Step 3: Spend Wisely
We live in a world in which we always want more. We spend more, we want more revenue or income, and then we spend more. Many of us buy cars, go on vacations, and we work to spend our way to happiness.
A 2015 research report by UBS has some interesting facts about the aspirations and desires of millionaires. Fifty-Eight percent of millionaires say they have an increasing standard of living. Sixty-Four percent say their living expectations have gone up. Those with $1 million want $2 million and those with $10 million want $25 million. They have an increasing fear of losing their money. Nearly half of GenX and Millennial millionaires (those born 1965 to 1995) fear the loss of their wealth and feel pressure to keep up with others.
We could have a whole discussion about wealth, abundance, and fear. The point I really want to make is that it seems the more people make, the more they spend. This means that if you are a business owner, then revenue might solve your problems in the short term, but eventually, expenses will catch up without some control.
I believe any business should work to grow revenue consistently, but it will not make you profitable by itself. We must be smart with our expenses and ensure we have the profit we desire.
Why Are You A Business Owner?
Ask yourself why you have a business. Why do you want to grow your business? Surely you don’t want to grow revenue with no profits or cash to show for it. Some businesses want high revenue growth to ultimately sell. This post is not for businesses that are taking on venture capital investment with losses for years to gain market share or launch a new product that has not yet hit critical mass (ex. Facebook or Amazon in their early years).
Maybe you started your business because you saw a need in the marketplace, and you want to provide a service or product to meet that need. Or maybe you want to build a business that has value. What about having the freedom to grow your business the way you see best? You could want to give your family a tangible money generating business that provides a great service to others. Maybe you want to have multiple revenue streams which provide more security in the long run than a job. As a general rule, business ownership is a better way to build wealth than being an employee.
There could be other reasons you did this. Understanding your “why” of being a business owner is essential to making sure you stay on track.
Below is a list of main expense categories that all business owners should understand and manage.
Cost of Goods or Services
If you sell a tangible product, cost of goods could be materials, labor, and shipping costs. If you sell a service, you might hire others to perform some of the services. You want to know your gross margin. The Gross Margin percentage [(Sales – Cost of Good/Services Sold) / Sales] varies by industry. In a high services or software business, it could be over 70%. For a tangible product business, it could be 20% – 50%. Obviously, you want higher margin within reason. You just need to find a way to streamline and differentiate yourself to grow margin without losing business to competitors.
Personnel (Salaries, payroll taxes, fringe benefits)
When can you hire? What is the fully loaded expense for an employee? Also, when do you use a contractor, and when do you hire?
There is the target allocation % approach. This means that you want your Personnel expenses to stay at for example 30% of your revenues or some percentage that you see fit. Be sure to account not only for salary expenses but also for bonuses, payroll taxes, insurance expenses, 401k match, and any other fringe benefits.
There is the Revenue by Person approach. I used this regularly at an online marketing agency. Basically, we determined how much revenue per employee per month we desired to get the margins we desired. When revenue grew, then we hired accordingly.
Advertising and Marketing
Advertising and Marketing are essential for the survival of any business. This includes some of the following:
- Business Cards and Brochures
- Your website and social media channel
- Paid online advertising
- Conference and trade shows
- Advertisement on billboards, radio, magazines, television, newspapers, etc.
- Content creation such as e-books, white papers, presentations, webinars, free courses
- Networking organization fees (Professional organizations, Chambers)
I am sure there are more areas, but I put the ones that are most prevalent.
How much do you spend here? I would say you spend as much as you can but still leave yourself with some sort of operating profit. If you are just starting out, you might want to consider as much as possible here after paying yourself. I know I had to dip into my savings to build a website and start networking.
Training & Development
In this day of change, we have to continuously improve ourselves. I have heard that we should spend 3% to 5% of our revenue on training and development. If we apply what we have learned, then we will receive benefits many times our investment.
Some ideas for training could be podcasts, books, online courses, conferences, classes, and business coaching.
Travel expenses may be necessary to visit clients or attend conferences. These expenses include airfare, hotel, meals, entertainment, taxis, mileage, parking, tolls, etc.
Planning out the number of employees and trips in advance will help you stay on top of this. It is usually cheaper to book everything a few weeks in advance to get the best deal. If you have many employees, you should have a travel and expense policy to make it clear what can be reimbursed. Consider using expense reimbursement software such as Expensify to help streamline online expense reporting, approval, and reimbursement process.
Equipment, Office, and Facilities.
Office rent, utilities, and maintenance expenses can be significant. It is important to understand how these expenses change as you add staff or equipment. Equipment or vehicle expenses such as fuel, repairs, and maintenance increase as they get older. It can be valuable to do a purchase vs. lease analysis as there are many options to consider that affect performance, down time, expenses, and cash flow.
You might have other expenses, but I have hit on the big ones. Overall, after you have deducted expenses from revenue, you desire an operating profit that is healthy. You want to get operating margin to 20% or more. This is different by industry, but 20% to 30% will allow you to build a business that becomes more valuable. You will be able to explore new products and services. It will allow you to be more flexible and nimble as the economy and industry change.
“You can’t grow out of your profit problem. You need to fix profit first, then grow.” -Mike Michalowicz from his book “Profit First”
Expense management might not be as exciting as revenue, but it is essential for profitability. It is one of the key components to cash management and growth. This leads us to step 4 in taking control of your business finances and forecasting your profits. Next week, we will discuss controlling your cash.
If you missed it, check out the following other articles in this series of the 5 steps to take control of your business finances:
Step 1 – Develop a Positive Financial Mindset
Step 2 – Implement a Revenue Plan