Your Financial Model is a Powerful Tool (And How to Itemize Each Component)May 13, 2022
Having access to solid information puts you in a position to make better financial and strategic decisions. Your business’s financial model can provide access to that data.
How often do you think about ways to bring more revenue in?
How often do you worry about not generating enough money inside your business?
Although a lot goes into building a sustainable business and scaling, numbers have their own voice.
What do I mean?
Without understanding your business’s financial model or how it works, you won’t have the information you need to grow your businesses revenue.
So, this article will guide you through the fundamentals of the financial model by covering its three core components.
The 3 Components
Component #1 - Revenue
This first component of your financial model is what you generate from sales, whether you’re delivering products or services.
As you sell more products, your revenue starts multiplying. You make a sale and generate cash that comes inside the business.
Component #2 - Variable Expenses
Cost of goods sold, direct expenses, and delivery costs are all under variable expenses.
But what does it mean?
In essence, these are incurred costs directly related to delivering or generating your revenue.
In my case, putting a team together or payroll expense could be costs of goods sold. Meanwhile, the cost of buying a product to resell it is a direct expense. And it applies to everything you buy or pay for that impacts your delivery or revenue generation.
Component #3 - Fixed Expenses
These are costs you incur in your business regardless of whether you sell 10 or 100 items or services.
Although they can fluctuate with inflation, they are still relatively fixed and less prone to swings like variable expenses. They’re not fully dependent on the sales inside your business.
A good example of a fixed expense is rent.
Your rent could cost $3,000 per month. It doesn’t matter if you make $1 million or $10 million in revenue – that expense doesn’t change unless you’re thinking about expanding your space.
Even insurance fits in this expense category. It’s a fixed monthly cost, usually associated with 12 months. Now, it may go up and down based on your revenue or inflation, but generally starting the next year.
Understanding the Financial Model
Let’s go through a simple example.
Say you’re selling a computer for $1,000.
It costs you $600 to get the components and put them together. Or you’re simply reselling it and buying it wholesale for $600. You can even have a labour component or delivery expenses.
These are all variable costs for the computer, which add up to $600 per unit. That’s how much you have to pay to deliver it to the consumer.
However, your gross profit on a $1,000 computer is $400. This is a key number to remember.
So far, we’ve covered variable expenses. But what about the fixed costs?
Let’s say your rent and everything else amounts to $700. It might sound like a lot of money, but remember that this number doesn’t change as you sell more units.
Therefore, your goal is to increase your sales volume to cover those fixed expenses.
In this scenario, the fixed expenses are higher than the gross profit. Thus, the business is operating at a loss.
Breaking Down Each Component of Your Financial Model
Suppose you want to take your business to the next level. In that case, you’ll need more than a foundational knowledge of your financial metrics.
To get there, it’s essential that you break down every component of your financial model. You need to know where every penny comes and goes in your business.
#1. Revenue Itemization
When you’re doing a revenue itemization, you’re essentially listing the total return for your different services and products delivered to customers.
In our case, we can itemize for:
- Tax advisory
- Million Dollar Year Membership
Figure out the total return from each to determine the overall income and percentages for each service line.
#2. Variable Expenses Itemization
If you’re a manufacturer, your variable expenses might look like this after you itemize them:
- Cost of labour
- Cost of raw materials
- Cost of freight and delivery
But if you’re in retail, the itemization could look different:
- Delivery costs
- Sales commissions
Even service-related businesses can have variable expenses, such as:
- Marketing costs
- Cost per lead
- Labour costs
This itemization can be unique to your business. That’s all the more reason for you to identify and list all your direct costs and understand how they impact your gross profit.
Once you have the numbers, you can calculate the percentage of each expense and figure out their impact on your business.
#3. Fixed Expenses Itemization
Now it’s time to do the same kind of itemization to your fixed expenses.
Remember, these are expenses that don’t go up and down based on the volume of revenue. Instead, they might fluctuate depending on the activity inside your business.
Let me explain.
Imagine you have to pay for repairs or maintenance on some equipment. Odds are that’s not a monthly expense. It’s a lump sum payment you may or may not have to pay occasionally to fix a product or piece of equipment.
Then you have rent, insurance, loan interests, utilities, overhead management wages, and other things you must pay to stay in business.
Travel, entertainment, maintenance, professional development, and other similar fees will also fall under this category. Although they can differ slightly every month, they don’t directly impact the cost of goods sold.
Numbers Track and Indicate Business Performance
Whenever you’re unsure where your business is heading, looking at the numbers will give you a pretty good idea. It can also be of help if you don’t know your next step to drive more revenue.
Understanding and itemizing your unique financial model can be a great way to get a detailed overview of how money flows inside your business. You’ll see what areas are draining resources and what’s driving more money in than anything else.
And from there, you’ll be able to make more informed decisions and tweak your financial model accordingly to stay in the black.
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