Lesson 8: The Economics of the Business, Part 1

How to Create a Business Plan Section 3: The Company's Business Model
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In this lesson, you'll learn how to describe your business will be making money. You'll also cover some key indicators such as gross and operating profits.

Transcript

Hello, and welcome to module five of this video training series on creating your own business plan. In this module, we're going to be learning about the economics of the business. Why is this important? Well, the economics of the business are going to help you to model a financial plan that forms a key component of your business plan. So at the end of this module, you'll be able to calculate things like gross and operating profits, you'll be able to understand net profits and profit percentages and again, how these are calculated. You'll be in a position to consider profit potential and profit durability, you'll be able to understand the difference between fixed and variable costs.

You'll be able to demonstrate the monster reach breakeven position in your business, and you'll be able to calculate the months to reach a positive cash flow in your business. Why is this all important? Well, simply stated, a business that's not profitable will not stay in business and this is the simple truth. So whether or not you're trying to use your business plan To attract investors or to attract loans to start and run or grow your business. Having a handle on what the economics of the finances of the business look like is an extremely important thing for you, that the owner to know. Understanding how the business finances will look allow not only for effective planning, but more importantly, they provide a mechanism for you to measure and manage the business having these numbers at a more detailed level.

For example, product sales per week, rather than just an overall sales number will allow you to more quickly identify problems within the business and address these problems. This section describes a key number of areas that are going to quiet careful planning for the inclusion in your business plan. But don't worry, you're not going to start with a blank slate. There are a number of documents or templates that are provided as part of this training course. And you can use these templates in conjunction with the content of this module to build out a robust financial plan that'll support your overall business plan. Let's start by looking at gross and operate profits.

While revenue remains an important measure of how well a business is performing, the measure of profitability or margins as they're sometimes referred to is more important. You'll recall from an earlier section, that it is possible to have higher revenues. But these don't necessarily guarantee success. You can have revenue without profit, and this is a disastrous position to be in. Gross profit in its simplistic form is calculated by subtracting the cost price to your business of an atom, or atoms from the selling price that you sell to your customer for. And this can also be referred to as the markup.

It can be calculated as either an absolute number, so pound value or dollar value, but it's sometimes expressed as a percentage of either the cost price or the selling price. It's important that you understand on which basis This is calculated, and also when you use these formulas, or these percentages which basis you're using. So for example, imagine an awesome that we buy for pounds, we sell onto a customer for 60 pounds. subtracting the cost from the selling price gives us a profit of 20 pounds. Now let's look at this another way. Again, taking our profit of 20 pounds, we've divided this by the cost price of 40 pounds, and this gives us a profit percentage of 50%.

Now, this is a profit percentage of 50%. As we've said, based on the cost price. In the next example, we've taken the 20 pounds again, but we've divided it by the selling price of 60 pounds, expressed as a percentage, this gives us a gross profit percentage of 33.3%. Now you can see in both examples, we've made a 20 pound profit, but we've expressed them differently in percentages. So which one do you use? Well, either way is acceptable as long as it's consistently used, and it's apparent which method which method you're using.

And this is important not only when you create your business plan, but also when you talk with business business stakeholders. It just applies for instance, and bank managers be clear about what type of profit percentage calculation you're using. Now in this example, we've only talked about fixed costs. And I've apologies variable costs, meaning the more you sell, the higher your costs are. So the more items you sell, obviously, the more revenue you make, but also the higher the costs are. So having established that you're making a gross profit, we're not quite out of the woods yet.

There are a number of other factors that need to be considered. And these are often referred to as fixed costs. And these are generally costs that your business incurs, regardless of the amount of things that are sold, whether they're products or services. And examples of these types of costs are things like rent salaries and office expenses. These costs are then added up and subtracted from the gross profit. And the balance that's left is known as operating profit.

Let's take a look at this in an example. Imagine that your business is sold 1000 of the items that we used in the previous example. And you've also had things like salary and office expenses. So expressed in a in a in a very simple example here, we've sold 1000 items at 60 pounds each and this has given us revenue of 60,000 pounds. Each of those items has cost us 40,000 pounds. So 1000 of those has cost us 40,000 pounds.

And this is left us with a gross profit of 20,000 pounds. Now factor into that, some salaries, 3000 pounds rent or 5000 pounds. And that gives us a net profit of 12,000 pounds. So what we've done here is added these up, which is 8000, subtracted that from the 20,000. And that's left us with the 12,000 pounds. And you'll see in some of the examples I've used parentheses, and this simply means that this number is to be subtracted from from the overall total.

You could also use a negative sign in front of these. So this example illustrates a gross profit percentage based on sales. 33% and an operating profit percentage of 20%. So the 12,000 divided by the 60,000 gives you a 20% net profit. Now let's look at the following example where a business has perhaps not been as successful, and it's not managed to sell as many items as it has in the previous example. Let's imagine for instance, that it's only been able to sell 500 of the items.

So taking the selling price of 60 pounds, multiply that by 500 items. This gives us revenue of 30,000 pounds. Remember that each item cost us 40 pounds. Now multiply this by 500. And that gives us a cost of sales of 20,000, which you'll see is a lot less than the above example, and this this was the gross profit of 10,000 pounds. Now you'll see things like salaries and rent have stayed the same.

And again, subtracting these from 10,000 pounds of growth. Profit geezers with a net profit of 2000 pounds. So you can see, while things like profit percentages remain the same, the absolute numbers differ or reduced, resulting in a lower gross profit. Unfortunately, the salary and rain costs remain the same. And this means that the business is now effectively 10,000 pounds worse off. So you can see that it's very important to understand the difference between fixed and variable costs.

Imagine in another example, you sold zero items, you'd have zero sales, but you'd also have zero cost of sales, profit of zero, but you'd still have to pay salaries of 5000 salaries and rent of 3005 thousand pounds, which is going to leave you in a bad position. So for this reason, it's important that you use both percentages and the absolute values when providing value model, you might ask why not just use absolute values? Well, gross profit percentages aren't very useful when comparing the profitability of different products or the same product over time. net profit percentages are very useful for understanding your return on investment, for example. So in the first example, the business made a 20% return on investment. So that is the 12,000 gross profit, sorry, the 12,000 net profit divided by the 60,000 revenue.

And if for instance, the costs were very high in the business, and you for instance, salaries and and rent were very high, you might have any made a profit of say 600 pounds. This would mean your net profit percentage would be reduced to 1%. That is 600 pounds divided by the 60,000 pounds. The business would probably have been better off just taking the 60,000 pounds and putting it in a bank savings account where it might have tracks say one or 2% interest rate. Profit is discussed a little more In the next section

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