The humorous story below demonstrates why you won’t get ahead unless you make more money than you spend.
“A partnership was created by two men. They constructed a simple shed next to a busy road. They rented a truck and drove it to a farmer’s field, where they paid a dollar a melon for a truckload of melons. They drove the loaded vehicle to their roadside shed and sold their melons for a dollar each. They returned to the farmer’s field and purchased another truckload of melons for $1 each. They transported them to the roadside and sold them for a dollar each. ‘We’re not earning much money on this company, are we?’ one partner muttered to the other as they drove back toward the farmer’s field to get another load. His buddy said, ‘No, we’re not.’ ‘Do you believe we require a larger truck?'”
The men in this narrative, as odd as it may appear, were caught in a common business problem: their revenue did not exceed their costs. The amount of money you receive when you sell something is referred to as revenue. However, just because you sell something doesn’t imply you’re making money. Like the two men in the narrative, you could be selling at a loss. To make money (generate a profit), you must sell your product for more than it costs.
Fixed Versus Variable Costs
Finding out what your costs are in relation to your revenue is the first step toward profitability. Let’s begin by calculating your expenses. Fixed costs and variable costs are the two categories of costs that most people are familiar with. Fixed costs are expenses that must be paid regardless of whether or not you sell anything. For example, even if you don’t sell any lemonade, you must pay the rent on your lemonade stand. Rent, salary, loan payments, and utilities are all examples of fixed costs (power, water, gas, etc.).
“Would I have to pay for this even if I didn’t create any products or services?” is the key to establishing if something is a fixed cost. It’s a fixed cost if the answer is yes.
Variable costs are those that vary depending on the number of units produced. Because variable costs are directly related to the creation of a good or service, they are also known as direct costs.
Consider it similar to owning a car. Even if you don’t drive it, you must pay for it (that is your fixed cost). The more you drive it, however, the more money you’ll pay on gas, maintenance, and tires (those are your variable costs).
Profit and Loss
Your revenue is the second factor to consider when determining your profitability. By multiplying your sales price by the number of units you sell, you may compute your revenue. If you sold 25 glasses of lemonade for $1 each, for example, your profit would be $25 (25 x $1 = $25).
By deducting your variable costs from your price, you may figure out what percentage of your sales goes toward covering your costs. This component is referred to as the contribution margin because it is the fraction of each sale (for this product) that goes toward covering your fixed costs. So, if your variable expenditures were 25 cents ($0.25) per cup in our example, you’d have 75 cents ($0.75) left over to meet your fixed costs ($1 -$0.25=$0.75).
Once you know your costs and revenues, you can figure out how many units you’ll need to break even—the point where your total costs and total revenue are equal. To put it another way, this is the point at which you have covered all of your expenses but have yet to make a profit. It is critical to understand your break-even point when running a firm. You can determine whether there will be enough demand to pay your costs and, perhaps, create a profit.
To review some of the core aspects, let’s take a closer look at the break-even chart from the video. This graph displays when you’ve sold enough units to cover your fixed costs.
While graphing these lines is a terrific method to visually depict profit and loss, what if you needed to figure out exactly how many units you needed to break even? You may obtain that number by dividing your fixed costs by your contribution margin using simple math. Remember that your contribution margin is the difference between the pricing and the variable costs. As a result, we can express the break-even formula as follows:
(Insert Break Even Point Formula)
You can rapidly determine how many cups of lemonade you’ll need to sell to cover your costs using this method. The actual break-even threshold in our previous example is 667 units (500/.75=667). A break-even analysis is one of many business tools that may be used to determine a company’s profitability. In the next section, we’ll go over some additional frequent words and formulas.
Understanding Business Terms and Ratios
In business, we use a variety of phrases to describe various parts of a business. We’re going to try to make the semester project basic. However, we must first define a few key concepts. You’ll notice that we’ve left a few things out if you’re familiar with business operations. Regardless, the ideas remain valid.
The term “gross profit” is one that you’ll need to know. After eliminating your variable costs, your gross profit is the amount of money left over. It’s a crucial figure because gross profit is what you’ll utilize to cover your fixed expenses. It’s computed by dividing your revenue by your variable costs. Let’s look at an example to show what we’re talking about. Your total sales revenue would be $1,300 if you sold 1,300 glasses of lemonade at $1 a cup. Your total variable expenses would be $325 if your variable costs were.25 per cup (.25 x 1300). After subtracting $325 from $1300, the gross profit is $975.
Sales Revenue – Variable Costs = Gross Profit
1300 -325=975
The next phrase you should be familiar with is net profit. After you’ve paid all of your expenses, your net profit is the amount of money left over (variable and fixed). Because it represents the amount of money you made or lost over a period of time, net profit is also known as net income or your “bottom line.” Net profit is calculated by removing fixed and variable costs from revenue. Let’s use our prior example of $500 in fixed costs to determine net profit.
Sales Revenue – Variable Costs – Fixed Costs = Net Profit
1300 -325 -500 = 475
You’re now seeing something you didn’t see before in your calculations: the amount of money you actually make. Net profit gives you a far more accurate picture of your profitability.
While raw numbers are useful in calculations, financial data is frequently presented as a ratio to provide context. It would be difficult to compare the profitability of one lemonade stand to that of another simply by looking at their net profit. You should investigate their profit margin. The profit margin is the amount of money you keep as a percentage of your total revenue. If Sarah’s lemonade stand makes a net profit of $500 and James’ lemonade stand makes a net profit of $400, you’d assume Sarah’s stand is more profitable.
However, dividing their net profit by revenue yields a ratio that shows how much of each dollar they profit from. You can calculate your profit margin using the formula below:
Profit Margin = Net Profit / Revenue
Sarah’s profit margin (or ratio) would be 25% if her revenue was $2,000 (500/2000=0.25). If James’ earnings were $1,100, The profit margin for him would be 36% (400/1100=0.36). This implies James keeps 36 cents ($0.36) for every dollar of revenue he generates.
That’s 11 cents ($0.11) per dollar higher than Sarah’s business. This indicates that James is more effective at turning sales into profits.