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Measuring Financial Performance

FastTrac, Kauffman Foundation

Performance is often measured in financial terms as entrepreneurs set specific financial goals concerning cash flow, profits, and overall financial performance.

In this article, you will review a variety of performance measurements that will guide you through your growth stage. Two key financial concepts contribute to effectively using financial analysis as a measurement tool: gross margin and operating expenses.

Gross Margin

Gross margin targets are particularly critical. They act as an initial snapshot of your profitability. A case could be made that gross margin is far more important than sales goals. Up to a point, would you really care what the sales volume is if you were handed a $5 million gross margin? In a quest to make sales volume, many firms cut prices to the extent that the resulting gross margins will not result in a profit. Remember—the key to profit is gross margin, so set a goal that is reasonable and achievable.

Every increased dollar in gross margin affects the bottom line in a significant way, but a dollar increase in sales volume may result in only a fractional increase in profits. In addition, the costs of the sales increase may exceed the results while the costs of getting a higher gross margin may be slight. Let's look at an example of this concept.

Let's say the ABC Company sells Spice it UP! fresh herb dispensers. It costs them $3.49 to manufacture this unique kitchen tool, but the market allows them to sell it for $19.95. That's a pretty great margin—margin being the difference between the expense they incur to produce it and what they make when they sell it. As the new fiscal year approaches, the ABC team learns that the market is excited about this product; research indicates that they could raise the price of the Spice it UP! fresh herb dispenser to $24.95. That extra $5 represents profit because it will not cost the ABC Company any more than it already does to produce this product.

In some cases, the costs of production may even go down with higher volumes because the purchase of raw materials in greater quantities often demands better prices from suppliers. On the sales side, every dollar increase in sales may actually only generate a small increase of profit or, in some cases, no additional profit because with each sale ABC incurs added costs. Costs of sales might include marketing, brochure development and printing, travel costs for sales personnel, or expense accounts.

Simply selling more Spice it UP! fresh herb dispensers may or may not improve profit. Without a careful analysis of price and gross margin, this entrepreneur will not know whether increased sales will result in increased profit.

Operating Expenses

If gross margin is the initial snapshot in profitability, the operating expenses are the second. Avoid the trap of thinking that operating expenses are all fixed. Even though they are called fixed, you still have some control over how much you spend on fixed expenses. Some expenses are variable. You should have greater control over how much you spend on variable expenses.

Fixed costs are those expenses that are always there, regardless of how much or how little you sell. For example, rent, salaries, and general overhead are considered fixed costs. As a rule, fixed costs do not change when sales increase. For instance, rent will not increase just because your sales efforts increase. Only if your growth demands more square footage will the fixed cost of rent increase. Likewise, administrative salaries don't usually vary with increased sales activities.

Variable costs are those expenses that can increase as your sales increase, such as additional telephone usage, postage, supplies, and even printing and copy machine costs. While many expense plans assume a level amount of monthly expenditures for many general expenses, in reality they do go up with volume. Expenses in your operations plan must be supported with an explanation of how the amount was derived as well as the assumptions that go into calculating that figure.

Keep in mind that what goes up can also come down. Variable expenses can be lowered with careful planning. For instance, printing costs may be significantly higher if you print one brochure at a time rather than preparing and printing your marketing materials all at once. Something as simple as watching the amount of office supplies purchased on a monthly basis or reviewing the costs of telephone services to make sure the charges are competitive can make a significant impact on controlling your variable costs.

© 2007 Ewing Marion Kauffman Foundation. All rights reserved.

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