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Identifying Your Operating Costs...

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  7. Identifying Your Operating Costs

Before you can calculate the profit potential of your business, you will have to identify all of your operating costs and classify them as either fixed or variable costs. 

creating an online home business

Gaining a good understanding the business operating expenses of your new venture is critical to the success of your startup and is a core element of the potential profitability of your business model.

Understanding your costs and what drives them is also important for anyone attempting to manage or grow an existing business and it is important information for anyone developing a business financial plan.  

The data you collect will also be invaluable when you are developing the operating budgets for your business.

The process is the same whether your business is online or offline, although it is easier if you have been operating for a while as you are less likely to miss (leave out) any costs for you analysis. 

Identifying all of your operating costs is the important first step.

But you will not be able to see the patterns in your costs until you classify them as the two types of costs (fixed and variable) behave very differently.   

The definitions for these two classifications are: 

  • Fixed costs are costs that do not vary in total as sales or production volumes changes over a relevant output range. These costs include administration costs such as rent (hosting), salaries, utilities (electricity, internet charges), and depreciation.
  • Variable costs are the costs that you incur as you produce or sell your products or services. These cost vary with any changes in production or sales volumes, and include costs such as material costs, sales commissions you pay to others or shipping costs.

What this means is that you have to pay the fixed costs whether your online business makes any money or not, while your variable costs will increase or decrease as your sales go up or down. 

Step 1: Identifying your Operating Costs

You will need to know what your operating costs are likely to be so that you can:

Your operating expenses will be reported in your Income Statement, Operating Budget and Cash Flow Forecasts will consist of the cost of sales, selling expenses and administrative expenses. Examples of operating expenses include:

Administrative Expenses

  • Accounting Fees 
  • Advertising 
  • Bank Fees and/or Merchant Account Fees
  • Depreciation 
  • Insurance 
  • Management Applications (online services - bookkeeping, email management, scheduling, video or image hosting etc.)
  • Membership Fees or Subscriptions 
  • Office Supplies 
  • Postage
  • Post Office Box
  • Rent
  • Salaries and Wages (non-production)
  • Telephone and Internet Costs
  • Training and Development Costs
  • Utilities
  • Vehicle Expenses
  • Website Development and Maintenance
  • Web Hosting

Production Costs

  • Freight In 
  • Inventory Purchases 
  • Equipment Leases 
  • Production Labour 
  • Raw Materials 
  • Wharehousing

Selling Expenses

  • Distribution Costs
  • Freight Out
  • Packaging Materials
  • Sales Commissions
  • Sales Discounts

This list is in no way comprehensive, as the number and type of operational costs will vary from one business to the next depending on the type and size of the business. It is presented here as a guide and a memory jogger for you as you begin to identify the operating costs for your business.

As you work your way through all of your expenses and estimating the amount you are likely to spend on each of them, make a note of the frequency - how often will you be buying inventory, or stamps or paying the freight company? Will you be paying for your business insurance one a year or on a monthly basis?

And also work out how quickly could you eliminate the cost - can you cancel at any time or the cost the subject to a fixed term contract?  Do you have to pay it every month or do you only make the purchase when you need to?

You are going to need this additional information for your detailed Income Statements and for your Cash Flow Statements.

Step 2: Classifying your Costs

Once you have identified all of your operating costs the next step is to classify the costs as variable costs or fixed costs. The reason for doing this is in the nature of the costs. 

Variable Costs...

 are just that - they vary with changes in proportion with any changes in sales.  Examples of variable costs would be raw materials or sales commissions. These costs are not incurred unless the product is manufactured or sold.  

There are other decisions around some of your variable costs, like do you plan on buying raw materials as you require them or will you keep some on hand?  If you are going to be holding inventories, you also need to consider storage costs - where are you going to hold them and will it cost more to do so - and is there likely to be any wastage due to items going out of date or becoming obsolete?

All of these decisions will have an impact on how your set up your business and what your operating  costs will be and it is better to consider them all up front, rather than face some unpleasant surprises later on!

Fixed Costs...

Fixed costs are fixed, in other words, they will remain the same regardless of how many widgets you sell. Examples of fixed costs would be rent, equipment leases, telephone contracts etc.   

Some costs will fall in between the two classifications and you will need to make a decision using your best judgement based on the time period you are using and how those particular costs typically behave.  For example, most salary costs (particularly production salaries) are deemed to be variable as they vary with  levels of production, but in most cases, even if you decide to increase or decrease your workforce it generally takes time to accomplish the required changes.  

So often salaries are treated as fixed in the short to medium term.  It may be that a certain percentage of your workforce is treated as fixed and the balance is treated as variable.  This can be achieved in practice by hiring your core people on a permanent basis and managing the periods of higher and lower demand using casuals.

Next Steps...

Once you have identified all of your operating costs and classified them as either fixed or variable you will be able to calculate your break-even point.

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