Fundamentals of Finance for Entrepreneurs–Cost aspects

The first 100 days of a startup are known as a valley of death, that is the time when a company has the maximum risk of survival – and one of the biggest causes for the death of a startup is lack of cost planning. Cost control and management are the most important aspect of entrepreneurship. While we looked at revenue aspect in our last article, I will like to explain the basic concepts of costs in a start-up. First let me define what are the costs involved in a startup, then we will share few tips to manage them and avoid pitfalls.

1. Variable costs

These are the costs that are incurred in a company that depend on the volume of business. For example, if you are selling a laptop, then for every laptop sold, you will have to incur material costs (may also include per laptop manufacturing costs), packaging costs, courier costs – basically, all the costs that are incurred if you sell and deliver a product. The variable costs are applicable even if its a service case – for example, if you get an IT project at 1000 Rs an hour and you pay your developer 500 Rs an hour, then that cost is the variable cost.

2. Fixed costs

These are the costs that you incur even if you do not sell, or that is not dependent on the quantity of sales. For example, office rent is something that you pay your landlord irrespective of whether you sell or not.

It is important to note that there may be some costs that are semi-variable, that is neither fixed not variable – for example, a salesman who is on salary basis as well as gets a sales commission. There may also be cases when you are not able to identify whether a particular cost is variable or fixed – you may develop your own principle on how to treat this, and allocate the costs accordingly.

3. Capital costs

These are the costs incurred in business for buying physical assets (like factory, machines) or software licenses, which are used further for creating products/services to be sold.

4. One-time costs

These are the costs that are incurred one-time in a business, usually for starting up. For example, incorporation expenses, getting registrations, website development etc. are one time costs.

5. Operating costs

The variable and fixed costs together are known as operating costs of business, as they are incurred for operating the company.

6. Other expenses

Interest – it is the expense incurred on a loan/debt taken by the company.

Depreciation – it is the expense incurred for an asset which is used for more than a year of a business, hence, the allocation of the cost is usually done on a cost divided by number of years.

Taxes – for a business that generates profit, tax expenses are incurred – usually the tax rate is 34% approximately of profits earned.

Revenue less variable costs gives you gross profit, and gross profit less fixed costs gives operating profit.

During my Nurture Talent training programs, we impress upon the fact that there is uncertainty in revenues of a business – but as an entrepreneur, please be 100% certain about the costs in your business – how much you are going to incur and at what time.

Some of the questions that can be answered using the costs as a starting point:

1. How much cash should I start my business with?

As a starting point, it may be important to make a business plan and sales projections, on which basis you may calculate your monthly costs. We suggest that you should start your business with cash that covers at least 6 months of your fixed costs, plus the capital costs and one-time expenses.

2. Should I take loan to do business?

If you can cover the interest expenses from your cash flows or monthly surplus for about 6 months, then you should go for the loan option, else, it may affect your business growth.

3. When should I approach investors?

If you see growth potential in your business, and as per your plans you need to invest in capital costs or one-time investments (maybe support operating expenses if you are running in losses), you should start approaching investors. Typically, venture capitalists take 3-6 months for making investment decisions, so make sure that you approach them about 6 months before you need the money.

4. How can I decide pricing of my product?

While there is no silver bullet that can give you this answer, a clear financial plan based on revenue and cost projections, can tell you at what level of pricing are you earning profits or running into losses. It can also guide you how much below or above your average pricing you can go. Be flexible and move fast to correct your pricing, and you can go a long way in your venture.

5. How much time will my company survive?

The best chance of a company’s survival is to get a paying customer to cover the monthly fixed costs at least. However, it may take about 3-6 months to a year before you get your first paying customer (depending on your business). So, on an average if you started with 50 lakhs, and have 10 lakhs monthly expenses – you have 5 months to go!

For all the above reasons, I suggest the budding entrepreneurs following:

1. Keep your monthly fixed costs low – avoid taking an office, that high-flying salesman or a fancy domain name till you are 100% sure
2. Avoid capital costs – one of the most successful entrepreneur told me he bought a chair and table 6 months after starting business – so sacrifice some comforts for future gains!
3. Note down your expenses in an excel sheet daily and analyze monthly
4. Do not pay any team member more than 1 lakhs salary – if you have to then negotiate a variable based on sales revenues or give ESOPs
5. Replace your fixed costs with variable as much as possible – for example, if you can outsource the manufacturing to someone on per unit basis, then you can avoid the capital costs of setting up a factory as well as monthly fixed costs of running your own factory.

With the fundamentals in place, I hope you can avoid the “valley of death” and grow your start-up strongly!

About the Author Amit Grover is an IIT Delhi and IIM Indore alumnus, an individual with a passion for entrepreneurship. He is the founder of Nurture Talent Academy (www.nurturetalent.com), which has conducted 35 programs, across 10 cities, attended by 550 startups. It conducts programs for budding entrepreneurs on areas like finance, business plan, marketing and setting up a company. He is also a member of Mumbai Angels, a group of early stage investors and has led over 25 deals in last 4 years.