This is a guest post by Jessica Oman.
COGS versus Operating Expenses
As a creative business owner, your art is your main product. But even when sales are great, creative entrepreneurs often find there is no profit left at the end of the month. If you’re selling a lot, but you still run out of cash, it’s time to look at what it’s really costing you to run your business.
Painters, for example, may buy a tube of cobalt blue paint and use it up over ten or twelve paintings. Every painting is different, so knowing exactly what it costs in paint to produce one painting is nearly impossible. Luckily, there are easier ways to measure the costs in your creative business.
It starts with knowing the difference between direct costs (COGS) and operating expenses. The COGS (Cost of Goods Sold) are the things you have to buy in order to make each product – paint, for example, or packaging to ship your products. If you produce music, your COGS might be your payment to backup singers, or a person to edit your tracks. These COGS are expenses that you wouldn’t have if you didn’t make any products.
If you’re a painter, you could measure COGS is by determining how long a tube of paint lasts you, on average. If you discover that you have to replenish all of your paints about every 10 months, and you produce one painting a month, then your COGS for a painting is 10% the cost of your paints – but that’s only the paint. You also have the cost of the canvas, as well as the shipping container to consider.
A musician, or any creative entrepreneur who works with people on contract, might only need three hours of help on one project, but twenty on another. To determine COGS, simply average out the hours you use over one year.
Once you know what it costs to produce the things you sell, you will also know how much money you have left to pay for the rest of your costs – your Operating Expenses. These are costs you incur regardless of whether you sell anything, like your rent, your insurance, your internet. Every month, that bill comes, whether you made $10 or $10,000. You would include tools in this like your paint brushes, knitting needles, or printing press.
After tracking your COGS and operating expenses for a few months, if you find that the difference between your total sales dollars and your COGS/operating expenses isn’t always enough to pay for everything else and leave you a little profit at the end, you have a problem. To fix it, you need to either raise your prices or lower your expenses. You might look at a cheaper supplier for your raw materials, or maybe a smaller studio space that costs less.
Why Cash Flow Counts
When you make a product, it sometimes takes a while to sell it. Meantime, you’re sitting on inventory that cost you money to produce, but isn’t giving you any cash in return. That’s why cash flow is so important – you need to make sure you have enough money to cover your operating expenses while you wait for your art to sell. Even if someone commissions you to create something and gives you half of the money up front, it will only last so long; you need the other half of the payment as soon as possible so your cash balance doesn’t dwindle.
I’ve talked to countless entrepreneurs whose income statements show a profit; meanwhile, they wonder why they don’t have any money in the bank. The answer is usually poor cash flow management. You might earn $5000 from that painting, but it costs money to produce it. The lag between the production and the selling can sometimes cause a cash flow problem if you don’t plan for it adequately.
Understanding all of the costs of running your creative business might seem daunting, but it can actually be really empowering. With that knowledge, you have a powerful tool to help you run a business that allows you to stay relaxed, focused and creative without worrying whether you can pay your bills at the end of the month.
Laura’s Action Step:
Take a Saturday and calculate your COGS and operating expenses as best you can for now. If you aren’t sure, just write down everything you know is some type of expense, like the things Jessica has mentioned in this article. That way, you can fill in the amounts later. Return to this list when you go to price your next piece and see if you can better calculate a price that will keep your bank account in the black.
Wondering how to plan your creative business by the numbers? Talk to Jessica Oman, founder of Write Ahead Inc., a boutique consulting firm that helps entrepreneurs launch and grow businesses that support their lives and passions. Grab their free business planning report that will help you build your business the “write” way.