If you’ve been to one of our business development events before, you’ll likely be familiar with the bucket analogy we often use. Put very simply, your business is like a bucket with holes in it: when you earn money, the bucket fills up. Running costs such as direct costs (COGS) and business expenses create holes, causing the bucket to empty. You need to keep the bucket filling fast enough so it doesn’t completely empty out, or you need to reduce the number of holes in the bucket. Some business expenses (holes) are mandatory, you can’t run your business without them. Others are controllable – and you can reduce the amount of money leaking out by managing these costs better.
It’s important to understand the different types of overheads, in order to know which ones you can control, and therefore manage better to keep your bucket fuller. Most people you speak to will tell you there are two types of overheads: Fixed and Variable. But I propose that a third type exists, the Optional ones – and my advice below is based on these 3 categories…
First, let’s clarify what a business expense is: Business expenses (also known as overheads) are indirect costs that don’t directly relate to the product or service you provide, but they do support your activity. For example, direct labor and materials wouldn’t be considered overheads but things like office rental and stationery would be.
Now let’s look at the different types:
Fixed Business Expenses
As the name implies, fixed overheads don’t change. They’re the non-negotiables you must incur in order to stay in business and they aren’t overly affected by changes in activity. Common examples include rent, insurance, phone, petrol, etc. Most fixed overheads don’t fluctuate all that much from year-to-year either, so the best indicator of what you can expect for the year ahead is to look at what you paid the previous year.
Working out your total fixed overheads for the year is a pretty quick calculation, but the trick to keep your head above the water and ensure you earn enough to cover your fixed overheads is to divide up the total amount by 11 months instead of 12. Why? Working on an 11 month year allows for the seasonal effects of Christmas/NY and Easter when you’re typically a lot quieter and work is hard to come by. After you’ve done that calculation, you then know how much Gross Profit you need to earn each month to cover your fixed overheads.
Variable Business Expenses
Variable overheads are the ones that do change month-to-month, reflecting changes in output. A few examples include advertising, sales activity, gear for the staff, etc. While they are variable, and you can’t strictly control them that much, you’ll generally know enough to be able to budget fairly accurately if you look at your previous year – and this will help inform your decisions re optional overhead spend.
To work out variable overheads, again do the 11-month calculation and then add this amount to the Gross Profit figure you need to earn each month.
Optional Business Expenses
This is where things get interesting and the bit I really want to talk about because these are the overheads you have the most control over. They’re the overheads you don’t need to spend to keep your business running, but they’re things you want to do.
Without question, you can always spend more money in your business – new carpet for the office, a better website, replacement tools for the staff, another office support person, health and safety improvements, business mentoring and coaching… There is literally no end to how much money you could spend.
But there aren’t endless jobs, nor endless amounts of time to do those jobs, which means there isn’t endless money to pay for these overheads either. So what do you do?
You have to budget. Make a wish list. Prioritise the things you really want to do and work these into your budget. The combined total of your fixed, variable and optional overheads must be covered by Gross Profit. So you have to realistically work out how much Gross Profit you can earn each month, then deduct the amount you need to spend on Fixed and Variable Overheads. Whatever’s left – if anything – is what you have available to spend on your Optional overheads. Or you could keep it and help increase your Net Profit… the decision is yours.
And finally, whatever you do, don’t spend more on business expenses than what you’re earning in Gross Profit. Do that and you’ll be back looking for a new job within months.
Need Some Extra Guidance?
If you need some extra guidance or training on exactly what to look for, the team at MBP have a range of solutions to help. Our Financial Awareness Coaching can help you to develop the skill to manage your business finances like a pro. Also, keep an eye out on our Facebook page as we share updates on the timings for our Know Your Numbers and other key business education webinars.