Sales revenue
The sales revenue levels that you use in the formula are the sales revenue levels that you want to experiment with. They probably represent possible — or maybe even likely — sales revenue levels for your business. Accordingly, the sales revenue levels don’t really come from QuickBooks. You may want to look at past income statements to determine reasonable or likely sales revenue levels. The formula inputs are probably just rough estimates, however; they don’t actually come from a QuickBooks income statement.Gross margin percentage
The gross margin percentage, as illustrated previously, is calculated by subtracting your variable costs from your sales revenue and then dividing that result (which is the gross margin) by the sales revenue. The variable costs include the costs of the items that you sell: inventory, commissions, shipping, and similar costs.Because calculating the gross margin percentage can be a little bit confusing the first few times you do it, here are a couple of examples to review:
- Boat building: If you sell $100,000 boats, and the material, labor, and commission expenses for each boat total $40,000, you can calculate the gross margin percentage by using the formula
($100,000 – $40,000) ÷ $100,000
That formula returns 0.6, or 60 percent, which is the gross margin percentage of the boat-building business.
- Tax return service: For another example, assume that you’re running a personal service business in which you prepare tax returns for a living. Further assume that you charge $200 for a small-business tax return and that the only variable cost is a $40 fee that you have to pay to the tax software company for the return. In this case, you calculate the gross margin percentage by using the formula
($200 – $40) ÷ $200
This formula returns the value 0.8, or 80 percent. In this case, 80 percent is the gross margin percentage for your tax return preparation business.
The key point is that variable costs vary with the sales revenue. If a sale occurs, the sale produces variable costs. If no sale occurs, no variable costs are incurred.So what does all this mean? Well, typically, the variable costs equal the cost of goods sold (COGS) number that’s shown on your QuickBooks income statement. This COGS number probably includes the inventory items that you sell (if you’re in a business in which you resell inventory) and other items, such as freight and sales commissions. Therefore, you can get most or all the variable cost information right off the QuickBooks income statement.
You may need to fiddle with the COGS amount reported in the QuickBooks income statement. Remember that variable costs are those costs that vary with sales, and as a result, some of the costs that you’ve included in the COGS section of your income statement may not be variable. Some of the costs reported in the regular operating-expenses portion of your income statement are actually variable.
Therefore, you may want to think about the costs reported in the COGS section and in the operating expenses section of your income statement. If you realize that the COGS value isn’t a good estimate of variable costs, make some adjustments. A fixed cost that’s included in COGS number should be subtracted, obviously. And a variable cost that’s included with the other operating expenses may need to be added to the COGS number.Fixed costs
Fixed costs include all your other nonvariable costs. In a nutshell, fixed costs are fixed because they don’t change with sales volume. Fixed costs include items such as rent paid on an office or factory, salaries paid to permanent employees, overhead for insurance, and so forth.To see how fixed costs work and get calculated, return to the examples of the boat-building business and the tax return preparation service:
- In the boat-building business, the firm carries overhead of more than $160,000. This amount may include $80,000 for the shop in which you build your boats and $80,000 for the salaries that you pay to two craftsmen whom you continue to employ whether or not you have boats to build. In this case, then, these overhead costs constitute your $160,000 of fixed costs. These fixed costs don’t change based on changes in sales volume.
- In the tax return service, your only fixed expenses are $100 a month for yellow-pages advertisements and $700 a month to rent a small office. In this case, then, your fixed costs equal $800 a month. Again, these fixed costs don’t change based on changes in sales volume.