Basics for
Engineers
by
Mike Volker
|
|
Business
Basics for Engineers by Mike Volker |
The Cost of Goods sold is what we expect it to cost us to produce those units which we sell in that particular month. This is easy if we outsource, i.e. buy our products from another company. If we make the products ourselves, we will have to carefully analyze our costs - materials, labor, and some overhead allocation. This may entail a completely separate spreadsheet. In this example, we are working on the basis of outsourcing our production requirements. This may increase our direct costs somewhat, but will allow us to keep our indirect, i.e. fixed overhead, costs down initially.
In the "Expenses" category, we have broken our expenses down into three commonly used categories: Sales expenses, Research and Development (R&D) expenses, and General and Administrative (G&A) expenses. Each of these categories should be broken down further as to salaries, office costs, rent, utilities, etc. Salaries usually account for the bulk of the expenses in each category. We might even want to show a subtotal for salaries to help us in our planning. It is relatively easy to produce estimates of expenses. These estimates are driven by our marketing mix and how aggressively we wish to build our venture. It is a good idea to do some sanity checks by consulting with peers in your industry. Also, review some statements of publicly listed companies to get additional ideas.
What about equipment and facilities expenditures? Where do these go on a P&L projection? And how to we account for depreciation? Well, usually on a first-pass projection, you may not go into great detail on equipment and facilities. You could use some monthly rental or lease figures to substitute for equipment or facilities investments. However, depending on the nature of your business, e.g. software vs hardware, you will undoubtedly have to include these items. Major capital equipment expenditure items belong in the cash flow projections. In the P&L, it would be useful to include any carrying costs, lease or finance costs, as well as depreciation calculations.
The "Total Expenses" line will be very useful to you. Because it is a line that you control, almost absolutely, you can very quickly estimate your break-even point (i.e. how long will it take until you start to make a profit), and be able to develop a sense of your "burn rate" - i.e. how much you are spending each month, assuming no revenue from sales. Even though these expenses do not equate exactly to cash flow, they give you a good "feel" for initial cash requirements because you know that these expenses will have to be paid for either in the current month or the month following.
When looking at financial statements of other firms (which are readily available - especially for junior public companies such as those listed on the TSX Venture Exchange), look also at their margins and ratios and compare these to yours. This is a good sanity check on your numbers. If you're showing a gross margin of 20% and others are showing 40%, you may be out to lunch!
After you complete the detailed planning for the first two years, it may be sufficient to project results for the subsequent three years by using certain targets and goals and applying these to your spreadsheet. Month-by-month numbers should be prepared for the first two years. You can then apply some formulas to your annual figures for year two to produce the following years. At the early stages of business development, you will be updating your numbers very frequently. The reason for having a 5-year view is that it will show you how well you are seizing the market opportunity which you have identified and it gives you and potential investors a "dream" to shoot for.
In this example, we will only look at the first year's plan on a month-by-month basis for the sake of brevity. Our profit and loss projection for the first year should therefore look something like this:
MONTH#1 MONTH#2 MONTH#3 ... FYTOT: (FY = "fiscal year") GROSS REVENUE($): 11200 27720 54886 ... 2162713 (taken from sales forecast) COST OF GOODS SOLD: 7680 19008 37636 ... 1483003 GROSS MARGIN: 3520 8712 17250 ... 679710 (this is your variable cost) EXPENSES: Sales: 9060 8167 12222 ... 199954 R&D: 1100 867 1022 ... 92044 G&A: 1100 1267 1322 ... 93944 TOTAL EXPENSES: 11260 10300 14567 ... 385942 (these are your fixed costs) NET PROFIT (BT): -7740 -1588 2683 ... 293768(NB: This spreadsheet can be downloaded for those who wish to study it in greater detail.)
This tells us that, in our first year of operation, we will be profitable to the extent that we will earn $293,768 in net profit (before taxes are calculated).
What we have developed so far is a financial profit an loss statement that looks very much like those reported by companies in their annual reports to shareholders. There is some additional terminology which is worth mentioning (just in case someone mentions these terms, you'll know what they mean). The costs associated with the actual production of goods shipped (i.e. "cost of goods sold") are usually referred to as "variable" or "direct" costs. These costs will vary directly with our output - the more we make, the more raw materials and units of labor will be used. If we have a factory in which we produce these goods (rather than buying from subcontractors), then there may be a certain amount of factory "overhead" or "indirect" cost which is "fixed" regardless of volume. Of course, these gets into the topic of capacity - usually a given fixed cost will allow us to produce a range of output units (e.g. a 3,000 square meter plant will give us a capacity of 10,000 units per year). Fixed costs are usually reported under "Expenses" rather than as cost of goods sold for convenience.
I once had a comptroller who said "there is no such thing as a fixed cost". Of course he was correct. If you have to slash costs, nothing is sacred. Insofar as it is practical to keep costs variable, it makes good sense to do so. By adding extra facilities, equipment, space and people, fixed costs increase, thereby increasing the output required to cover these fixed costs before a profit can be reported. In the "Sales and Marketing" expenses category, you might show your team of salespeople as "fixed" overheads because they are on salary whether they sell or not. On the other hand if you make some (or all) of their compensation commission-based, you have just converted these expenses to direct or variable ones!
Of course, as time marches on, you will show month by month increases in your staffing and facilities in order for you to ramp up to the sales numbers you are planning to achieve, i.e. increasing these fixed costs. You will hear venture capitalists and others referring to your fixed expenses as your "burn rate". So, if your burn rate is $50K/month and you have $500K in the bank and no sales, it takes little thought to figure out that you'll burn out in 10 months - faster if you're also building up your inventory!
From this P&L we can now develop a cash flow statement as well as balance sheets.
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