Do you ever wonder if all of your operating expenses are justified? There’s a saying most entrepreneurs are familiar with: “It’s not how much you make, it’s how much you keep.” While it may be an oversimplification, it’s also a pretty good summary of the difference between top line revenue and net profits. It also explains how a company that appears to be doing well on the outside may have a cash flow issue on the inside.
If you’re bringing in a lot of money, your top line revenues are high. Unfortunately, it’s very easy for many entrepreneurs to focus on these top line numbers while failing to look at the bigger picture. Net profits (or “net income” in GAAP speak), on the other hand, are how much of that money will actually make it to your bottom line, after you subtract out all of the expenses that go into making and selling your product and operating your business.
Many businesses have operating expenses that are higher than they need to be, which cuts into their net profits, so even if they continue to attract bigger and bigger customers and make more and more money, they continue to find themselves barely breaking even.
What are Operating Expenses?
Business experts agree that pricing products is one of the most difficult challenges facing entrepreneurs. Choosing the correct price for a product requires you to look at many factors outside of a simple cost analysis, but let’s look at how you determine your profitability after you have done your pricing work. Direct costs include the cost of the materials that go into the product, as well as the cost of the labor to make it. So the Gross Profit on each product or service sold is the result of your sales price less your direct costs. Indirect costs—sometimes referred to as “operating expenses”—are all the expenses that affect the company as a whole, not just the production of one particular product.
These operating expenses include marketing, facilities, general supplies, bookkeeping, utility costs, professional fees, and many other factors. When pricing a product, you have to factor in the Gross Profit percentage you need to achieve to be able to cover your operating expenses and produce enough net income to satisfy your operating goals.
Many entrepreneurs find that their operating expenses are higher than they need to be, and for many businesses, reducing this kind of overhead is one of the quickest and best ways to improve net profits. Reducing unnecessary operating overhead expenses can have an immediate impact on your bottom line, as long as you are not tied into long term fixed contracts. By dropping these unnecessary expenses, you can drastically reduce your operating expenses and improve cash flow.
Reducing Operating Expenses
There are many tried-and-true methods entrepreneurs can use to reduce operating expenses. The first step is to take the time to actually analyze every operating expense line item on your income statement and justify the existence of every expense.
Choosing which of your operating expenses are justified and which aren’t is an important step to reducing your operating expenses.
How are expenses justified? A great criteria is does the expense actually improve the experience of your customer or key team members. For other operating expense cost cutting ideas, see our earlier blog article 7 Ways to Cut Business Costs in 2014.
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