Why it's crucial to calculate how much you have to increase your sales by, BEFORE you commit to a new business cost.
A blog from Growth Hub Client SAS Business Box
Before you make any commitments to additional costs this year, it is imperative to calculate how much more you need to sell, in order to pay for these additional costs. If you aren't confident you can generate the extra sales needed, don't make the commitment.
From success to a BIG mess!
My Dad is a serial entrepreneur and in 1983 he started a double glazing business that manufactured and installed windows, doors and conservatories. He had a factory, a showroom and 8 employees. Also, 4 teams of self-employed fitters and 2 salesmen. By 1986, the company had a turnover of more than £1M and was making a profit, so my dad decided to expand his sales team and also lease company cars for them. He did what a lot of business owners do. He saw the additional overhead costs as the cash outlay only and didn't work out the required increase in sales, to pay for the additional costs. The company gross margin was 35%. So, for every £1,000 of additional cost, sales needed to increase by £2,857, to leave the same net profit (after tax) Unfortunately, although there was an increase in sales, it wasn't enough and my dad had to use cash reserves to keep the company going. The stock market crash of 1987 had a big impact on the struggling company and it didn't survive. We lost our family home!
It doesn't have to be this way!
So, how can you avoid a similar situation? Before you commit to any new costs, work out how much more you need to sell to support this decision and know you can achieve this sales target, BEFORE you make the commitment. Here is a table showing the extra sales you need to achieve for every £100 of additional cost you commit to. There are three columns:
-
Gross margin.
Sales - Cost of Sales = Gross Profit (GP)
Gross profit/Sales = Gross margin (Basically the GP as a percentage of sales)
Watch this video to understand the difference between Gross Profit, Operating Profit and Net Profit. - Additional cost of £100
- Sales needed to cover the new cost and still leave you with the same net profit
Here is a table showing the average gross margins of various industries in the UK over a period of one year.
So, you can see that most businesses have a gross margin of less than 100%. It's never just the cash outlay. Sales have to be more than any additional cost, if you want to be able to pay for it and have the same net profit.
How to calculate the sales needed to cover your additional cost.
Lets say your additional cost is £200 and your gross margin is 80%. The calculation is: (£200/80) x 100 = £250 So, for every £200 of additional cost, you need to sell £250 more to cover the cost.
Summary
It is common to think of additional costs in terms of the cash outlay only. In order to protect your net profit (the amount you want to be left with after you've paid for all your costs and the tax due on your operating profit), it is imperative that you work out the additional sales you need to cover this new cost. You can calculate this for yourself or use the Revenue Target Calculator on The Box. You plug in your numbers and it works out your sales targets for you. Don't fall into the same trap as my dad! Work out your sales target. If you feel confident that you can achieve it, then make the commitment!
Find out more about SAS Business Box on their website.
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