Understanding the full overheads of your business is essential for any creative entrepreneur. This article is written particularly with sole traders and self-employed individuals in mind, though its advice applies to any size of business, in any sector. It is especially relevant to designer-makers, artists, photographers, graphic designers, illustrators, writers, musicians and other artistic individuals.
Firstly, let’s clarify some terminology. In any business there are “fixed costs” and “variable costs”. Fixed costs are those that the business will incur irrespective of the level of trade. For example rent, insurance, heating and lighting etc. Variable costs are those that vary according to the level of activity. These include materials, shipping costs, energy usage, etc. It’s important to distinguish between these two types of business costs.
Fixed costs are also called “Overheads”.
Sometimes, especially in the early days of a business, the owner does not take into account all of the overheads involved in running their business. That’s because they use their family computer, personal phone and car for the business and fail to acknowledge that this is a cost to the business. In this way, the new business is receiving a subsidy – from the owner! See ‘Financial Support for your Business’.
Of course it makes sense to use the family car, home office and personal phone. I’m not suggesting you buy or rent different ones for the business. But if we don’t include the cost of these resources in our calculations, we are kidding ourselves about the true cost of running the business. As a result, we calculate prices wrongly, because these low prices only work when these hidden subsidies are propping up the business. If/when those subsidies are no longer available and the props are removed, the enterprise collapses.
So let’s not kid ourselves. In fact the opposite, let’s empower ourselves by truly understanding the economics of our business fully. Then, we can make realistic decisions about pricing and how to grow the business.
One imaginative and helpful way to think about overheads is to imagine you are working for a boss; let’s say it’s me. I require you to have a car to be able to work for me, but I don’t pay you properly for using it (see note below). And I ask you to use your own mobile phone for my business. And I want you to use part of your house as a studio or office for my business, without paying you. I would be accused of exploitation! You would surely demand that I pay part of your phone bill, pay you properly for use of your car (including wear and tear, not just fuel), and pay you some kind of fair rent for use of your personal premises. Of course I should pay you for these things because they are part of the costs of running my business, and I would factor them in to my costs and pricing.
Now let’s look at things that way for our own businesses.
Some typical items of Overheads:
- Studio or office rent (see note below)
- Studio/office heating and lighting (see note below)
- Marketing and publicity costs
- Stationery and office supplies
- Accountancy and bookkeeping fees
- Professional memberships and subscription
- Books, eBooks, magazines and journals
- Postage (baseline level, not trade orders)
- Travel – taxis, trains, flights etc (baseline level, not particular projects)
- Travel – in own car (see note below)
- Insurance premiums
- Computer software
- Computer and printer consumables
- Equipment: computers, cameras, printers, etc (see Depreciation below)
- Repairs and maintenance of equipment
- Training costs
- Meeting and subsistence expenses (coffees, lunches etc when on business)
- Depreciation (see note below)
- [Other items should be added that are relevant to your particular business]
All of the above are classed as fixed costs or overheads because they do not vary significantly according to the level of business. Of course there are other business costs that do vary according to the level of activity. These are the variable costs. Obvious ones are materials and supplies for particular goods, services or projects. Also, some items will increase from a ‘baseline level’ that you incur generally, to a higher level because of particular projects or orders. For example postage, travel and even insurance might increase from a ‘baseline level’ as a direct consequence of the level of sales, or for particular projects. We’ll come back to these variable costs later.
How to deal with some specific fixed costs / Overheads
Depreciation of Equipment
This applies to business related items that last for more than one year and have significant value* (see note below).
For example, a computer system might cost €1,500 and be expected to last for 3 years. So we need to acknowledge that in each of these three years the business is “using up” €500 of the computer system. This is classed as “Expenditure”** each year in accounting terms, even though it was paid for in year one. In practice, we spend €1,500 every three years on computers, so we need to “spread out” how we account for this usage of resources over three years, so that we get an accurate view of the true annual expenditure** of the business and consequently its profitability. (If we only look at cash payments we get a skewed picture of real profitability.)
Depreciation is most easily overlooked if the item was donated, grant-funded or is a personal possession. Nevertheless, it is wearing out and will need to be replaced at the end of its life. The business needs to acknowledge its usage in the enterprise and make sure there is enough cash to buy a new one when needed.
A couple of examples of how to calculate depreciation are in this downloadable PDF.
Use of personal vehicle for business activities
It’s easy just to pay for the fuel when it’s your own car. But if I were your boss, would it be fair to pay you only fuel per kilometre? No! You’d expect me to pay more, to account for servicing, wear and tear, depreciation etc.
The UK tax authorities (HMRC) have calculated that the true cost per mile is £0.45p (GBP). This is significantly more than the fuel cost per mile because it takes into account the full cost of vehicle usage. An employee can claim 45p per mile from their employer, and it’s tax free, because they are not making a profit; it’s the true cost and they are just breaking even. So use this, or your own country’s equivalent regime, to calculate how much your enterprise should be charged for every mile of use of your own vehicle for business purposes.
Use of home as studio or office
If I were your boss, we would agree that I should pay a proportion of heating and lighting costs associated with the section of your home you use for my business. Perhaps 20% of your home’s heating and lighting expenses. This would be fair and reflect the value of your home studio to my business. I’d pay it and class it as an overhead in my business accounts.
*Significant Value. By this we mean things that cost more than 100 €, $ or £. So forget the kettle! It’s not worth calculating its depreciation; instead just count it as expenditure in the year of purchase.
**Expenditure. In accountancy terms, this has a specific technical meaning and is different than a “payment”.
What are you worth?
Now that we have established exactly what our overheads are, we can start to do some calculations about how much gross profit (see below) we need to make from our sales.
At this point, we should add in your earnings. Again, if I were your boss, your salary (plus employer’s tax and other costs) would be a business expense I’d have to pay you, irrespective of the level of trade; in other words a fixed cost or overhead.
[Note: In a self-employed or sole trader situation, the owner’s earnings are often called ‘drawings’ and are not normally classed as an overhead. Instead, the money remaining after paying all other expenses is assumed to be the owner’s income and they pay tax on this amount.]
However, if we want to pay ourselves properly, and fix our prices accordingly, we should put our ‘salary’ into the equation now.
There are two approaches you can take at this point:
1. Don’t include what you are worth, then see how much is left in the bank for you after pricing your products without considering your earnings up front. Then sigh deeply when this amount is not enough to live on.
2. Decide what you are worth, and make sure you get paid what you are worth, by factoring this amount into the calculations now, so that you can make good decisions about pricing your products and services. (See separate blog about pricing calculations.)
Let’s go back to the scenario if I were your boss. Would it be acceptable to work for a boss who paid you only what little was left in the bank after forgetting to include your salary when calculating prices? Would you just shrug your shoulders and say “Well, OK then. I love what I do so I don’t need him to pay me properly. Perhaps if I work extra hard I might start to make a living wage in a few years. Fingers crossed!”
I strongly recommend that you include your salary at this point.
Each sale makes a “contribution to fixed costs”
Now that we know how much we have to make to pay our Overheads (now including your salary), we can start to calculate how much contribution to fixed costs each sale of a product, service or project needs to make.
Gross Profit is the difference between the direct costs of a product (or service or project) and the price we charge for it.
Let’s take a simple example:
Jane sells a designer necklace in her jewellery studio for €100 and has calculated that the cost of the materials is €50. These are the direct costs of that necklace (as distinct from the indirect costs or overheads of running the business). At this point, the necklace has made a gross profit of €50. This €50 gross profit makes a contribution to overheads. If Jane’s total overheads (including salary) are €50,000, then she needs to make and sell 1,000 necklaces. At this point the total gross profit is €50,000, which, after payment of overheads of €50,000, leaves a net profit of zero. She has paid for all her materials, all her overheads plus her salary and her business has ‘broken even’.
If she sells 1,001 necklaces, the net profit will be €50. At this point she has covered all her costs, direct and indirect, and also has €50 in assets for investment in the development of her business.
More than once, I’ve had a conversation with a jeweller who tells me that they are making a €50 profit because they sell a product for €100 and the cost of the materials is €50. Yes, they are making a gross profit on the sale of that item but at the end of the year they usually have not made a net profit. Then they wonder why there is no money left in the bank to pay themselves a living wage. They, and we, need to be absolutely clear about the economics of our business and be precise about what we mean when we use the word ‘profit’:
Gross Profit is the immediate or ‘big’ profit that is the difference between what you sold it for and what it cost. On the other hand, Net Profit is what’s left, the ‘bottom line’, after Overheads have been deducted from the total Gross Profit.
Dealing with Variable Costs
We deal with variable costs by calculating the cost of materials etc associated with each sale. These direct costs are those that are obviously connected to each sale of a product, service or project. Raw materials, postage and packing, travel and anything else that is directly associated only to that product, service or project.
Then, we can calculate how much we need to charge for each item so that the gross profit from each item, multiplied by the number of all items sold, results in a total contribution to overheads that is equal to or greater than the full cost of overheads (including salary). When this equation adds up, we have a viable and sustainable business. If it doesn’t, we need to go back to the drawing board and look again at prices. And if we conclude that prices need to increase, we might also need to look at strategic marketing, ie choosing different customers. This is all part of the job of designing your creative business and creating your own business formula to achieve the success you want.
The purpose of this article, and my professional mission, is to empower creative entrepreneurs. An entrepreneur is empowered when they fully understand the economics of their own business. Then they can make rational decisions about pricing, markets, competitors etc.
The sad truth is that there are too many really creative and enthusiastic people who are not making a sustainable living from their creativity because they do not fully take into account all the real costs involved in their business and how to factor them into decisions about prices. The result is too many failed businesses, too many underpaid creatives, too many people struggling to make a living.
Let’s change that!
Other related articles worth reading:
Click the image above to download this one page PDF on Depreciation. It is part of the materials for the ‘Creative Finance’ workshop, one of David’s creative business training workshops.