Operating Expenses ...

Estimating Monthly
Demand, Expenses & Overhead
 
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Identify & Estimate Operating Expenses

 
In business, an expense is defined as the use of an asset. In other words, as you expend your assets to run and operate your business venture, the dollar value of those assets are noted on an Income Statement as expenses. The more expenses you have, the less profit you make and the less taxes you pay.

Operating Expenses - use of your assets & services to produce revenue. Some specific, common examples are:

  • Cost of Goods Sold (non-cash expense)
  • Rent (cash expense)
  • Prepaid Insurance (non-cash expense)
  • Wages & Salaries (cash expense
How Expenses are Categorized on the Income Statement.

Expenses usually are put into one of two categories:

Cost of Goods Sold (CGS) - direct labor & materials. These vary/change as your sales volume increases or decreases. The are the use of your asset called inventory. CGS is usually a non-cash expense. The cash was expended in months past to buy the inventory. The amount of the inventory sold each month (expended or used up) is the expense you show on the Income Statement.

Overhead - all other expenses of operating your business. These tend to be fixed. They tend not to change as your sales volume changes in the short run. They may be cash or non-cash expenses.

  • operating expenses - rent, insurance
  • selling expenses - commissions, mileage
  • administrative expenses - management salaries, office expenses

Demand - estimate of future sales measured in customers, units, or dollars. Your actual demand is called sales revenue on an Income Statement.

Why Estimate Demand, Expenses & Overhead?
  • determine total dollar amount needed to start your business
  • determine appropriate type of financing
  • assess risk, feasibility, and personal investment
  • have better information to help make decisions
  • set appropriate price
  • manage controllable expenses
  • assure profitability
  • manage cash flow
Income Statements

Income statements vary in style, However, there are parts to an Income Statement that help us separate activities and categories for tracking and managing our sales and expenses.

In the simplest form, an Income statement is three lines

 Revenue
-Expenses
= profit/loss

 

Elements of an Income Statement

The most important element is your Sales Revenue or just revenue. This is the measure of success of your business and marketing strategies. This is the top of the Income Statement.

REVENUE = P x Q (your selling price times quantity sold or demand in units)

DEMAND = Quantity of:

  • Units (measured in hours, items sold, gallons, meals served, etc.)
  • Customers (individuals, groups, businesses, etc.)
  • $ (dollar value of the units demanded)

The next section of an Income Statement shows the inventory expended in producing those sales. This figure includes items given away, lost, damaged and sold.

CGS = Cost of Goods Sold

  • portion of inventory sold or otherwise used up to produce sales
  • cost of making or buying the product sold

The sales revenue minus CGS gives us our gross profit, that is profit before accounting for operating expenses and taxes.

GROSS PROFIT = Revenue less CGS
(gross profit before operating expenses and taxes)


OPERATING EXPENSES = Expenses to run the business and generate sales


PROFIT/LOSS = the bottom line before taxes

 

Operating Expenses and Overhead

Operating expenses are the expenses to produce your sales and to run the business. They usually recur each month with slight fluctuations.

There are two types:

  • Selling Expenses - may vary with demand; often thought of a variable expenses
  • General & Administrative Expenses - likely constant; often referred to as fixed costs or overhead
Sales Revenue
Revenue equals price x quantity demanded. We need to use our estimated demand and estimated selling price to calculate Revenue.

Total Revenue = P x Q

Selling Price = CGS + FCC + Profit

How the Selling Price is Determined
Total Costs

CGS

+ Overhead/unit
(Fixed Cost Contribution)

$5

$14

$ Markup +Target Profit $6  
  Selling Price = $25
     
 
When and How Much Revenue?
There are two methods for determining when and how much revenue to record on an Income Statement.

(1) Accrual
     versus
(2) Cash accounting methods

Cash accounting means that you consistently record sales when the cash is received from the customer. Consequently, you must also record expenses when the cash is paid to vendors and suppliers.

Accrual accounting means that you consistently record sales when the deal is struck and the goods are delivered to the customer. Consequently, you must also record expenses when the deal is struck and the supplies are received from the vendors and suppliers.

For example: suppose you had the following sales chart for a typical month.

Sales Revenue:

Cash sales              = $35,000
Accounts Receivable= 15,000
Total Sales Revenue = $50,000

What is our Revenue for our Income Statement and tax liability?

By Cash accounting it is $35,000
By Accrual accounting it's $50,000


NOTE: The bank would want to see $50,000 to give us a loan.
We would like the $35,000 for a lower tax liability.

Typical Income Statement

Review the following sample Income Statement.

 

Income Statement Exercise
Use the following data to make both an Income Statement and a Cash Flow Statement for the same time period.

Cash Sales $ 15,000
Credit Sales 10,000
CGS 10,000
Rent 3,000
Depreciation, buildings 1,000
Advertising 1,000
Payroll 2,500

The company was started with a $100,000 loan and an investment of $100,000.

Click here for a Word document blank Income Statement form

Click here for a Word document blank Cash Flow Statement form

 

Basic Financial Analysis

 

Cost of Goods Sold

Cost of Goods Sold can be complicated to calculate. The following example illustrates the components of CGS. Click here for a blank form Word document version of the example below.