefully you have something left.
Now, if you have more than one type of product or design, it’s best to cost out each item separately. That way, you can tell which make money, and which (if any) lose money. Some people lump certain direct costs in with overhead/sales costs. If you do this, you can’t tell which products are profitable.
For example, if you have a graphic tshirt business, complex designs may have an initial setup cost of up to $500, and simple designs might be $100.
If all other direct costs are $4.00 per shirt and you sell the complex design for $9.50, that leaves you with $5.50 per shirt to cover the setup cost. You must sell 91 shirts before making gross profit on that design.
If all other direct costs are $4.00 per shirt and you sell the simple design for $6.50, that leaves you with $2.50 per shirt to cover the setup cost. You must sell 40 shirts before making gross profit on that design.
Because you pay your rent, utilities and yourself with your gross profit, you only want to carry products that earn a gross profit. You make more per shirt with the fancy shirt, but if you only sell 50, you've lost money. If you sell 50 of the other shirt, you're $25 ahead.
I have oversimplified this example, but hopefully you can see how important it is to understand how much it costs to produce your goods. I know accounting and numbers are painful for some of you, but this information will let you know what works and what doesn’t. And only then can you make necessary adjustments to your product line.
