Understand your costs and you understand your profit.

Have you ever seen a really busy business go under? Its hard to fathom huh, but it can happen. The issue isn't lack of business its either not understand their costs or not understanding cash flow, or a combination of the two.

We bandy about the phrase "cash flow is king", but its absolutely true. If you can't manage your cash flow you're dead in the water. Imagine the thriving business with orders left right and centre, but cash reserves are tight and their customers don't pay on time - soon enough the rent is due and they can't make it & the landlord is talking about changing the locks. The problem here isn't lack of business, its cash flow. And it has to be the most horrible feeling in the world - knowing you can do a great job, but going under anyway.

And it might in part come from misunderstanding your costs, and what you need to have aside in capital terms, the bugger you need in the bank until the clients pay.

Even if this is not your business understanding costs helps you make decisions, daily.

Here's a simple technique I used:

• In my business its very easy to work out an average income per "deal", say $2400
• I know, because I have tracked it, that it takes 10 hours work per "deal" to complete
• I also know my costs very well, it costs me $4500/month to run my business.
• $4500 / the number of hours worked gives me a good "cost per hour"
• and, multiplying this by 10 hours gives me a "cost per deal"
• The difference is my profit or loss, 
• We're all hoping this is a profit!

Expense wise, what does it cost you to run the business in an average month? Your costs needs to include all of the costs of running the business, down to the lighting and postage on an average basis. 

It helps to exclude extraordinary expenses and kind of put them aside - there will always be extraordinary expenses, like replacing a piece of equipment or a one off marketing event, so knowing an average of these separately helps, but for now...keep them as a separate, variable figure.

On this basis I know it costs me $1100 to "do a deal", and if my average deal generates $2400 theres a profit of $1300 to me.

Of course not every deal is average and some actually cost me money (smaller deals take just as long but don't of course generate as much income), and you weigh up a decision - do I do them or not? For me its a resounding yes because I have the capacity and I never know what else might come from it. If you're in retail you wouldn't necessarily make the same decision, you'd kill a line that was costing you money.

Equally it helps me make decisions, can I afford to introduce a new procedure? Will it cost or save me money? Can I afford a new offering? What effect will changing premises have on my income?

Knowledge is powerful stuff hey!