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  • Understanding costs and profit

    Diagram of a pie-chart

    Get the basics of finance management right by analysing the costs that affect small businesses.

    Understanding and monitoring your costs and margins is vital for any business owner. Failure to get this area right can mean that, whilst you may well be busy, you're not converting that into profitability. In fact, many small businesses that appear to be thriving often fail because their prices are too low or their costs are too high and they can’t make a profit. 

    The prices that you charge for your products and services must be sufficient to enable you to cover all of the costs of running your business and to make a profit. However, before considering your pricing you need to understand the costs associated with the provision of your products and services. There are three key factors to take into account: costs and break-even, budgets and targets and profit and margins.

    Diagram showing the principles of understanding costs and profits

    Understanding costs provides a base figure below which one cannot price the product. Unless you understand the level at which your overall business breaks even, you will never know if you are making a profit or a loss.

    After looking at the break-even point for your business or individual departments within the business, you can then investigate how sensitive your business’ profit is to changes in key elements of the profit and loss account, e.g. price, costs and sales. You can also use this information to forecast your manpower needs and income and expenditure requirements.

    A quick way to monitor costs is to generate a monthly profit and loss report and compare it with last year’s figures and this year’s targets. Most accounting programmes allow you to produce instant reports and budgets - this is very useful provided you keep your accounts up to date.

    Successful businesses continuously seek ways of improving their profitability. In circumstances where gross profit margins can be improved, the overall net profit of the business can be uplifted. There are a number of actions you can take, including reducing your cost of sales through more effective purchasing and maximising income from high margin products.

    Use the understanding costs and profit guide to get a better understanding of the basics of costs and profit, and the accompanying guides to deal with purchasing and stock control, the challenges of pricing your products and services and steps you can take to manage cash flow.