This is From Pillar 1 Your Key Numbers and Module 3
Let’s try to de-construct your accounts and take your numbers down to the basic drivers of performance. Sales (revenue) and costs are like the two blades in a pair of scissors and the profit is the gap between them. In effect, profit is the small difference between two much bigger numbers.
You can’t work directly on profit because you have to influence sales (revenue) and costs.
Sales or Revenue
Your sales or revenue equals the volume sold multiplied by the average selling price.
A consultant may sell 100 days per year at £1,000 per day and have total sales of £100,000.
A steel stockholder may sell 2,000 tonnes of steel in a year at £400 per tonne and have total sales of £800,000.
In a multi-product business, total sales equals the cumulative of the quantity sold of every item multiplied by the price.
A coffee shop or bar may sell 15,000 coffees at £3 each plus 5,000 cakes at £2 and so on…
Every business can be taken down to quantities and prices although some are easier to understand than others and once you understand the basic principles, we may have to revert to money for your business.
Total Costs = Variable Costs & Fixed Costs
Costs can be split into two categories – variable costs and fixed costs.
Variable Costs
Variable costs depend on the volume sold.
Just like sales, it’s the volume sold multiplied by the average cost price per unit.
So if the consultant who sells one hundred days of consultancy subcontracts 25 of those days at £800 per day to a related specialist consultant, then the cost would be £20,000 (= 25 * 800).
If he sold an extra day of subcontracted consultancy, the cost would increase by another £800 because it is a variable cost.
If the steel stockholder sells more tonnes of steel, then the total cost of steel sold increases.
If the café owner sells more cakes they bake themselves and assuming everything made is sold, more money would need to be spent on ingredients because it all links back to volume.
Fixed Costs
Fixed costs are independent of volume … and instead …a matter of time or management decision. Fixed costs don’t automatically increase when sales go up.
The café owner is going to have to pay the same rent for the premises regardless of whether there are ten customers per day or a thousand.
The consultant may decide to attend a £5,000 advanced course and the costs don’t vary whether he sells 10 days or 200 days of consultancy per year..
I hope you can now understand the difference between variable costs and fixed costs because it the key to what follows.
You may want to stop for a moment and write down some of your costs and decide whether they are variable or fixed.
If you sell one more, would your costs change?
What about if you sold 10% more?
Return to P1M3 How Profit Is Created
or move to The Real Income (link)
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