4.7 Financial Fundamentals

Revenue, Costs, and Profit

The basic formula of any business is:
Profit (Net Income) = Revenue – Costs (Expenses).

• Revenue (or sales) is the money brought in from customers over a period. For example, if you sell 100 T-shirts at $20 each, revenue = $2,000.
  
  

• Costs/Expenses are what you spend to make that money. This includes the cost of goods sold (materials, production) plus operating expenses (rent, salaries, marketing, utilities, etc.).
  
  

• Profit (also called net income) is what’s left after you subtract all costs from revenue. If that $2,000 from T-shirts cost you $1,500 to produce and sell, your profit is $500.
  
  

Accountants call revenue the “top line” and profit the “bottom line” on income statements. If expenses ever exceed revenue, the company loses money (negative profit). To stay solvent, startups must eventually reach positive profit. They can do this by increasing revenue (e.g. selling more or raising price) and/or cutting costs (e.g. finding cheaper suppliers, automating tasks). Investors always check these numbers: high revenue with out-of-control costs can still spell trouble.

Fixed vs. Variable Costs

Not all costs behave the same. Fixed costs stay the same regardless of how much you sell or produce. Examples include rent, office salaries, insurance, or loan payments. You pay them every month even if sales are zero. In contrast, variable costs change with production or sales volume. These include raw materials, packaging, sales commissions, and some labor directly tied to making products. If you make 2× as many units, your variable costs roughly double.

Understanding this distinction is important for scaling your business. If you sell only 10 items, fixed costs per item are very high; if you sell 1,000 items, fixed costs are spread thinner, lowering cost per unit. Variable costs are constant per unit. Companies often focus on covering fixed costs with their sales first (see break-even analysis below). For example, if renting a factory is $2,000/month (fixed) and each widget’s materials cost $5 (variable), selling more widgets improves profit by covering the rent faster.

Contribution Margin

The contribution margin helps link sales, variable costs, and fixed costs. It is defined as:

Contribution Margin = (Price per Unit – Variable Cost per Unit)

This can be thought of as the profit each unit contributes before covering fixed investopedia.com. For example, if you sell a gadget for $50 and it costs $30 of materials and labor, the contribution margin per gadget is $20. That $20 goes first to paying off fixed costs (like rent, salaries). Once fixed costs are covered, any remaining contribution margin is pure profit.

You can also calculate it for total sales: Total Contribution = Total Revenue – Total Variable Costs. This measure is fundamental for break-even analysis (below) and pricing decisions. A higher contribution margin means each sale helps more with overall profit. Some businesses (like software) have very high margins, while labor-intensive businesses often have lower margins.

Cash Flow Basics

Revenue and profit on paper are one thing, but cash flow is another vital concern. Cash flow is simply the movement of cash in and out of the business. You can have a profitable company on paper yet fail if you run out of cash at the wrong time. A classic warning from small business research: “Cash flow is the lifeblood of any business” – 82% of small businesses fail due to cash flow problems.

Positive cash flow means more money coming in (from sales, loans, etc.) than going out (expenses, loan payments, inventory). Negative cash flow (spending more than receiving) can sink a startup quickly. For example, if customers pay you 30 days after purchase but you must pay suppliers immediately, you might run short on working capital. Therefore, founders must manage cash carefully: track when invoices are paid, delay costs when needed, or arrange credit. A helpful tool is a cash flow statement, which tracks inflows and outflows over time. In practice, many young companies keep a close eye on their monthly cash position. Ensuring you have enough cash to survive until break-even or until the next funding round is a constant challenge.

Break-even Analysis

Break-even analysis answers the question: How much do we need to sell to cover all costs? The break-even point (BEP) is the sales level where revenue equals total costs, so profit is zero. It’s a critical milestone: below BEP you lose money, above BEP you earn profit.

Mathematically, the break-even point in units is:

Break-even (units) = Fixed Costs ÷ (Price per Unit – Variable Cost per Unit).

Here “Price – Variable Cost” is the contribution margin per unit. For example, if fixed costs are $5,000 per month (rent, salaries) and each unit sells for $25 with $10 variable cost, then each unit contributes $15. You’d need $5,000 ÷ $15 ≈ 334 units sold to break even. Below 334, you lose money; above 334, you start making profit.

A break-even analysis is useful for setting sales targets and pricing. It also highlights risk: if your required break-even sales are unrealistically high, the business may not be viable. It forces you to scrutinize costs and pricing. For example, a student-run bakery might compute how many cakes per month to sell (using its own fixed costs) before making any profit. This helps in planning whether to cut costs (lower fixed or variable costs) or increase price.