No one goes into business or makes investments without the aim of making money. Successful entrepreneurs and investors know that making money comes with a cost.
For investors, it is the capital, time and percentage returns (%ROI) that determine these costs. For entrepreneurs, it’s the capital and operating expenses incurred that reveal the cost of making money. Here, we’ll focus on the cost of making money in your business (this is also an investment to the entrepreneur).
Why is it important to determine the cost of making money?
For every cost incurred in the course of your business, there should be an expectation. Determining these costs will make you strategic about your business operations. With this, you know which expenses are necessary or not.
Depending on your business model, you can optimize your business operations to spend less which is more money for you. Some other reasons for this include:
It helps you achieve a feasible financial plan
It helps your business cope with unexpected fluctuations
The costs are specific to the needs of your business
You have an estimation of the profits to expect
You know which aspect of your business needs more or less
How to determine the cost of making money
Check your Business Model
A business model refers to how your company makes money and generates revenue. This is the framework for daily operations and production activities.
Does your business involve manufacturing products or providing services? Do you manufacture or buy the products you sell? Do you rely on human resources alone or do you also need specific equipment to operate? How do you reinvest your earnings? Which percentage of profit will you reinvest?
These questions will help you understand the nature of your business and determine the feasibility of your business model. It also helps you determine what to include when determining your overall business cost and which category the various expenses belong to.
Determine production costs
Production costs include the expenses incurred in producing goods or offering services. This plays a key role because it determines how much your business makes in the long run. The production cost includes fixed (like rent and cost of equipment) and variable costs (labour, raw materials, utility etc). It is also influenced by your business model.
Also, there could be an unexpected hike in the variable costs. With a frequent visit to your production costs, you can determine when your business will likely run at a loss and revisit your strategy where necessary.
To determine the production costs, add the total direct labour and material costs with the total manufacturing cost (indirect costs).
Total Production Costs = Direct labour cost + Direct Material cost + Total manufacturing overhead
Cost per unit of production = Total production cost _______________________
Number of units produced
Determine Operating costs
“While production costs are specific to the production process, operating costs cover the overall business operations.”
Operating costs reveal how much you spend in your daily business operations. They consist of the cost of goods sold and the operating expenses.
Cost of goods sold refers to the cost of goods purchased or manufactured by your business. Operating expenses are not directly linked to the products you sell but refer to the costs incurred through regular business operations (direct, indirect and general administrative expenses).
Total Operating cost = Cost of goods sold + Operating Expenses
For a manufacturer, Cost of goods sold refers to the cost of production.
You can make smart business choices by determining the cost of money you make. Comparing your operating cost to the profit your business makes will help you make long term decisions. As a business owner, this is the key to staying abreast in difficult periods.
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