A Guide for doing First Warning Calculations Yourself |
If you wish to do First Warnings caution and warning calculations yourself, then use your pocket calculator and follow my directions. These calculations require that you forecast or "guess" costs and prices for your business. Test 1 First calculate the estimated direct cost per sale by subtracting the estimated annual fixed costs F from the estimated TOTAL of all costs of the business for this year, then dividing the result by the estimated number of sales N. The estimated annual fixed costs should include the mortgage or rent, the utilities, the salaried employees pay, the insurance and other costs that come due, whether you sell anything or not. What is left are the costs that can be attributed to selling the product or service you may provide to clients. Now, divide the "not fixed cost" (I call it the direct cost as it varies directly with the number of sales) by N your forecast annual sales. In the calculator example shown on calculator webpage, the estimated annual direct cost was $375,000 and the estimated annual sales were 5,000 cars so the estimated direct cost D is calculated as follows: D = $375,000/5,000cars = $75/car Now subtract D from the average price per sale P. If the number is negative, be WARNED that you may have a serious immediate price/cost problem. Contact me or your accountant immediately for free help. See the banner below. If the difference is negative you have violated the first law of business, namely that P must exceed D for a business to succeed. If D exceeds P then the harder you work, the more sales you make, the more customers you serve, the quicker you will go out of business. In mathematical terms, the first law is: For a business to be profitable, (P-D) > 0. For the example above, P is $100/car and D is $75/car so (P-D) = +$25 indicating that there is no need for a warning at this time. Test 2 Provided P is greater than D, you are now ready to run the second critical test. Do the following calculation: Divide F by the number you got when you subtracted D from P. Remember that F is the sum of the forecast annual fixed costs and should include the mortgage or rent, the utilities, the salaried employees pay, the insurance and other costs that come due, whether you sell anything or not. For the example above the calculation would proceed as follows: B = $8000/Month * 12 Months / (P-D) = $96,000/($100/car - $75/car) = 3840 cars B is your estimate of the number of sales that must be made before your business becomes profitable. Now subtract B from your estimated sales N. If the number is negative, CAUTION is advised. You may have a sales problem. This sales problem is somewhat less sever than price/cost problem. Contact me for free help. If (N-B) is negative you have violated the second law of business, namely that N must exceed B for a business to be profitable. In mathematical terms the second law is that for a business to be profitable, (N-B) > 0. For the example above, N = 5,000 cars and B = 3,840 cars so the calculation yields (N-B) = +1,160 indicating that there is no need for a warning at this time. Test 3 Finally, if your business is priced to achieve maximum profit, your optimum price O will be approximately half the sum of D and the maximum marketable price M for the item. Here M is the price at which only a very few items are sold. Think of M as a price that is so high, only one sale will occur. For the example above, M = $200 thus the optimum price is approximately: O ~ (M + D)/2 = ($200 + $75)/2 = $135 If your price P is much less than O, then it is possible that your business will be chasing prices to even lower levels, eventually violating the laws of business and sudden failure. Note that in the automotive example above, P is less than O: Thus I would say BE WARNED THAT CAUTION IS ADVISED. |