Understanding your business finances – From good idea to viable business
Entrepreneurs are are usually very good on the creative side of a business They are great at thinking outside of the box in the creation of their products or service. They have wonderful ideas on color schemes, create marketing plans, website creation, and many other important factors of creating a small business. Where many fall short is having a realistic and accurate objective financial plan and origination of their business.
There are 3 very important questions you need to answer before spending a single penny on a small business idea:
How much will the total, absolute, all in cost to get this business launched?
This question is most often under-represented by the entrepreneur, as most people just look at the product costs themselves, and compare it to the potential sales price. To be in the know, you need to break down all costs associated with the startup of the business. Moving from a ‘good idea’ to a ‘viable company’ is a big step, and knowing the up front cost of your business is the most important question you need to answer before moving forward with any business.
Here are the most common upfront costs associated with starting a small businesses:
- Logo development costs - A good logo that aligns with your vision and feel of your company is very important. I wrote an article called how to come up with your business logo. Budget conscious people can find a logo designer for under $20, and if you want to go fancy you can spend hundreds even thousands of dollars on a logo designer.
- Product research costs – Once you have an idea for a product to sell - you need to find a manufacture. There are often dozens of potential manufactures for your product. You need to reach out to them and find a manufacture that lines up with your own needs. The first step for most businesses is to order sample products for 3-6 different manufactures and test their products to find the highest quality with the most reasonable prices.
- Product design costs – Once you have found a manufacture for your products, you will likely need to custom design. You want the product to be your company's branded product, and not a generic product. Most of the time there will either be an up front one time cost to OEM your product (Original Equipment Manufacture - essentially branding the product with your logo and design), or a high upfront MOQ (Minimum Order Quantity) for the first order to compensate for customizing the product.
- Initial inventory costs Once you have chosen your manufacture and decided on the OEM of your product, you need to make a large initial product purchase. This is often the biggest purchase you will make. If your product has several skews (different versions of the product), or has a lot of accessorizes or options - you need to stock each of these options initially. Once you know what options and colors sell better you can make smaller more precise orders in the future.
Product Shipping Costs - Depending on the physical size of your products the shipping cost to have them imported to your location can be sizable. I have had product shipping costs as low as 5% and as high as 50% of the manufacturing costs. Typically the larger and heavier your products are, the more the product shipping costs will be.
TIP: Heavy or bulky and inexpensive products are some of the most difficult to sell for a big profit.
- First time promotional / advertising costs - Depending on your business, when you business launches you will want to begin promoting it. This comes with a cost, and for some competitive businesses this can be a high cost. Think of having an advertising budget up front that is at least 25% of your expected net margins on first shipment of products. For example, if you are spending $10,000 for your first shipment of products, and plan on making $20,000 profit once all of these products are sold, your advertising budget should be a minimum of $5,000 ($20k *.25).
- Physical shipping costs – What costs will be associated with getting the product to your customers? Will you be offering free or discounted shipping? What will the average shipping price be to get your products to your customers? What are the prices for printers to print labels, boxes or envelopes to hold your products,
- Swag and Promotional Items - Do you want to send business cards with each order? A post card? A printed invoice? Do you want to add pens, stickers, magnets, or any other branded items with your orders? If so, there is often a significant up front cost to these
- Website design costs - Are you tek savvy? Do you know how to design your own website? Will you need to hire a website designer? Depending on the complicated nature of your products or business, website design costs can be from a few hundred to many thousands of dollars.
- Website hosting costs - Typically these costs are handled monthly, but it is often the case that paying for a year or more will provide you significant savings to the cost of website hosting.
- Specialized Printer costs / Ink Costs / paper costs - Depending on your mailing setup, you may need to purchase a specialized printer to print out labels. If you are adding an invoice to your order, you might need a stanrdard printer
- Exchange Rates - There may be costs associated with exchanging currencies. What currency does the manufacture accept payment? Will you be selling your product in USD or in your local currency? Being Canadian, our current exchange rate is 1.4-1 vs. the USD - so each product will carry a deep exchange rate challenge.
- Other product or service specific costs - You know your business, so what other initial costs may be associated with your own business? Do you need a business licence? Are there service fees, governmental fees, or any additional costs associated with selling your product?
Once you have added all of these individual costs – you will have complted the first part of your finance plan – initial costs to start your business. This is the first thing to consider with your new business finances... but wait, there is more!
What are the monthly operational costs of my business?
The monthly operational costs are going to be smaller then your initial startup costs, but are still very important to understand. You don’t want to start your business with a 0 bank account, so it is important to consider how much it will cost jsut to maintain your business
- Monthly website hosting costs - These costs may have been paid up front if you chose a 1 -3 year hosting package, however some things like domain name renewals, SSL security services, and
Re-stocking costs + return policy and return shipping costs - You will never have 100% of your customers satisfied with your product or service. Maybe they bought it on a whim, and their significant other gave them crap, and now they must return it. Even if your product is tip top quality with the strictest quality controls, you need to expect a percentage of orders to be returned for refund or returned for warranty. This is more often thought of as a percentage of sales but you can expect anywhere from 3-20% depending on what type of products you are selling.
TIP: Over 90% of customers return an item within the first 30 days of ordering, so increasing your return policy to 60 days or 90 days will have a great improvement to reduce customer worry, while only slightly increasing your costs.
- Credit card processing Costs & Fraud - Most customers will use credit cards to purchase your products or service. The costs associated with this can rage from 1% all the way to 3.5% or even higher. Its an import ongoing factor to consider these processing costs in your business finances. In addition a (hopefully small) percentage of your sales will be fraud, when someones credit card is compromised. In these situations you will typically have to eat the loss of the product and shipping costs. Fraud rates can vary between 0.5% and as high as 2%. Having SSL security and using a trustworthy credit card processor with verification software can greatly reduce fraud.
- Salary - Its important to understand that it is unlikely you will be able to pay yourself in the early stages of your business. Your own time and sweat equity in your business will help get it off the ground, and taking a salary too early can lead to significant financial stress and collapse of your business. If you abolutly need a salary consider factoring it into the initical cost of your business, and have a plan to eventually acquire your salary from the business.
How do I grow the inventory and advertising budget
It is absolutely crucial that you create a ‘siphon’ system for all of your first sales to go directly to supporting the business growth. This includes new inventory, expanding inventory, supporting advertising growth, and eventually your salary and salary for new employees.
Here is an example of a sales siphon system at work:
- Product MSRP $100 Retail price of your product(s) - or average order size
- Product cost: $25 - Or average product margin compared to average order size
- Gross Margin: $75 - Removing your costs from purchase price.
The siphoning process:
1.25:1 product return - ($25 * 1.25) $31.25 – For every product you sell – you will purchase 1.25 new products. This will help to grow your inventory.
Average discount (10%) + average defect rate/return (5%) - $10 + $5 = -$15 Customers will be more likely to make a purchase with a discount code or coupon. This needs to be reflected in your net margin.
Cost of product, shipping costs, envelopes, tape, etc. -$4
Average Cost of shipping (if free shipping is offered ) -$10 If you offer customers free shipping, this cost will be paid with the gross profits of your product sale.
Advertising cost per transaction – -$10 Facebook ads, Google Ad words, etc. This is the cost on average of how many dollars are spent per new sale. It can range in price
Costs of promotional items -$2 – This could include business cards, leaflets, pamphlets, etc.
Final siphon Costs: -$72.25
As you can see, after all siphon systems are applied – in order to grow your product inventory by 25% per order, you will be left with a final net profit of just $2.75 per $100 order. This is perfectly OK at first, as your goal when starting your business is inventory growth and increasing promotions.
It is also important to understand that you may not take a salary or any personal income for a long time when starting a business. In the early months and even years of a business, the majority of all profits for the business need to be re applied to the business to grow inventory, product lines, increase promotions, etc.
I hope this gave you a little taste of the financial thoughts you need to be having before you step your toe into a small business idea. So often I see people say things like “oh I can get this for $20 online and sell it for $200 – what a no brainer” -
For YoniFlex, we went through this entire financial process. If you are intersetd in reviewing our spreadsheet that we broke down some of these costs you can click here.
I want to leave you with is this - The first stages of starting a business are challenging, and having a solid financial understanding is crucial to your success. As your business grows, so does profitability, as you are able to order larger volumes of products at reduced costs (and reduced shipping costs), larger orders of packing tape, boxes, business cards, and promotional materisl You will also be able to optimize your advertising budgets to be more cost effective. The first 6-12 months of a small business are the most crucial to be very accurate with your financial numbers. Stay the course and keep track of all costs. With this info you should be alto to avoid unexpected expenses or 'money pit' businesses.