For most people, accounting and bookkeeping are boring tasks that they'd much rather avoid. However, there is one basic bookkeeping task that is fundamental to the successful operation of any business. Not only that, but mastering that technique makes all the other bookkeeping chores much easier.
It goes by several names: unit cost analysis, unit profit and loss, and product-level breakeven analysis. But the label that makes the most sense to me is the economics of one unit. And, I'm sorry to say, it does require arithmetic.
But before you get out the pencil and the calculator, let's take a few minutes to think about how this works. One of the ways that I've found helpful to get your head around this concept is to think about a simple product like a pizza. We can all easily make a list of the basic ingredients of a pizza: dough, tomato sauce, cheese, maybe some pepperoni or some mushrooms.
If you know anything about the basics of the food service industry, then you know that portion control is the key to profitability. So, let's say that the basic list of ingredients for a pizza might be:
2 cups of flour 1 tomato 1/2 cup tomato sauce 2 onions 1 teaspoon chili flakes 1 teaspoon baking powder 1 teaspoon sugar 1 cup grated cheese 4 mushrooms 1/2 green pepper 1 teaspoon oregano 1 tablespoon dry yeast
Now that we've got our list, we need to know how much each ingredient costs. That information might look like this:
|2 cups of flour||$0.80|
|1/2 cup tomato sauce||$0.20|
|1 teaspoon chili flakes||$0.05|
|1 teaspoon baking powder||$0.01|
|1 teaspoon sugar||$0.01|
|1 cup grated cheese||$0.75|
|1/2 green pepper||$0.34|
|1 teaspoon oregano||$0.02|
|1 tablespoon dry yeast||$0.01|
|Cost of One Unit||$3.42|
In case you're wondering, it really is that simple, and it really needs to be that precise.
But at this point, all you've got is some basic information on unit cost. The next thing you need to do is figure in the labor cost. So, let's say that you pay your pizza chef a living wage of $18 per hour. You then calculate that it takes the chef 15 minutes to make the pizza (and we can assume here that the dough was made ahead of time–a cost we'll get to in a minute). So, 18 divided by 4 is $4.50, so now the cost of making the pizza is
$4.50 + $3.42 = $7.92
For the sake of this example, we'll say this is an eat-in pizza so we don't need to add the cost of a box or a delivery driver.
At this point, you have what the accounting folks refer to as total variable cost, which means that you've accounted for the expenses that are directly related to the production of your product. You also have the first critical decision point in determining if your product or service is viable.
This decision point (one that you will return to frequently) is known as a break-even analysis. It's simply a calculation to see whether you can sell your product for more than it costs to make. In this case, the break-even price for this product would need to be at least $8.00. Understanding this point (and being brutally honest in its calculations) is vital to the success of any enterprise.
The hardest part of this exercise is what you need to do if you don't cross that break-even point by a substantial margin. If you don't clear this hurdle, you only have two choices. Ideally, you can go back to the drawing board ato see whether there is any place where you can cut corners. For instance, you may have noticed that cheese is the most expensive ingredient. Perhaps you can do with less cheese, or a less expensive brand of cheese. Beware: those decisions may have unacceptable consequences in sacrificing the quality of the product.
You probably don't want to try to cut labor costs (particularly in a tight job market), but that may be an option in some cases. Alternatively, there may be a way to automate some labor tasks (probably not in this example, but in other cases, perhaps). If none of that works, you need to scrap the idea and move on.
And that, my friends, is the hardest thing for any aspiring businessperson to face. You see, we too often become enamored with our own brilliance and are convinced to the depths of our being that our idea is a winner. Unfortunately, the market does not always agree with us. More importantly, if the business can't cover its expenses, then it's a charity, not a business (not that there's anything wrong with charity–it's just a different financial model).
If you've been able to successfully pass that bar, then you've accounted for all of your variable costs. But before you move on to a higher-level break-even analysis, you need to check to see what your competitors are doing. If the going rate for a pizza like yours is $12 and yours costs $8 to make, then you've got some room to maneuver. If the going rate is $7.50, you're out of luck once again.
Let's say that it's good news and $12 is the average price your competitors are charging. That means you've got what's known as a profit margin, and that margin is $4 per pizza. Now we need to add in what's known as fixed cost: things like rent, utilities, insurance, legal fees, etc. Just to keep things simple, let's say that all of that adds up to $20,000 per year. It's pretty clear that 4 is less than 20,000, so you obviously need to sell more than one pizza to cover your fixed expenses. In fact, you need to sell 5,000 pizzas to cover that cost (20,000 divided by 4).
So now you've got your expenses covered. There are still two problems left to solve. The first is to figure out the size of your market. If you live in a small town (typically less than 5,000 people) then you need to sell a pizza to every single person in town (or two to half of them, etc.). The problem here is that most people don't eat pizza every day, so you need to have enough folks who buy your product often enough to keep this business afloat.
You also need to think about what other competitors might be trying to reach that same customer–other restaurants, as well as the local grocery store, etc. You also need to consider that pizza tends to be what's known as a hyper-local product, which means your customer will likely be geographically close to your shop.
That's why population density and competitive analysis are critical steps at this point. More importantly, you may have noticed that covering your costs–while vital–still doesn't leave any money for you to pay yourself. Unless you're independently wealthy, it's pretty sure that you're going to need to make a few bucks off of this business. While how much you may need to pay yourself can vary significantly, it's pretty clear that you'll need to sell more than 5,000 pizzas.
So, now that we've got the basic concepts down, let's take a minute to translate this into the product or service that you're developing. Where I've described a pizza, you can substitute the word "unit," which means one single product or one service. If you've set up a housekeeping service, it's one house. If you're offering tax preparation, it's one tax return. The exact definition is not as critical as it is to try to break the business down to its smallest possible unit. Then you run the numbers as we've outlined here.
Before we leave this subject, we need to underline the point that was made a minute ago. Many aspiring entrepreneurs understand the basic idea that the firm needs to break even, but just as many fail to perform the break even analysis at the ground level. And if that ground level analysis–the economics of one unit–doesn't produce a positive result, then you need to drop the idea.
It's that simple, and that clear cut.
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