Operating Costs for Small Businesses A Self-Teaching Program Click to Advance Slide
DirectionsThis self-instructional module is designed to insure that you learn several basic numeric conceptson how small business operations are measured in terms of cost efficiency and profitability.The purpose is to provide you with some groundwork that will give you a better grasp of “thenumbers” that small business owners and managers need to deal with, including how they relateto advertising. Specifically, you will learn : • Typical costs of doing business – direct costs and overhead. • Operating statements and the concepts of gross and net profit. • Business costs, especially advertising costs, as investments. • Return on investment (ROI) for advertising.The information itself is divided into manageable chunks on a screen-by-screen basis. Typically,a screen gives some information, including examples – and then (in most cases) asks you aquestion that makes use of the information or asks you to draw conclusions from it. Sometimes,the question will require you to recall information from previous screens. The idea is to decideonyour response and then verify it with the correct answer that appears at the bottom of the screen.So read the material and question on each screen, decide on and make note ofyour answer, then click to check your answer. Click again to go on to the nextscreen.
Operating Costs Generally1. Two basic business costs are capital costs and operating costs.Capital costs are outlays for buying, expanding, or improving a companys physical plantequipment, tools, or other assets. Operating costs are the daily costs of putting people andassets to work in order to offer or produce something for sale.For example, Tom Smith forms Acme Remodeling Corporation to go into the remodelingbusiness. For starters, he contributes $14,000 to cover salaries, rent, phone, etc. until Acme’sincome increases. Also, Smith borrows $15,000 to buy major remodeling equipment such asajointer, planer, lathe, radial saw, etc.Which of the following is/are true statements? (CHOOSE ONE OR MORE) a. The $14,000 from Smith was for capital costs. b. The $14,000 from Smith was for operating costs. c. The $15,000 loan was for capital costs. d. The $15,000 loan was for operating costs. Answer #1: Choices (b) and (c) are correct. Smith’s $14,000 contribution was earmarked for salaries, rent, and other such items that will be part of the day-to-day costs of running the business – while the $15,000 loan was to be used to buy major remodeling power tools, which are part of the definition of capital costs.
2. In this module, we are concerned only with operating costs. Basically, there are two types ofoperating costs – overhead costs and direct costs. Overhead costs are costs that stay the sameregardless of the company’s sales volume. Direct costs are costs that are directly related toproducing the product or service being sold – and they do vary with changes in company salesvolume.Sometimes, overheads are referred to as fixed costs, while direct costs are often called variablecosts (because they vary with sales volume). For example, Acme Remodeling signs a one-yearlease to rent workshop and office space at $800 a month. The company is on the hook to makethat rental payment no matter how much or how little business it does during that period. Howwould you characterize the $800 monthly rental? (CHOOSE TWO) a. Fixed cost. b. Variable cost. c. Overhead cost. d. Direct cost.Answer #2: Choices (a) and (c) are correct. Rent is always an overhead cost because it will have tobe paid no matter what Acme’s sales are. Thus, the $800 is fixed for the lease period – and fixed cost is infact a synonym for overhead cost.
3. An important point to remember is that all salaries start out as overhead. Here’s Acme’s personnel chart after a year: EMPLOYEE DUTIES SALARY Tom Smith Supervision/Sales $ 54,000 Administrative Assistant Bookkeeper/Receptionist 11,000 Carpenter Project Work 25,000 Carpenter Project Work 23,000 Mason/Roofer Project Work 23,000 Finisher Project Work 19,000 Acme starts a new year with all $155,000 of salaries in overhead. All the administrative assistant’s salary ($11,000) will remain as overhead because none of it is directly related to producing the product (project work). On the other hand, if things go well, all of the project workers’ salaries will be converted to direct costs during the year. And some of Smiths salary can also be converted to direct costs – i.e., based on how much time he spends supervising specific projects. For example, if Smith spends 40% of his time overseeing projects, how much of his salary will move out of overhead and become direct project cost? (CHOOSE ONE) a. $32,400 b. $54,000 c. $21,600 Answer #3: Choice (c) is correct – i.e., 40% x $54,000 = $21,600. Since Smith spent 40% of his time supervising projects, he is part of the costs of the projects – so 40% of his salary, or $21,600, can be moved from the overhead column to the direct costs column.
4. As noted in screen #3, the salaries of "project workers" ($90,000) can also be converted to direct costs – but only to the extent they produce work that generates revenue. (That’s what the phrase “if things go well” meant in screen #3.) For example, during a fiscal year, if the carpenter who makes $25,000 spends 80% of his work time on remodeling projects and the rest is "down time," which of the following is true? (CHOOSE ONE) a. $5000 of the salary becomes direct cost, and the other $20,000 stays in overhead. b. $20,000 of the salary becomes direct cost, and the other $5000 stays in overhead. Answer #4: Choice (b) is correct. Since 80% of the carpenter’s time was spent on project work, then 80% of his salary, or $20,000, is converted to direct costs. The other $5000 stays in the overhead column. The fact is, if one out of every five days is downtime for that carpenter, it’s an indication that Acme has a sales problem. Acme’s objective should be to sell enough project work to convert 100% of each production worker’s salary to direct costs.
5. Certain costs stay in overhead no matter how much work the company produces and sells – items like sales salaries, administrative salaries, rent, utilities, repairs, phone, office supplies, etc. We call these standard overhead costs. As a going business, Acmes task is to sell and produce enough project revenue to ABSORB ALL OPERATING COSTS (not only project workers salaries but all standard overhead costs as well) – AND HAVE SOME LEFT OVER AS PROFIT. For example, if Acme’s operating costs for a year are $210,000, how much project work does Acme have to sell and produce in that year to have a $10,000 profit? (CHOOSE ONE) a. $220,000 b. $200,000Answer #5: Choice (a) is correct – just add $10,000 to the $210,000. The $220,000 absorbs all theoperating costs – both direct and overhead – and leaves $10,000 as the company’s profit.REMEMBER: The goal of any business is to generate enough revenue to ABSORB ALL OPERATING COSTSAND HAVE SOME LEFT OVER AS PROFIT.
6. Here’s a breakdown of Acme’s basic operating costs: Total Salaries $155,000 Rent/Utilities 12,000 Telephone 1,000 Equip/Supplies 25,000 Fringe Benefits 10,000 Other 7,000 Total: $210,000 Note that these costs do not include the costs of materials for remodeling projects – lumber, shingles, dry wall, etc. These are direct costs that we’ll deal with shortly. Acmes basic $210,000 of operating costs must be absorbed by project revenue first – before Tom Smith can even think about profit. But say his profit goal is 15% over operating costs (ignoring, for the moment, any profits on job materials). How much is Acmes dollar profit goal? (CHOOSE ONE) a. $15,000 b. $31,500 c. $241,500Answer #6: Choice (b) is correct. Acmes profit goal is $31,500 (15% x $210,000).
7. Now, lets consider the costs of the materials required to do remodeling jobs. First, the costs of job materials are never overhead, because they arent purchased until the job is sold. Thus, materials costs are always direct costs. Typically in the building and remodeling business, materials will generate some profit if the contractor (1) doesnt pass his contractors discount on to the customer; and (2) tacks on another 5% or so. But there may be times when a contractor forgoes any profits on materials – e.g., to win a bid or just to get work in slow periods. For example, materials for a building job cost $40,000 retail, but Acme pays only $36,000 after a builder’s discount. Smith plans to bill the client for materials at full retail – and tack on another 5% (of the retail price). Thus, the client’s total bill for materials will come to: (CHOOSE ONE) a. $38,000 b. $41,800 c. $42,000Answer #7: Choice (c) is correct. The bill will be $40,000 plus 5% of $40,000 – or $42,000.
8. Lets say Acme wins a contract to put up a small building for $121,350. Tom Smith might have computed the price this way: Project Workers Costs $ 50,000 Supervisory Costs 7,000 Standard Overhead Absorbed 12,000 • 15% Profit on all the Above 10,350 Materials Cost to Acme 36,000 • Markup on Materials 6,000 TOTAL PRICE $ 121,350 If the contract worked out exactly as planned, the total profit for Acme would be: (CHOOSE TWO) a. $16,350 c. $10,350 b. 15% d. 15.6%Answer #8: The correct answers are (a) and (d). The projected profit on the project is a combination of $10,350,which is 15% of all costs except materials, plus $6000 from materials – a total profit of $16,350. And if you divide $16,350by the $105,000 total cost, the overall profit percent is about 15.6%.
9. The basic goal of any business is to make enough sales revenue to absorb all costs and have some profit left over. For a service business like Acme, an accountant would typically add up all the years anticipated overhead expenses (including all salaries) at the beginning of the year – plus the projected profit – to see how much revenue is needed to meet the profit goal. Then, he’d work out a multiplier or factor that tells Tom Smith how much to charge per hour, day, job, etc. for each project worker. For example, when you take your car to be serviced, you may notice the repair shop’s labor rates posted – such as $60 an hour. Which of the following is/are true? (CHOOSE ONE OR MORE) a. The mechanics in the shop are paid $60 an hour. b. The $60 an hour includes a part of the shops overhead costs plus an allowance for profit. c. The $60 an hour includes repair parts used. d. If a mechanic is paid $20 an hour, the multiplier (or factor) for that mechanics rate is 3.Answer #9: The answers are (b) and (d). The $60 an hour includes not only what the mechanic makes,but also a percentage of the shop’s overhead plus a share of the shop’s projected profit. And if, in fact, amechanic is paid $20 an hour, that means the multiplier for that mechanic is 3 – which is $60 divided by $20.
10. Service businesses must be able to estimate jobs accurately – high enough to be profitable and low enough to be competitive. Some businesses have it down to a science, particularly for services that are relatively simple, repetitive, and/or brief in duration. Some examples are: Beauty Salon Restaurant Chiropractor Appliance Repair Carpet Cleaner Dentist Driving School Counseling Other service businesses are more complex but have developed reliable rules of thumb for estimating time and costs. For example, which of the following could use dollars per square foot as a measure? (CHOOSE ONE OR MORE) a. Builder e. Roofer b. Plumber f. Well Driller c. Floor Finisher g. Tree Surgeon d. Burglar Alarms h. PainterAnswer #10: Our choices are (a) builder, (c) floor finisher, (e) roofer, and (h) painter.
11. REVIEW. Which of the following are true? (CHOOSE ALL THAT APPLY) a. The two basic types of operating costs are overhead costs and direct costs. b. Direct costs are costs directly related to producing a product or service. c. At the beginning of any operating year, all salaries start out as direct costs. d. Salaries of "production workers" are converted to direct costs to the extent they produce work that generates revenue. e. "Standard overhead" costs describes costs that typically arent converted to direct costs. f. Examples of standard overhead costs are sales rep salaries, administrative salaries, rents, phone costs, and office supplies. g. Profit is what’s left after overhead costs are subtracted from revenue. h. A "multiplier" of direct costs is used to price a service so that it absorbs operating costs and has profit left over.(a) TRUE (d) TRUE (g) False (...after direct costs and overheads are subtracted...)(b) TRUE (e) TRUE (h) TRUE(c) False (All salaries (f) TRUE start out as overhead.)
DIRECT OPERATING COSTS12. Lets look in more detail at direct operating costs – usually called just "direct costs." For a service business, the largest direct cost is generally the labor of workers who perform the service – for example, the salaries of a carpet cleaning crew. But many services also involve costs for materials – for example, the various jobs performed by Acme Remodelers or any other building trade. The same goes for landscaping, dentistry, auto repair, and many others. Some services have a third type of direct cost – the operating cost of equipment used in performing the service. For example, a funeral home needs a hearse and one or more vehicles suitable as flower cars. The price of each funeral would include an allowance for depreciation, or a portion of lease payments if the vehicles are leased. On this screen, weve discussed 3 basic types of direct costs that a service business typically incurs. What are they? (CHOOSE THREE) a. Office rental. d. Materials b. Labor e. Yellow Pages advertising c. Administrative f. Equipment operation Answer #12: The three main types of direct costs for service businesses are (b) labor, (d) materials, and (f) equipment operation. The other choices are standard overhead costs, including advertising. Not every service business will have all three of the main direct cost types – but every service will at least have labor costs, or its not a service business.
13. Salaries paid to salespeople are generally treated as overhead costs and not as direct costs. Commissions, however, are direct costs. We’ll talk more about sales costs shortly – but first, let’s look at direct costs for product-oriented businesses. For product-oriented (retail) businesses – such as computer dealers, sporting goods stores, florists, and hardware stores – the main direct cost is what the dealer pays for his inventory. The technical term is cost of goods sold, or COGS for short. (By the way, if a dealer pays for inventory with borrowed money, any interest he pays on the loan will also be part of COGS.) Let’s say a computer dealer pays a manufacturer $280 for a printer he sells to end users for $600. Thus, the cost of goods sold is: (CHECK ONE) a. $600 b. $320 c. $280Answer #13: Choice (c) is correct. $280 is what the dealer paid the manufacturer for the printer – soto the dealer, $280 is the cost of goods sold – or COGS.
14. In the example of the previous screen, the computer dealer paid a manufacturer $280 for a printer and sold it to an end user for $600. Assume that $600 is the regular retail price and is not a rock-bottom closeout. The $320 difference between the sale price and COGS is: (CHOOSE ONE) a. All profit. b. Part profit, part overhead. c. All overhead.Answer #14: Choice (b) is correct. The $320 is part profit and part overhead – and is called gross profit, asopposed to net profit. We’ll talk more about gross profit later.
15. One other direct cost that relates to both product and service businesses is direct sales cost. First, whats the difference between direct and “indirect” sales costs? If a salesperson works only on salary, the salary is generally treated as an indirect sales cost. In fact, its an overhead cost – because it would continue to be paid at the same level, even though sales may vary or fluctuate. On the other hand, the cost of a salesperson who works only on commission is a direct sales cost, because its paid only when a sale is made. Some salespeople get a base salary plus a commission for each sale. For example, in a given month, a computer salesperson receives $1000 in base salary plus $2000 in commissions. Which of the following is/are true? (CHOOSE ONE OR MORE) a. The $3000 total is all direct sales cost. b. The $1000 is an overhead cost. c. The $3000 total is all overhead cost. d. The $2000 is all overhead cost e. The $1000 is a direct sales cost. f. The $2000 is a direct sales cost.Answer #15: Choices (b) and (f) are the only true statements. The $1000 is an overhead cost, because itwould be paid in a month when no sales are made, or in a month when 20 sales are made. But the $2000commission would be paid unless the salesperson sold the number of units that generated that much commission.
16. The costs of on-going advertising like Yellow Pages and weekly newspaper spots are part of standard overhead. But some advertising costs can be direct costs – for example, short-term promotions that can easily be linked to specific sales results. However, most accountants lump all advertising costs together as standard overhead items. We’ll do the same. Heres a summary of the most common direct operating costs for small businesses: SERVICE BUSINESSES PRODUCT DEALERS Labor Costs Cost of Goods Sold Costs of Materials Sales Commissions Equipment Operation Sales Commissions Most small local businesses dont pay commissions. (Exceptions include real estate, auto sales, and insurance.) So to simplify, well use examples in which sales commissions are not a factor. For product-oriented businesses, that leaves COGS as the main direct cost. And for service businesses, we will frequently refer to the main direct costs as labor and materials – and call it cost of service sold – or COSS. Go on to the next screen.
17. REVIEW. Lets briefly review some basic terms. (1) Which of these items define COGS? (CHOOSE ONE OR MORE) a. Direct costs of selling a product. b. Mainly, labor and materials costs of producing a service. c. What a dealer pays for goods he re-sells. (2) Which of these items define COSS? (CHOOSE ONE OR MORE) a. Direct costs of producing and selling a service.. b. Mainly, labor and materials costs of producing a service. c. What a dealer pays for goods he re-sells. (3) Which item defines standard overhead? (CHOOSE ONE) a. Direct operating costs. b. Indirect operating costs. c. Labor and materials costs of producing a service. d. What a dealer pays for goods he re-sells.Answer #17: (1) Choices (a) and (c) (2) Choices (a) and (b) (3) Choice (b)
STANDARD OVERHEAD COSTS 18. Heres a list of standard overhead costs, most of which weve referred to already. Administrative Salaries Telephone and Utilities Non-Production Equipment Sales Salaries Building Maintenance Reserve for Bad Debts Clerical Salaries Office and Other Supplies Business Loan Interest Other Non-Production Salaries Employee Fringe Benefits Inventory Losses Rents or Mortgage Advertising and Promotion Miscellaneous One item that hasnt come up in our examples is non-production equipment – which is equipment used in a business, but not to produce a product or service. Which items below are examples of non-production equipment for Acme Remodeling? (CHOOSE ONE OR MORE) a. Acme’s company car driven by Tom Smith. b. Acmes radial arm saws. c. A computer used by Acme. d. A truck used by Acme to carry tools and materials to and from job sites.Answer #18: Choices (a) and (c) are examples of equipment used by a business, but not directly in the production ofa product or service. Therefore, their depreciation and other operating costs are part of overhead.
19. Another standard overhead cost for many businesses is a reserve for bad debts – I.e., a business that extends credit on its own (i.e., not through credit cards) can forecast from experience the percentage of billings that wont be paid. For example, a lawyer knows that about 10% of his fees a year wont be paid off. So, to the detriment of his paying clients, he factors that 10% into his pricing as a standard overhead item – and in effect, they pay for it. Another standard overhead item listed on the previous page is interest paid on general business loans. The point we need to emphasize here is that this item does not include interest paid to finance inventory – such as, for example, interest paid by an auto dealer to finance an inventory of new cars. How would you characterize interest paid to finance inventory? (CHOOSE ONE OR MORE) a. Part of COGS. b. Part of COSS. c. A direct cost. d. An indirect or overhead cost. Answer #19: Choices (a) and (c) are correct – because the interest is tied specifically to the inventory, and not to any other asset. Thus, it’s a part of the cost of goods sold, and a direct cost.
20. An overhead item that some product dealers have to consider is inventory losses – which includes inventory that spoils or becomes obsolete, and is sold at a loss. In certain businesses such as fashion retailing, some inventory items turn out to be "dogs" and end up being given away. And unless the manufacturer has some type of return policy, the resulting loss is carried as unabsorbed overhead by the dealer. Finally, the category of miscellaneous may include a variety of cost items – like entertainment expense, research, conventions, administrative travel, memberships, etc. However, where significant sums are regularly spent on any one of these items, it will be listed separately on the Operating Statement and not be lumped with other miscellaneous costs. The next screen provides a brief review of direct costs and standard overhead items. Go on to the next screen.
21. REVIEW. Decide whether each of the following items is a direct cost item (D) or a standard overhead item (OH). a. D OH The cost of lenses used by an optometrist to make eyeglasses. b. D OH The costs of gas and oil for a van used by a mover. c. D OH A salary paid by Acme Remodeling to its administrative assistant. d. D OH The amounts a florist pays to wholesalers for roses, carnations, etc. e. D OH A for-profit hospitals factor for bad debts. f. D OH The cost of repairing a laser printer for a plastic surgeon’s office. g. D OH Interest paid to finance ABC Computer’s hardware inventory. h. D OH Advertising costs paid by a law firm. i. D OH Amounts a funeral home pays to buy “house flowers” for a wake. Answer #21: a. D d. D g. D b. D e. OH h. OH c. OH f. OH i. D
THE CONCEPT OF GROSS PROFIT 22. Small product dealers (retailers) are usually easier to analyze than service businesses – because most product dealers (retailers) have only one direct cost to worry about, and thats the cost of goods sold, or COGS. The rest is treated as overhead. Of course, the ultimate goal is the same – to absorb all COGS and all overhead costs, and have something left over as profit. Which brings us to a new concept that’s important in measuring advertising – the concept of GROSS PROFIT. Gross profit is the figure you get after you subtract direct costs from revenue – but before you subtract any overhead costs. Stated another way: Gross Profit = Revenue minus COGS (or COSS). Thus, for example, if Acme is paid $10,000 to build a deck, and the direct costs (COSS) are $5200, what is the gross profit from the job? (CHOOSE ONE) a. $4800 b. $5200Answer #22: Choice (a) is correct – i.e., $10,000 revenue minus $5200 COSS = $4800.
23. Below is a quarterly operating statement for Sam’s Book Shop. Note that the gross profit is shown. Revenue $47,000 COGS 20,000 Gross Profit 27,000 Overhead: Owners Salary 11,000 Clerk Salaries 7,000 Benefits 1,500 Rent, etc. 2,900 Advertising 800 Phone, supplies 500 Other 300 Net Profit $_______ What is Sam’s net profit for the quarter? (CHOOSE ONE) a. $24,000 b. $ 3,000 c. $ 7,000Answer #23: Choice (b) is correct. If you add up all the individual overhead costs, you get $24,000 – andthen you subtract the $24,000 from the $27,000 gross profit to get $3000 net profit.
24. Operating Statements are also called Profit-and-Loss Statements, or just P&Ls. The Sam’s Book Store example was a quarterly report, which is typical for businesses that use accountants. But most small business owners see a P&L statement once a year – and more often than not, its the tax return itself. Heres another (simplified) example of a P&L for a software consulting service: Sales Revenue $225,000 Direct Costs (COSS) 183,000 Gross Profit 42,000 Other Expenses (OH) Salaries $19,600 Rent 5,000 Supplies/Other 8,000 Total Overheads 32,600 Net (Pre-Tax) Profit $ 9,400 Based on the above, on a sheet of paper WRITE OUT the “formulas” for: (1) Gross Profit and (2) Net Profit.Answer #24: (1) Revenue minus direct costs (or COSS/COGS) = Gross Profit (2) Gross Profit minus Overhead = Net (or Pre-Tax) Profit
25. THE CONCEPT OF GROSS PROFIT IS VERY IMPORTANT TO YOU, because its the yardstick used to measure the return on an investment in advertising. Well get into ROI for advertising shortly. The P&L example you just worked with was a service business, since COSS was used. As you reviewed the example, these questions may have crossed your mind: "What does the owner get out of it? Is it just the $9,400 in net profit? Or just the $19,600 in salaries shown as overhead costs? Was it a bad year for information technology consulting?“ The likely answer is that the owner (or owners) are active in performing the service. Therefore: (CHOOSE ONE OR MORE) a. The owner is paid out of net profit. b. A substantial part of COSS is compensation paid to the owner. c. The owner’s compensation is included in the overhead costs. d. The firm’s net profit is a small part of the owner’s compensation Answer #26: Choices (b) and (d) are most likely true. First of all, most of the $183,000 of COSS is likely to be compensation for consultants. That compensation would start the year as overhead, and then gradually be converted to direct costs as project work is completed. The owner is likely to be the top consultant – and possibly the only consultant – and therefore earned most of the $183,000 as compensation. That means also that the $9400 company profit is a small part of the owner’s compensation
26. Net profit on an Operating Statement is before taxes, and is often shown as a percentage of sales revenue, as well as in dollars. For example, the software consulting company’s $9,400 net profit is about 4.2% of their $225,000 sales revenue ($9,400 ÷ $225,000). Just to make sure you’re clear on the difference between gross and net profit, try another example. Remember Acme Remodeling? In a recent year, Acme had these results : Total Revenue $360,000 COSS 164,000 Gross Profit $_______ Overhead 146,000 Net Profit $_______ Profit % of Revenue _______% ON A SHEET OF PAPER, FILL IN THE BLANKS ABOVE FOR ACME.Answer # 26: Gross Profit = $196,000 ($360,000 - $164,000) Net Profit = $ 50,000 ($196,000 - $146,000) Profit % = 13.9% ($ 50,000 ÷ $360,000)
27. REVIEW. Which of the following is/are true? (CHOOSE ONE OR MORE) a. Gross profit = revenue minus overhead. b. Gross profit = revenue minus direct costs. c. Net profit = gross profit minus overhead. d. Net profit = revenue minus overhead. e. P&L Statement is another term for Operating Statement. f. Net profit is often expressed as a percent of sales revenue.Answer #27: The true statements are (b), (c), (e), and (f). Remember that you always start the equation with revenue – and then you subtract direct costs to get gross profit. Then, once you have gross profit, you subtract the overhead from that figure to get net profit. Net profit is what people call “the bottom line” – and it’s also called pre-tax profit.
BUSINESS EXPENSES AS INVESTMENTS 28. Many business owners think of costs as something you try to avoid. Actually, legitimate business costs are investments on which the business hopes for a fair return. For example, Acme Remodeling invests $310,000 ($164,000 in COSS and $146,000 in overhead) to produce revenue of $360,000 – a net profit of $50,000. So the return on the $310,000 investment was about 16% ($50,000 ÷ $310,000). In general, all legitimate business costs contribute in some way to running the business and generating revenue. But some costs contribute more to revenue production than others. Which two of the costs below do you think are most important to generate revenue for a heating contractor? (CHOOSE TWO) a. Rent for workshop and office space. b. Labor costs for furnace technicians. c. Advertising costs. d. Secretarial salaries. e. Accountants fees.Answer #28: In our judgment, the two most important costs related to revenue production are choices (b) and (c) – labor costs for furnace technicians and advertising costs.
29. In the heating contractor example, installation and repair of heating systems obviously cant be done without the labor to do it. But without advertising, there could be very few jobs for the technicians to handle. Granted, the business needs offices and a shop to operate from – but the rent is not as important to generate revenue, since the work is done primarily on the customers premises. Which two of the costs below are most important to generate revenue for a building materials store? (CHOOSE TWO) a. Advertising costs. b. Costs of operating delivery trucks. c. Interest to finance inventory. d. Secretarial salaries. e. Costs for phone and utilities.Answer # 29: The best choices here are (a) and (c). There can be no business without inventory – but without advertising, the inventory wont move. And if it sits for long periods, it can end up a loss.
30. The fact is, all the costs given in the previous two examples are investments that are necessary to operate the businesses and generate revenue. But as we have established, some investments play a more important role in revenue production than others. AND THERE CAN BE NO DOUBT THAT ADVERTISING IS ONE OF THE MOST CRITICAL REVENUE-PRODUCING INVESTMENTS FOR ANY BUSINESS. Why, then, do so many business owners consider advertising costs a cash drain? The likely reason is that many owners or managers have not really absorbed the concept of "Business Costs as Investments." If you have doubts about the “investment” nature of advertising, you need to be able to measure the return on investment (ROI) that your advertising brings. Go on to the next screen.
RETURN ON ADVERTISING INVESTMENT 31. For any business cost, the main issue is whether the likely return justifies the risk. Lets say a business owner now has a $200-a-month Yellow Pages advertising program – and a Yellow Pages sales rep is proposing that she move up to a $500-a-month program. Which of the following statements do you think is/are true? (CHOOSE ONE OR MORE) a. The advertiser is well aware that her Yellow Pages investment risk would be increased by $300 a month. b. The advertiser doesnt see the additional $300 a month as additional risk. c. The advertiser knows how much return she would likely get from a $300- a-month investment increase. d. The advertiser doesn’t know how much of a return she would likely get from a $300-a-month increase.Answer #31: Statements (a) and (d) are true. Unfortunately, too many small business advertisers only hear the specific figure for the amount of advertising cost (risk) being proposed, but they have little or no idea of what they can reasonably expect to get in return.
32. For example, a lawyer can easily envision a return from investing in an updated set of law books – or a beauty salon operator can easily see an increased return from investing in expanded services – but these same individuals (and many other small business owners) have difficulty visualizing higher returns from increased advertising. The reason is that law books are tools of a lawyers trade, while advertising is not – and the beauty salon operator easily connects more services with more customers, but doesnt automatically associate advertising with developing that connection. What can you conclude from the above? (CHOOSE ONE OR MORE) a. Theres little risk in advertising – and you can assume you wont lose your investment. b. You need to be aware of the connection between advertising investments and revenue production. c. You need to measure ROI for every significant advertising investment. d. Since you know the dollar amount of risk in an advertising investment, you can evaluate the risk only by measuring the resulting ROI.Answer #32: Choices (b), (c), and (d) are valid conclusions. Choice (a) sounds like the kind of vague claim an advertising sales rep might make. It emphasizes not losing the investment but fails to focus on an expectation of gain. The fact is, nobody advertises just to break even.
33. With most types of small business advertising, the measure of success is the number of responses or inquiries the advertising generates – and not necessarily the dollars that end up in the till. For example, two tire dealers similar in size, product line, and brands run promotions inthe newspaper at the same time. As a result, dealer B gets 250 qualified leads and makes25 sales, while C gets 100 qualified leads and makes 50 sales. Which dealer probably had the better advertising? (CHOOSE ONE) a. Dealer B. b. Dealer C.Answer #33: Choice (a) is correct. But even though dealer B had the better advertising, he may have serious problems in converting responses to sales. Dealer C, on the other hand, had less effective advertising, but a much higher sales conversion rate.
34. The measure of effectiveness for Yellow Pages and most newspaper, radio, etc. ads isthe number of inquiries resulting from the ad, and not the sales revenue – because at the point of inquiry, several things could happen to make a great advertising campaign fail in terms of actual sales. For example, poor phone manners by the advertisers employees could turn off many callers who would otherwise have come in and bought. Or the unkempt condition of an advertisers premises could discourage many consumers who drop in. Exceptions to the above are the advertising used in direct marketing, such as direct mail and 1-800 TV offers, and some advertising coupon redemptions. In such cases, the measure of effectiveness usually is the number of actual orders received. Go on to the next screen.
35. On the other hand, businesses cant pay their bills with inquiries. So we need a way to equate the inquiries generated by advertising with potential sales revenue. As an example, which of the following would work for a Yellow Pages ad? (CHOOSE ONE) a. The number of inquiries actually converted to sales. b. Considering each inquiry to be a completed sale. c. An estimated average number of inquiries it takes to make one average sale.Answer #35: Choice (c) is the best answer. As has been pointed out, too many things can happen at the point of sale that could make actual sales a misleading indicator of the effectiveness of the advertising. Also, choice (a) is after the fact – plus, the great majority of small business advertisers do not do a good job of keeping track of sales from their advertising – and that’s why choice (a) is not the best answer. Choice (b), of course, is too far-fetched.
36. To plan for (or forecast) a reasonable return on an advertising investment, you need to estimate or decide on the following pieces of data: • DOLLAR AMOUNT OF YOUR AVERAGE SALE • YOUR GROSS PROFIT ON AN AVERAGE SALE • THE AVERAGE NUMBER OF INQUIRIES IT TAKES TO MAKE ONE AVERAGE SALE. • YOUR ROI OBJECTIVE (AS A %). As noted earlier, we use the gross profit on an average sale to measure ROI – and not the revenue from an average sale or the net profit. For example, a building materials store pays $185 for a table saw and sells it for $350 – for a $165 gross profit. After subtracting a $90 share of overhead costs, net profit on the saw is $75. First of all, for any table saw sold through advertising, why can’t we use the saw’s $350 sales price in computing the ROI from the advertising? (CHOOSE ONE) a. The $350 includes a $185 COGS that cant be counted as part of a return on investment because its part of the overall investment. b. The $350 doesnt include the $90 element of overhead.Answer #36: Choice (a) is correct. The $185 from a $350 sale is just a return of money spent for the inventory. It’s a return of investment, not on investment. Regarding choice (b), overhead is not a factor in estimating ROI on advertising.
37. The next question is: Why do we use gross profit instead of net profit in measuring the ROI on advertising? Using net profit would, in effect, include overhead costs in the calculation. Thus, for example, if some of the advertisers overhead costs are excessive (say, from mixing personal and company expenses), using net profit would unfairly skew ROI downward – and we don’t get a true measure of the advertising’s effectiveness. In other words, net profit can give a false impression of advertising effectiveness if the advertiser manages his overhead poorly. Go on to the next screen.
38. Consider the following franchise outlets in the same business using the same advertising campaign and getting the same response and sales results: ALPHA CO. BETA CO. Advertising Cost $ 1000 $ 1000 Gross Sales 8000 8000 Direct Sales Costs 3500 3500 Gross Profit 4500 4500 ROI Using Gross Profit 350% 350% Overhead (Except Adv.) 1500 3000 Net Profit 3000 1500 ROI Using Net Profit 200% 50% Which of the following is/are true? (CHOOSE ONE OR MORE) a. Using net profit gives Beta a false ROI picture. b. Using gross shows both ads got the same results. c. Beta runs its business more efficiently than Alpha. d. Alpha runs its business more efficiently than Beta.Answer #38: All but (c) are true. Choice (a) is true because Beta’s excessive overhead in determining net profit results in a false picture of ROI from the advertising. Indeed, overhead management (good or poor) is irrelevant to advertising effectiveness. Choice (b) is true because, in fact, the two outlets did get the same advertising results. And (d) is true because Alpha clearly manages its overhead more efficiently than Beta.
39. We used the term "gross profit from an average sale." This refers to the fact that a business may sell many different items or services at a wide range of prices. For example, a computer dealer makes sales ranging from a $5 accessory to a $3500 system. Or a florist varies from a $10 carnation to $2000 for wedding flowers. Thus, you will usually need to establish how much an average sale is first – before getting to gross profit. Suppose a tire dealer estimates his average sale is $400. In gathering information to plan for ROI measurement, which of the following should be his next question? (CHOOSE ONE OR MORE) a. “What’s my average net profit on the $400?” b. “How much of that is gross profit?” c. “What percent of that is my cost for the tires?” d. “How much of the $400 is overhead?”Answer #39: Either (b) or (c) would be appropriate. Choice (b) is direct – “How much of that is gross profit?” Choice (c) is the back door approach – i.e., if the tire dealer says about 60% is his cost, that would mean the cost of goods sold (COGS) is $240, which means the gross profit is $160. Choices (a) and (d) are incorrect because net profit and overhead are not factors in estimating return on investment for advertising.
40. If you sell a wide variety of products, don’t try to factor in the price of every product to come up with a figure for average sale. An easier way is to estimate your most frequent sales and estimate the price range of such sales. Then, use the midpoint of the range as the amount of your average sale. For example, a furniture dealer estimates that most of her sales are in the $400 to $700 range. In that case, her average sale for ROI purposes would be: (CHOOSE ONE) a. $400 b. $500 c. $550 d. $700 Answer #40: Choice (c) is correct. $550 is the midpoint between $400 and $700.
41. The furniture dealer in the previous example would then have to come up with a figure for average gross profit on the $550 average sale. For example, if she estimates that her COGS typically runs about 60% of the sale price, her average gross profit for ROI purposes is: (CHOOSE ONE) a. $330 b. $550 c. $220Answer #41: Choice (c) is correct – $550 x 60% COGS = $330; and $550 – $330 = $220.
42. Some service businesses also offer a variety of services that may vary widely in price – such as an auto repair shop that does everything from replacing a tail light reflector to overhauling an engine. For general advertising, the same rule of thumb can apply – use the midpoint of the price range of the most frequently sold services, and then estimate an average gross profit on that amount. Of course, a great deal of advertising is limited to promoting one product or service, or maybe one group of products or services. For example, a dealer in all-terrain vehicles advertises a 20% off sale on a particular brand and model of ATV that regularly sells for $3600. For purposes of ROI measurement for this advertising, the average sale price he would use is: (CHOOSE ONE) a. $2880 b. $720 c. $3600Answer #42: Choice (a) is correct – $3600 x 20% = $720 and $3600 – $720 = $2880. And if the dealer’s cost on the item is $2400, the gross profit he would use in an ROI measurement is $480.
43. Another piece of information needed for advertising ROI is an estimate of the number of inquiries, calls or responses it generally takes you to make one average sale – i.e., your conversion rate, also called the “hit rate.” For example, a computer dealer estimates that it takes 20 calls to make one average sale – while a florist estimates she makes an average sale every 4 calls. If you reduced their hit rates to percentages: (CHOOSE TWO) a. The computer dealers hit rate would be 20%. b. The computer dealers hit rate would be 5%. c. The computer dealers hit rate would be 15%. d. The florists hit rate would be 25%. e. The florists hit rate would be 100%. f. The florist’s hit rate would be 75%.Answer #43: Choice b. for the computer dealer (1 ÷ 20) and choice d. for the florist (1 ÷ 4) are correct.
44. The final estimate you need to plan for ROI is the percent of return you would like to get on the advertising investment – for example, 100%, 200%, etc. As a review, the other two items of information (besides % objective) you need for an ROI plan are: (CHOOSE TWO) a. Gross profit from all sales. b. Gross profit on an average sale. c. Net profit for the year. d. Net profit on an average sale. e. Estimated number of responses you expect from the ad. f. Estimated number of responses to make one average sale. g. Estimated monthly sales revenue.Answer #44: Choices (b) and (f) are correct. Gross profit on an average sale and hit rate (or conversion rate) are the two other pieces of information you need for return on investment besides your ROI objective itself.
45. Once you have all your estimates, how do you use them to plan for ROI? CLICK THE SCREEN for the basic ROI plan steps in a worksheet format: (1) Number of Ad Responses to Make One Sale ________(2) Average Gross Profit per Sale (Average Sale minus Direct Costs) $________(3) Proposed Advertising Investment $________(4) ROI Expectation @______% = $______ Cost plus $______ More $________ (5) Number of Sales Needed for ROI Expectations (#4 ÷ #2) ________(6) Number of Responses to Achieve ROI Expectations (#5 x #1) ________ REVIEW THE STEPS ABOVE, AND THEN GO ON TO THE NEXT SCREEN.
46. Lets say a muffler shop’s gross profit on an average sale is $160. They estimate a hit rate of 3 ad responses to make one average sale, and they’d like an ROI of 150%. The advertising investment in question is $700. ON A SEPARATE SHEET OF PAPER, COMPLETE ITEMS 1, 2, AND 3. (1) Number of Ad Responses to Make One Sale ________(2) Average Gross Profit per Sale (Average Sale minus Direct Costs) $________(3) Proposed Advertising Investment $________(4) ROI Expectation @______% = $______ Cost plus $______ More $________ (5) Number of Sales Needed for ROI Expectations (#4 ÷ #2) ________(6) Number of Responses to Achieve ROI Expectations (#5 x #1) ________ Answer #46: (1) 3 (2) $160 (3) $700
47. Here is what we have so far: (1) Number of Ad Responses to Make One Sale ____3____(2) Average Gross Profit per Sale (Average Sale minus Direct Costs) $__160___(3) Proposed Advertising Investment $__700___(4) ROI Expectation @______% = $______ Cost plus $______ More $________ (5) Number of Sales Needed for ROI Expectations (#4 ÷ #2) ________(6) Number of Responses to Achieve ROI Expectations (#5 x #1) ________ As you recall, the ROI objective was 150%, which you would enter in #4 in the first blank – but we need to convert that to dollars. If you recover only the $700 cost, the ROI so far would be zero percent. So to get an ROI of 150%, you need to get back an additional 150% on top of the cost recovery. COMPLETE ALL THE BLANK SPACES FOR STEP 4.Answer #47: (4) ROI Expectation @__150_% = $_700__ Cost plus $_1050_ More $_1750___ (The $1050 is the gain - $700 x 150%)
48. In order to get a 150% ROI, you would have to realize a $1750 gross profit from the $700 advertising expenditure. Heres what we have so far : (1) Number of Ad Responses to Make One Sale ____3____(2) Average Gross Profit per Sale (Average Sale minus Direct Costs) $__160___(3) Proposed Advertising Investment $__700___(4) ROI Expectation @__150_% = $_700__ Cost plus $_1050_ More $_1750___ (5) Number of Sales Needed for ROI Expectations (#4 ÷ #2) ________(6) Number of Responses to Achieve ROI Expectations (#5 x #1) ________ Now lets see how many average sales that would take. To get that figure, divide the $1750 by the $160 average gross profit per sale. Or, as item 5 simplifies it, just divide the figure in item 4 by the figure in item 2. COMPLETE ITEM 5 FOR THE EXAMPLE. Answer #48: (5) Number of Sales Needed for ROI Expectations (#4 ÷ #2) 10.9 (or 11)
49. To make $1750 in gross profit from the advertising, the advertiser needs to get the equivalent of about 11 average sales. (1) Number of Ad Responses to Make One Sale ____3____(2) Average Gross Profit per Sale (Average Sale minus Direct Costs) $__160___(3) Proposed Advertising Investment $__700___(4) ROI Expectation @__150_% = $_700__ Cost plus $_1050_ More $_1750___ (5) Number of Sales Needed for ROI Expectations (#4 ÷ #2) ___11___(6) Number of Responses to Achieve ROI Expectations (#5 x #1) ________ All thats left is to determine how many calls it would take from the ad to generate 11 average sales or the equivalent. COMPLETE ITEM 6 FOR THE EXAMPLE. Answer #49: (6) Number of Responses to Achieve ROI Expectations (#5 x #1) 33__
50. In most areas, 33 calls (sales opportunities) for a muffler shop from a $700 advertising campaign is probably a very reasonable expectation. Optional Exercise: If you had any problem with the ROI steps, it was probably on item 4, which deals with converting an ROI expectation from a percent to profit dollars. The example below addresses item 4 – but if you feel confident about it, you can skip this exercise and click through to screen 51. Given an advertising investment of $600, how much gross profit in dollars is needed to meet the advertiser’s goal of 200% ROI? (CHOOSE ONE) a. $1200 b. $1800 c. $ 600Answer #50: Choice (b) is correct – $600 + (200% x $600) = $1800. The first $600 of that amount is a return of investment. The other $1200 is the return on investment. The return on investment is 200% over and above the $600 investment.
51. Try this example. A local moving company owner estimates an $800 gross profit on an average move – with an estimated hit rate of one average move for every 5 calls. He would like at least 200% ROI on a monthly advertising investment of $400. (1) Number of Ad Responses to Make One Sale _______ (2) Average Gross Profit per Sale (Average Sale minus Direct Costs) $_______ (3) Proposed Advertising Investment $_______ (a month) (4) ROI Expectation @______% = $______ Cost plus $______ More $ _______ (5) Number of Sales Needed for ROI Expectations (#4 ÷ #2) _______ (6) Number of Responses to Achieve ROI Expectations (#5 x #1) _______ COMPLETE ALL THE BLANKS FOR ONE MONTH OF ADVERTISING.Answer #51: (1) Number of Ad Responses to Make One Sale ____5___ (2) Average Gross Profit per Sale (Average Sale minus Direct Costs) $__800___ (3) Proposed Advertising Investment $__400___ (a month) (4) ROI Expectation @__200_% = $_400__ Cost plus $_800__ More $_1200___ (5) Number of Sales Needed for ROI Expectations (#4 ÷ #2) ___1.5___ (6) Number of Responses to Achieve ROI Expectations (#5 x #1) ___7.5__ To get a 200% return, the mover needs an average of 7.5 ad responses a month over the period of the advertising, which should result in 1.5 average sales worth $1200 in gross profit.
52. As you can see, the number of responses to meet a reasonable ROI goal turn out to be very attainable for the types of businesses in question – and probably for yours, too. And there’s an added positive for many types of business – i.e., the ROI figures don’t reflect any repeat business from customers who respond to the ad for the first time. For example, a fuel dealer who gets a customer from a Yellow Pages ad may keep that customer for 5 or 10 years – or more. Or a person who responds to a hardware dealer’s advertising and comes in to buy a chainsaw may come back several times to buy other items. In either case, the actual ROI for the advertising in question may be quite large over the long term. Go on to the next screen.
53. If you’re trying to forecast ROI for, say, a three-month advertising campaign, you probably wouldn’t be factoring in any repeat business estimate. But doing a marketing plan for the year may be a different story for many businesses. For example, a business may be considering a year-long newspaper or radio ad contract, or a year-long Yellow Pages program. If they are apt to get repeat business from new customers initially brought in by the advertising, they can plug in an estimate. For which of the following businesses is repeat business within 12 months from a new customer a potential ROI factor? (CHOOSE ALL THAT APPLY) a. Roofing Contractor b Sporting Goods Store c. Travel Agent d. Restaurant e. Kitchen Remodeler f. Aluminum Siding Dealer g. Computer Supplies h. LawyerAnswer #53: Our choices are: (b), (c), (d), and (g).
54. In general, repeat business can be factored into your ROI worksheet by appropriately increasing the figure for gross profit per average sale (step 2). For example, a carpet cleaner who makes $50 of gross profit on an average job estimates that 1 in 5 new customers (20%) will buy again within 12 months. Thus, for step 2 on the worksheet, you would increase the gross profit per average sale by 20% – from $50 to $60. As a result, fewer sales from the advertising would be needed to meet the ROI objective – and hence fewer ad responses. Say a jeweler with a $60 gross profit per average sale estimates that 1 out of 3 new customers buys once more in the next 12 months. Which of the following figures would reflect the repeat business in worksheet item 2? (CHOOSE ONE) a. $93 b. $80Answer #54: Choice (b) is correct - $60 + (33% x $60) = $60 + $20 = $80.
55. Let’s say a hardware dealer estimates that 1 out of 4 new customers (25%) comes back and makes another average buy within the next 12 months. COMPLETE THE DATA IN THE RIGHT-HAND COLUMN TO INCLUDE AN ESTIMATE OF REPEAT BUSINESS. (1) Number of Ad Responses to Make One Sale ____5___ ____5___(2) Average Gross Profit per Sale (Average Sale minus Direct Costs) $__ 60__ $_______(3) Proposed Advertising Investment $__600___ $__600___(4) ROI Expectation @__150_% = $_600__ Cost plus $_900__ More $_1500___ $_1500___ (5) Number of Sales Needed for ROI Expectations (#4 ÷ #2) ____25__ ________(6) Number of Responses to Achieve ROI Expectations (#5 x #1) ___125__ ________ Answer #55: (2) $75 ($60 plus 25% of $60 = $75) (5) 20 ($1500 ÷ $75 = 20 sales) (6) 100 (20 x 5 = 100 calls)
56. Review. Which of the following is/are true? (CHOOSE ONE OR MORE) a. The items of information needed to project ROI on advertising are your gross profit on an average sale, your conversion rate, and your ROI goal. b. The conversion rate refers to the estimated number of calls it takes for you to make one average sale. c. If you expect a 150% ROI on a $500 advertising investment, the ad needs to pull $750 of gross profit. d. To find the number of average sales needed to meet an ROI objective, youd divide the gross profit per sale by the total gross profit dollars expected from the ad. e. A business owner with a $50 gross profit on an average sale and a goal of $1750 of gross profit to meet his ROI objective needs 35 average sales to do it. f. The business owner in (e) has a conversion rate of 4 calls to get one average sale – and thus needs 70 calls to meet his objective.Answer #56: The true statements are (a), (b), and (e). Regarding (c), it would be true if the ROI objective were only 50%, not 150%. Statement (d) is stated backwards – the correct operation would be to divide the total gross profit dollars by the gross profit per average sale. Finally, (f) has wrong math – the correct math is to multiply 35 sales by 4 to get 140 responses.
57. THAT’S IT! You’ve completed this Sell4Search interactive self-teaching program, which was designed to give you a grounding in some basic accounting principles as they relate to advertising – and you’ve also gone through some exercises to help you get a handle on how much return you’re getting on your advertising investments. Keep checking Sell4Search.com for more programs in the future.