To determine the most important factors with respect to costs in your business, you can calculate critical costs. This will help you to determine profitability and the factors that can and cannot be easily changed to impact your profits and cash flow.
Calculating Total Gross Profit (Contribution Margin)
You can use EOU to calculate whether and by how much you will come out ahead on your per-unit costs for each sale. By using the EOU, you can figure the gross profit per unit (contribution margin per unit sold, which is the selling price minus all variable costs).
Calculating EOU When You Sell Multiple Products
Most businesses sell more than a single product, and they can also use EOU as a value measure of product profitability. A business selling a variety of products has to create a separate EOU for each item to determine whether each is profitable. When there are many similar products with comparable prices and cost structures, a “typical” EOU can be used.
Using a simple average works as long as Jamaal sells roughly the same number of each brand of bar. If he can no longer get Chocolate Delight and Almond Euphoria at some point, for example, he should then change his EOU to reflect the higher price of the other two bars.
What if each unit of sale is made up of a complex mix of materials and labor? The EOU can still help you figure the COGS, other variable costs, and gross profit for the product, although the process will be more complex.
Example: Denise sells sandwiches from her deli cart downtown on Saturdays. She sells each for $5. The materials and labor that go directly into making one sandwich are the COGS. The costs of the materials and direct labor for production are called inventory costs until the product is sold. There will also be some other variable costs, such as napkins, a paper wrapping for each sandwich, and plastic bags. First, make a list of the COGS and any other variable costs:
- Turkey costs $2.60 per lb. Each sandwich uses 4 ounces of turkey meat (1/4 of a pound).
- Large rolls cost $1.92 per dozen. One roll is used per sandwich.
- A 32-ounce jar of mayonnaise costs $1.60. One ounce of mayonnaise is used per sandwich.
- Lettuce costs 80 cents per pound. One ounce (1/16 of a pound) is used on each sandwich.
- Tomatoes cost $1.16 each. Each uses one-fourth.
- Pickles cost 5 cents each. Each sandwich comes with two pickles.
- Employees are paid $8 per hour and can make 10 sandwiches per hour (we are assuming no down time and no payroll costs).
Other Variable Costs
- Napkins cost $3 per pack of 100. One napkin is included with each sale.
- Paper wrapping costs 20 cents per foot (cut from a roll). Each sandwich uses two feet of paper.
- Plastic carryout bags cost $7 per roll of 100. Each sandwich sold uses one plastic carryout bag.
Fixed Operating Costs
Costs, such as rent or the Internet bill, which do not vary per unit of production or service, are called fixed operating costs. Total fixed costs do not change based on volume (an advertising cost of $1,000 will be the same whether it generates 50 sales or 500). Fixed cost per unit decreases as the number of units increases ($20 per unit above versus $2).
Fixed operating costs do not changes based on sales activity levels; therefore, they are not included in the EOU. A sandwich shop has to pay the same rent each month whether it sells one turkey sandwich or a hundred. However, the owner of the shop can change the cost of the rent by moving or can increase or decrease the advertising budget, for example. These changes are not calculated on a per-unit basis.
It is easier to remember several of the most common categories of fixed expenses by remembering the phrase:
I SAID U R ∙ “Other FXs”
Insurance
Salaries (indirect labor—managers, office staff, sales force)
Advertising
Interest
Depreciation
Utilities (gas, electric, telephone, Internet access)
Rent
Other Fixed eXpenses
Most of these categories are self-explanatory, but depreciation may need clarification. Depreciation is the percentage of value of an asset subtracted each year until the value becomes zero—to reflect wear and tear on the asset. It is a method used to expense (list as an expense on the income statement) costly pieces of equipment. Some items, such as a computer server, are expected to last for a number of years. A business could choose to expense the server during the year it was bought, but that would not be accurate. The server that will be used for four years will have been only 25 percent “used up” during the year it was purchased. Expensing the entire cost during that year would make the accounting records and financial statements inaccurate. If more than 25 percent of the server’s cost is expensed in the first year, the income statement will show a lower profit than it should. Meanwhile, profits in subsequent years will appear to be higher than they should.
Depreciation spreads the cost of an item purchased by a business over the time. If the computer server is expected to have a useful life of more than one year, the full price should be shown as an asset and then expensed according to federal tax law and accounting practice. The LSBF is the source to learn about marketing and business costs.