Budgeting for Profitability and Expense Management

Overview

This session focuses on the mathematical foundation of business survival: ensuring your pricing covers your expenses and your desired profit. It breaks down the critical differences between fixed (operating) expenses and variable expenses, and teaches entrepreneurs how to calculate the exact profit margin they should expect in their specific industry using the RMA Annual Statement Studies.

Core concepts

• The Profit-First Equation
• Standard thinking: Sales - Expenses = Profit (whatever is left over).
• Correct thinking: (Desired Profit + Operating Expenses) = (Unit Price - Variable Expenses) Units Sold.
• You must budget for your profit first, before calculating what you need to charge.
• Determining Your Target Profit
• Your business must generate enough money to cover two separate "paychecks" for the owner:
• The Worker's Salary: What you would have to pay someone else to do the daily job you are doing (e.g., the baker). Resource: The Bureau of Labor Statistics Occupational Outlook Handbook.
• The Entrepreneur's Reward (Profit Margin): The financial return for taking the risk of starting the business. Resource: RMA (Risk Management Association) Annual Statement Studies.
• Action: Find your NAICS code, look it up in the RMA book at the library, and find the average Net Profit Margin for your industry. Aim to eventually beat that average by 20%.
• Categorizing Expenses
• You must separate your costs into two categories to price correctly:
• Fixed/Operating Expenses: Costs that do not change regardless of how many units you sell (e.g., rent, liability insurance, salaried office manager).
• Variable Expenses (Cost of Goods Sold): Direct costs tied exactly to the production of one unit (e.g., flour, sugar, and packaging for a cupcake; hourly wages for a temp worker).
• Managing Your Profit
• Defeating Parkinson's Law: The law states that expenses will rise to meet income. If you leave profit in the main checking account, you will spend it.
• The Fix: Open a separate savings account at a different bank. Transfer your predetermined profit percentage (e.g., 1% in quarter one, rising to 5% later) into this account regularly.
• Order of Distribution: When you take money out of this profit account, use it in this order: 1) Build an emergency fund, 2) Pay down debt, 3) Pay your "Worker Salary," 4) Take your "Entrepreneur's Reward."
• Strategic Expense Management
• Prefer Variable over Fixed Costs: It is safer for a small business to have higher variable costs than high fixed costs. If sales drop 20%, variable costs drop 20%, but fixed costs stay the same. Minimize fixed costs by leasing equipment instead of buying, or using temp agencies instead of full-time salaried hires.
• Stress Test: If your sales dropped 20% tomorrow and stayed there, where exactly would you cut expenses to survive? Plan this before it happens.

Action steps

• Go to the Bureau of Labor Statistics website to find the average salary for the "worker" job you will be performing in your business.
• Identify your 6-digit NAICS code via a web search.
• Visit your main branch public library, locate the RMA Annual Statement Studies, and find the average Net Profit Margin for your specific NAICS code.
• Open a separate business savings account at a different bank to act as your "Profit Account."
• List all your anticipated business expenses and strictly categorize each one as either "Fixed/Operating" or "Variable."

Key terms

• Parkinson's Law: The adage that demand (or expenses) will expand to match the supply (or income) available.
• NAICS Code: North American Industry Classification System; a 6-digit code used by the government to classify businesses by industry.
• RMA Annual Statement Studies: A reference book containing financial benchmark data (like average profit margins) for thousands of industries, sorted by NAICS code.
• Variable Expenses: Costs that fluctuate directly with the volume of production or sales (e.g., raw materials, commission pay).
• Fixed (Operating) Expenses: Costs that remain constant regardless of sales volume (e.g., rent, salaries).

Examples

• The Bakery Example: A bakery (NAICS 311811) has an average net profit margin of 4.3%. For every $100 in sales, the owner keeps $4.30 in profit. The speaker suggests aiming for 5.2% (20% better than average) once established.
• The Temp Worker Strategy: If you need 10 employees, hire 7 full-time and 3 from a temp agency. If a recession hits, you can easily release the 3 temps (variable cost) without the emotional and legal difficulty of firing permanent staff (fixed cost).
• The Sales Commission Trap: Do not pay salespeople a flat commission on total sales. Pay them a percentage of the Gross Profit Margin to incentivize them to sell high-profit items rather than discounting items just to close a deal.

Cautions & verification

• RMA Availability: The speaker notes that the RMA books are very expensive and usually only available at the main branch of a city's public library, not local branches. Call ahead using the provided call number to verify availability.
• Family Employees: The speaker warns against hiring distant relatives (aunts, cousins) unless you have strict, written job descriptions, as they often expect to "skate" by without doing the work.

Further considerations

Calculating the Break-Even Point: The transcript sets up the variables but leaves the math for "Session Two." Recommendation: The formula to find your break-even point in units is: Total Fixed Costs / (Unit Sale Price - Variable Cost per Unit).

Review questions

• According to the speaker, your business needs to generate enough money to cover two different "paychecks" for the owner. What are they? 1) The salary for doing the actual work (e.g., baking), and 2) The entrepreneur's reward (profit) for taking the risk of opening the business.
• Where can you find the average Net Profit Margin for businesses in your specific industry? The RMA (Risk Management Association) Annual Statement Studies, usually found at the main branch of a public library.
• What is the definition of a Variable Expense? A cost that changes directly in proportion to the number of units you produce or sell (like raw materials or hourly temp labor).
• Why does the speaker recommend that a small business should prefer having higher variable costs rather than high fixed costs? Because if sales drop suddenly (like during a pandemic), variable costs will drop with them, helping the business survive. Fixed costs (like high rent) must be paid regardless of sales, causing rapid bankruptcy.
• What is the speaker's strategy for defeating "Parkinson's Law" regarding business profits? Open a separate savings account at a different bank, deposit a percentage of your revenue into it regularly, and keep it "out of sight, out of mind" so you don't spend your profit on daily operations.