Understanding Costs

There are two broad categories of costs: Cost of Goods and Operating Expenses.

Cost of Goods is the cost directly related to the product or service. For example, the cost for a pair of jeans at Costco would be the cost of buying the jeans from the manufacturer plus the labor cost that was incurred in selling it to you.

Operating Expenses are the expenses beyond the above costs. For Costco, this would include advertising, utilities, accounting and legal fees, salaries for its buyers and management, leasing and other costs.

Subtracting Costs of Goods from Revenue gives us the Gross Margin. From this we subtract Operating Expenses to calculate the Profit (before taxes). A business must evaluate each element of cost and try to reduce it wherever possible while providing the level of service that it desires to offer.

 Capital Needed

To start a business, you will need Start Up capital before you have even made your first sale. Money will be needed for several things and this list will vary by type of business. Items may include costs to develop your product, legal and accounting fees, marketing help, website development, getting patents, etc. The business itself may need to be underwritten for some time before it becomes profitable. Think of these costs as start up costs.

Once the business gets rolling there are two other key needs for capital.

  1. Working Capital: This is the money that is needed to run the day- to- day business. There are three key components: Receivables, which is money that people owe you, Payables, which is the money that you owe others and Inventory, which can be in theform of finished goods or raw materials.

Let’s start with Receivables. Assume you are a small winery selling to wine distributors and you have to give them 60 day terms, meaning they will pay you 60 days after they receive the wine.(These terms are negotiated between the parties, but size and industry practices often determine such terms.) This is a Receivable on your book because the money is owed to you and you anticipate receiving it.

In turn, you have to pay your suppliers in 30 days for the glass bottles and the grapes you buy from them. This becomes a Payable on your books.

In addition to this, let us assume that you will need to keep 1000 cases of wine in Inventory to be able to fill the orders as they come in. This too will cost money.

In this example, you will receive the cash from receivables in 60 days, but you have to clear up your payables in 30 days. Hence you will need money to fund this gap. In addition, you will need money to fund the inventories that you stock. These are the three main things you will need to monitor and fund on a day-to-day basis. This is called Working Capital.

2. Fixed Assets: You also may need to buy equipment such as computers, cars and perhaps even land to build the winery. This capital is called Fixed Assets.

Admittedly, these components have been simplified, but by and large they are adequate to understand the concepts we are discussing.

Verinder Syal, Author: Discover The Entrepreneur Within

Written by Verinder Syal
Verinder is the Principal at Thoughtful Simplicity, an award-winning teacher at Northwestern University, and the author of Discover The Entrepreneur Within.