How Do I Calculate Variable Costs?

- Objective today:
    - Unit economics - like individual Lego building blocks that make up the overall profitability picture
    - Revenue per unit
    - Any cost during making and selling
    - Connected to gross margin.
        - 
            - Every % is a penny of each $ available to cover overhead
- Concept:
    - What makes it improve?
        - Increase price
        - Decrease variable expense
        - Cost of product
            - produce in bulk
            - cut costs where customers don’t mind (value engineering)
        - shipping
            - negotiate better rates
            - Offer free shipping above threshold
        - advertising & commission
            - Sell to existing audience
            - Partner with other brands to sell to their customer
    - Trade-offs
        - Sometimes spending more advertising dollars or offering referral or sales commission can accelerate revenues to help cover overhead but decrease our gross margin %
- Key Question + Action
    - **What is a unit for you?**
    - **What costs do you incur with each creation and sale of every unit?**

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Transcript

 How do I calculate my variable costs? And how do I know I'm making the right margin every time I make and sell a single unit. Most  entrepreneurs don't have a clear and compelling roadmap for the future.  Welcome to Forecast On Purpose, where we talk about how to define your purpose, build a growth plan and track progress along the way to make sure you stay on target. 

The result is clarity, confidence, and peace of mind that you are on the right track. My name is Ben Cooper and I'm the founder of Amplify. We help entrepreneurs better understand how today's decisions either positively or negatively affect your future. In each episode, we'll hear a short case study of a story of an entrepreneur facing an important growth decision, 

a concept that applies to the situation, and a key question or action step for you to apply to your own business. Also, it's possible we may be talking about your business and your specific challenges on future episodes as well. Today, we'll be talking about variable costs. Let's get started.  

Aaron makes custom hats. It all started in high school when he learned how to put his own design on his hats and friends and family started asking for their own. So ultimately he opened a website and they began selling online. And it's grown to the point where he has a huge following and he's got partnerships with different businesses and different brands and a whole lot of different industries. 

But as Aaron talks to other business owners, he started to wonder whether his margins are above average, or below average, or are they just normal? 

And here's why it matters: there's a concept called unit economics. And for Aaron's business, a single hat would represent one unit. But you think of it almost like building blocks, like Legos. When I watch my boys in their room and they're building different things out of these Legos, for Aaron in his business, each hat represents a single Lego. It's a little building block that all, you know, they join together and ultimately when he looks at his business at the end of the month, he can see, okay, 

here's how much revenue I generated here, the different types of expenses I incurred and here's how much profit I have. And for any business,  it's important to identify what a single unit is. And the reason this is important is because if we can make sure that we understand the economics on an individual unit level, then we can identify opportunities to 

potentially not just increase the profitability of the business, but importantly, accelerate the progress that you might be able to make as a business owner toward these big picture important goals that you do have for you and your business. So the objective today is to identify the three primary components that  play into a unit economic conversation. 

So first, when we look at a hat that Aaron is producing, he's able to sell it for a certain price. So there's the revenue per unit that represents the total bar in the bar graph that we're looking at here. And then secondly, there's the costs that he incurs when he makes and sells a single hat. So 

the cost of the materials, all the labor that goes into it, and then potentially if he's selling it through advertising dollars or there's a sales person making some sort of commission, these are costs that are only incurred when a product is either made or sold in the business. It's not like rent or some sort of overhead operating expense that is incurred no matter what. 

We, what we want to identify here is the expenses that are only incurred when we make or sell a single unit. And then the third piece, the resulting piece of this, if we take the revenue, the sales price of it, and then we can take out any of those variable costs that are incurred again when we make and sell, then what we're left with is the gross margin. 

And essentially the gross margin represents the dollars that are available to then go and cover overhead. And then once we hit that break even point, then we're able to then put more dollars into the business than we started the month with, for instance. And so every percent, like if we look at the unit economics of a, of a, of a single hat and we find an opportunity to increase the 

gross profit margin by 3%, for instance, then what that means is 3 cents of every dollar that we bring into the business through revenue is now available to cover and then over recover our operating expenses. So your economics are really, really essential to understand how profitable a business can be. And maybe how difficult of even a business idea that you might have could be to get off the ground when you start the business and when you go to validate its potential. So when we look at the unit economics, there are a few things that we can do to hopefully improve the profitability, potential of a business. So if Aaron was looking at his you know, the cost and revenue that come in with each single unit,

what makes the unit economics picture even better? Well, we can start on the revenue side first. The primary lever that we can do to increase our gross margin for a single unit is we can increase price. Now, if Aaron is talking to other business friends, and he's looking at other websites that are selling a similar product and he's talking to customers, he may be able to get a really good feel that 

what he's creating, he's maybe selling for $25 a hat, but customers would actually gladly pay more like $38 a hat. If there's opportunity to increase price, then that's the first place that we want to look to as quickly as possible, maximize the number of dollars that are going to flow through to cover overhead. 

The reason this is important is let's say the cost of producing and selling the hat for Aaron, maybe $10. And so it's costing him $10. He's selling it for $25. And if we did the simple math, we would have 25 minus 10 leaves, $15  of contribution toward the overhead. But if he's able to sell the hat for $38 and it still only costs $10 to make and sell. Then importantly, you know, now we have $38 minus 10, and that creates 28 new dollars. So instead of $15, we have $28 that can go to overhead. And if you do the simple back of napkin math there, essentially Aaron could be selling the same number of hats and then making twice as much in gross profit each month, just by being intentional with where the pricing is and pricing is a delicate topic. I mean, we'll, we'll dig into that in a future episode, but that is one key lever when we look at unit economics of how much are we able to sell each unit for. 

The second place we want to look is the cost of the product. 

So what can we do to decrease the expense that we incur when we manufacture the product in the first place? And some of these opportunities may be found in efficiencies of scale, where we are able to order more product in bulk material. We can maybe set up a more efficient manufacturing process. I think of like the Henry Ford assembly line concept, where instead of just taking a hat and manufacturing it from start to finish, maybe you do them in batches and you do 20 hats at the same time. 

And you're able to minimize the switching time and expense that is incurred in the manufacturing process. Another place that we might be able to save some money in the variable expense side is if we know what our customers value the most about our product, then we can actually identify areas that we may be 

over-delivering on in some ways. So if there's stitching in the back of Aaron's hat that people think, oh, that's cool, but that's not why I want the hat. You know, there are some elements of the manufacturing that if the quality doesn't go out the door, And the customers don't mind. We may be able to do something that's called value engineering, which is where we can evaluate the entire product in the eyes of the consumer and identify places where we are able to maybe remove some components of the product

without harming the customer experience. And in doing so we can cut some expense and further increased the gross profit per unit that we end up selling. Some costs that we incurred, aren't just in the manufacturing side. We also incur expenses when that product gets shipped out the door. 

And there are a couple places that we need to consider some of these variable expenses as well. One would be shipping and fulfillment. If you are an e-commerce business, there are a couple of ways that you could potentially improve the cost per unit here. And one is, if you haven't a relationship with a fulfillment service or a shipping company, then a lot of times when you do sell above a certain threshold, then there is opportunity to negotiate better rates for shipping. And then secondly, you can create a minimum order size 

through the website instead of offering free shipping to anybody in everyday, everybody who purchases, you may be able to actually bring in some additional shipping revenue from the customer to offset some of the shipping costs. It's easy with a lot of big e-commerce sellers out there to think that customers always expect free shipping, but that's not the case. 

Another place is if we are selling the product through some sort of channel where there's some sort of commission or advertising costs like digital marketing. For instance, if we are able to understand that there is a connection with, you know, the number of dollars we spend on digital marketing is going to translate into new sales. 

And I need to be aware that that's a lever that we can pull for better or worse. And that there is an expense that we incur similar to if we had a salesperson who made 10 or 15% per sale, then we need to be aware that those are expenses that we have to include in this overall unit economic analysis. 

So there are some practical ways that you also might be able to partner with some other brands and some other audiences too. Find ways that you can sell through existing relationships. It's either existing customers that you have on your own customer list, or potentially other brands who already have relationships with buyers who would also like your brand. And so it's important to 

look to the left and the right and find people who are doing other interesting things and try to link arms and, and find creative ways that you're able to deliver value to customers without needing to maybe pull some of the expensive levers like acquiring new customers through expensive advertising efforts. 

Now the reality is once you get the business up and running and we start to zoom out far enough from the building blocks to understand the overall picture, there are trade-offs the. Advertising example is a good one where well, You know, what, if we were able to sell a thousand more hats because we invest X number of dollars in digital marketing. 

The trade-off there is we have more throughput. We have more units that are being sold to customers and revenue goes higher, but our gross profit margin percentage may go down. Similarly, we can make our gross profit margin go up, but it might require ordering a lot of material in bulk. And that requires some working capital cash infusion into the business potentially 

to be able to afford some of those purchases in bulk. So sometimes there are trade-offs where we have to look at the overall picture and say, well, where do we want to push the gas over here? And where do we, we want to pump the brakes over here? All with the intent of maximizing the profit potential of the business, 

not necessarily so that you just end up with more cash in the bank, but so that we have more resources available to accelerate the progress that you want to see your business be making in the big picture. 

So the key question and action item for you today is for you to step back, look at your business and ask what is a single unit? 

What is a Lego in my business? What is the overall picture that I'm wanting these Legos to these building blocks to essentially come together to create. And what are the individual components at each unit? So what is the revenue per unit? Where does the variable expense per unit? And  📍 then how does that leave me with a gross profit margin contribution picture per unit?

 And what you will find like most businesses  is that you have a few different types of units and that's okay. But what's important is that you understand and you look for opportunities to focus in on maximizing what's available within each unit. 

If you are somebody, you know, is an entrepreneur and you'd like some help planning for the future or breaking down your unit economic picture, don't hesitate to reach out. 

Go to forecast on purpose.com to learn more. And remember you are not alone and you don't have to just keep blindly guessing about the future. Keep fighting the good fight and forecast on purpose.