Sunk Costs and Costly Decisions

Want to know why some people lose so frequently at poker? It’s not because they’re unlucky. It’s because they’ll often add chips to the pot generously during the early bets while they’re figuring out if they have a good enough hand to play… but by the time they realize they DON’T have a good enough hand to play, they feel that they’ve paid so much already, they should keep playing just in case (even though the odds of winning are now largely stacked against them).

This happens in business, too. A business owner will invest in something (a tool, a piece of software, an employee, or a new asset, just to name a few) in order to help their business. Things go well for a while, but sooner or later that thing is no longer useful, but the entrepreneur keeps using it because they feel that they’ve paid for it so they should try to derive as much value as they can out of it.

Although it’s a common practice, it’s a mistake… and it’s often a costly one.
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Proceed With Caution: When NOT to Change

If your business is just starting out, there’s a challenge that you’re about to face that you might not even realize. Yes, there are numerous business challenges you’re already going to be wrestling with over time, but here’s one that you need to figure out early.

Fortunately, this decision is a “set it and forget it” decision because once you’ve decided, you shouldn’t change.

I’m talking about depreciation. When you buy an asset, you spend a lot of money all up-front but it won’t always be worth that amount. To use a really simple example, if you bought a $25,000 car and kept it for 10 years, you know it wouldn’t be worth $25,000 in the asset column of your balance sheet the entire time. Cars depreciate just as all assets do.

So here’s the “set it and forget it” decision you have to make:

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Income Statement Breakdown (Part 4): Finding the Bottom Line

We’ve been taking apart the income statement to help you better understand it and so that you can find money-saving, profit-increasing opportunities inside of it. This is the fourth and final step in the process and here we are getting close to the bottom line!

So far we’ve…

• Looked at Revenues and came away with Net Sales
• Looked at Cost of Goods Sold (either accrual or cash-based) and came away with Gross Profit
• Looked at Operating Expenses and came away with Net Profit

But those are not the only people who have their hand in the cash register! Let’s not forget banks and the government. In this fourth and final section of the income statement breakdown, we need to make sure they get their share.

Like the other sections, you add up the various expenses you have here and subtract it from Net Profit. This section is sometimes called “Non-Operating Expenses”. If you have shareholders, some of their payouts go here, too.

Now let’s look at this part of the income statement and we’ll compare how the accrual and cash-based system work so you can see both in action:

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Income Statement Breakdown (Part 3): Operating Expenses

This is part 3 of a 4 part series on the income statement. Taking the time to understand each part of your income statement will help you to save money and make more money in your business.

In the Revenues section of your income statement, you started with Gross Sales and ended with Net Sales.  In the Cost of Goods Sold section of your income statement, you had the choice of either using the accrual method or the cash method to take the Net Sales number and end up with Gross Profit.

Now, we’re looking at operating expenses. Operating expenses, as the name implies, are the expenses associated with running your business. These expenses might include salaries, advertising, supplies, rent, insurance, utilities, and depreciation. These are added up and subtracted from the Gross Profit number we calculated in the last section of the income statement. The number we’ll end up here is sometimes called Net Profit and sometimes called “Income”.

Let’s keep building on the income statement of the fictional business we’ve been talking about, but we’ll use both the accrual example and the cash example so you can see how both work:

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Income Statement Breakdown (Part 2): Cost of Goods Sold

Over the next few blog posts, we’re breaking down the income statement so you can understand how it works, see how it impacts your business, and find new opportunities to improve your business because of it. Last week we covered the Revenue section. We started that section with Gross Sales and finished it with Net Sales.

Now we’re looking at the second section of your income statement, Cost of Goods Sold (sometimes called “COGS”). Here, we’ll add up all the costs associated with creating your product or service, and then we’ll subtract it from the Net Sales amount you came away with in the previous section.

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