Better Business Decisions: Make vs. Buy
I'm gonna go to about three slides and then I'm gonna do the rest on the board here. So I mentioned before the break that this is about making business decisions. In fact, my whole reason for being here was not just QuickBooks an accounting, but more broadly to help you make business decisions. So the purpose of the segment is using accounting to make decisions. And I've got four decisions that are mentioned here on the board that I'm going to do first. I've got three that I put on the easel at the end of the last segment that I'll do after that. And then I'm just going to keep going and going until I just dropped at the end of this every I'd every business decision idea I can. OK, so that's where we're headed. The first, I think, is very applicable to the creative audience, which is a make versus buy decision. Should I make a product or service myself, or should I purchase it from a vendor? Now we've been had a lot of discussion about those of you who go out and hire people to help yo...
u do things, and I use the example of Christine hiring production people. Or it might be, Candace goes out and hires somebody to help sell our product. Whatever it might be, you've got a decision to make on make versus buy decision. Is it cheap? There's two parts. The decision. What's the cost of doing it yourself versus buying it? That's one decision, and the second decision is. What about quality? What about timeliness? Oven employees, quality of the product, etcetera. So there are economic decisions. Is it cheaper to make it or buy it? And then there are non economic decisions, like the quality of the product or service, depending on your decision. Okay, so first of all, what information do you need to make the decision? And this is a big one. The second line, their fixed costs or ignored and not included in your decision. If you go back to the example that I did on the airline where I said, I'm running to the gate to buy a ticket and I said that all those costs, almost all the costs of the airline will incur to put me on the plane have already been incurred. They played for the paid for the plane the fuel, the insurance, the salary and benefits for the crew. The fee for the gate. Everything's been paid for. The only additional cost of having Megan on the plane is a soda and some peanuts. So all those costs I described in a prior segment are sunk or fix costs with the make versus buy decision. You ignore those Why? Because you can't change them. So the fact that you pay a lease payment this month and it's a fixed cost does not enter in your decision making, whether you're gonna make a product or buy it. I used the example, the least payment from a retail shop. You will consider variable costs, certainly, and you'll also consider, as I said, not monetary decisions, like the quality of the work that comes out based on your decision. And I know that for most of you in this audience that are created, folks, you have a very high expectation of the quality of your work. It's got to be of high quality. Okay, let me give you an example of a make versus buy. The best example is somebody that's making a product visit, making a physical product OK, so Let's say you make blue jeans and you make a line of blue jeans and you'd like to add a line and stick your label on them. OK, so you go toe acne Jean company, and you want to buy their genes, slap your company's label on him, make a few minor changes and selling to the general public. You want to add a new line so you have a choice. You could write a check and simply by the jeans. Let's say that that cost is $20 a pair a pair. Being one unit is a pair of pants, so that's a choice. The other choices you could make him yourself. You're going to incur material costs like denim and thread. You're going to incur labor costs. Somebody's gotta show the denim and probably run some machinery. Okay, if that's $15 a pair, it would seem that it would be cheaper just from a pure economic decision to make the product and not write the check and buy it. No, bear in mind that these costs are variable costs variable costs. None of these into this type of decision. None of these air fixed costs they're all variable. So if it was $15 a pair, you just go ahead and make him and not by. But what if it was $30 appear for you to do it? Yeah, you've got to take a long, hard look at whether it's worth it to buy it from the outside vendor. Now there's a risk and we talked about in the last segment. And the risk is, is that the quality of the product in this case, the pierogies does not meet your standards. The denims frayed. The sewing is poor. Whatever. It's poorly packaged, it's shipped and product. It's wet. There's all there's a dozen things that could go wrong. So even though it may be less expensive for you to buy it, you may have a quality issue, and buying it may be a bad idea. Okay, so I've picked on Chris Creek. Christine told me that I was picking on her today, and I'll continue to pick on her if she goes out and hires a production assistant, pays them a fee to do a task that she could do on her own, and she could do it better on her own. I mean, now, you got to start having that conversation about? Is it worth my time, or should I hire somebody to do it? So under this category of make, maybe the May category would be spending your own time. For those of you who are creative folks and don't necessarily make a make a physical product, do I spend my own time and essentially do it right? Or am I able to contract out and have somebody else do it and maintain the same level of quality? All right, that's a make versus buy decision. Yeah, jacket. And I say is particularly your production, which I am in, and I have the choice between making something that's a high quality or buying it, outsourcing it for the most part. A lot of things aren't made in the U. S. And the factories that whether being made our factories that are, um, and what the values of my company are right. That's an issue. My oldest daughter is involved in this, that there is a movement at her school in the area that handled social justice about whether what they call it, fair trade, whether the product is made there. So there's an ethical decision there, too. We talked about Tom's earlier in the day about okay, Yeah, there's economics decision about making time shoes and how much that costs. But part of the mission of the company is, too. Give shoes away to people who need them. And so part of the mission is charity. And it's not just about money. You're exactly right. Other questions on that Josh factoring in wear and tear on your machinery to make. Yes, it's yes, absolutely. That that's a factor here because you're obviously going to use fixed costs to do the business. And you would save wear and tear if you didn't use your machine. Absolutely true. Now the problem is, is that that could be difficult to quantify. I am gonna do something later on special orders that I think will address that taking on a special word. Other questions that okay, next, one, sell or process further, which is related should you sell your product as it is, or add on mawr costs and try to sell the product for a higher price? Do you sell the product as is, or do you add on Mawr costs and sell the product for a higher price. Now this gets back to a comment the Jackie made where she said, My client has a budget for what they want to do. If they have a budget for what they want to do, it is unlikely that I can add on costs and charge them. Or so there's a ceiling on what they're willing to pay. So if what I'm doing hits the ceiling, you know I really can't process any further is my is what I'm getting at. So what information again do you need to make the decision? How much more cost is there involved? And we call that incremental cost. So I'm gonna write on the board here so you can see it and know what I'm talking about. A seller process Further incremental cost. How much Mawr costs do I incur? If I continue to produce the good, I'm gonna give an example in a minute. The other is how much more revenue do I get? In other words, can I charge a higher sale price? Okay, so if I go back to my blue Jean example and I'm a blue jeans for 15 bucks and I could sell them for 30 but I can add on mawr costs. I can add Rhinestones, and I can add other other decals on the jeans and Aiken incur more costs, but I can sell them for more money. The question is this Okay, if my costs to move from the blue jeans as they are now to the more fancy jeans, is another 10 bucks. But the revenue that I make is an additional 15 box. I can charge 15 bucks more per gene. Should I do it strictly economically? Yeah, I should. Because I come out $5. Better off. I'm $5 better off, Okay. In your fields. I think cilla process further might work like this. You create a video, you create a product for somebody, and you're probably going to stop you created, you know, you create a video, Siri's to promote a company, and you're going to stop. And you're going to say to the client, I did what you asked me to do, and I stayed within your budget. If you want me to do mawr, here's how much it will cost. And, you know, here's the sale price. If you want me to do this much Mawr. I need to charge it this. But if you can't afford the higher revenue I can't incur. The additional costs will just leave it as it is. And you let the client decide that. See what I mean? Anything else on that that is called cell or process further. Okay, if you remember to back to earlier today. And it's also on the bonus material on the formulas I talked about the break even formula, which was sales less variable, costless fixed cost. Okay, Okay. Let's use that and talk about something called Margin of safety. Okay, you can look at this in sales dollars, or you can look at it in terms of units Soul. Okay, I'm gonna use b slash e for break even. Let's say that my break even in sales dollars sales less variable costs. Let's fix costs equals zero. Which we've talked about repeatedly is $100, dollar sign. It's dollars. Let's say that represents 2000 units. Now. I'm gonna put the road word unit below it, so I know this is dollars and this is units, right? That's break even. That's just the point of both dollars and units where I just get all my money back. That's not the goal. The goal is obviously be profitable. Here's what margin of safety means I have a profit goal as well, and I could express that profit goal in terms of a certain amount of dollars. So remember Target net income, where I took the break even formula and put a prophet of the end. And I found out if I sold more units, I cover all my costs and I make a profit. So I'll make numbers up and I'll say the sales dollars is 120, and I have a self 2500 units. I want to keep blue. Okay, Margin of safety says, How much of a cushion do I have between the profit goal and break? Even in terms of dollars, I have a 120,100. I have a $20, cushion here, 20 k when I budgeted at the beginning of the year and we've talked about budgeting. I've got a profit. I've got I've got a sales goal to reach my profit level, which I don't have on the board of $120,000 in sales. However, if I you know actual never turns out exactly like budgeted, my sales could go as low as $100, I'm still profitable. My sales could go as low as $100,000 I'm still profitable when you think margin is safe. Margins safety. Think cushion. What's my cushion? Okay, A lot of friends of mine who are self employed think about. There's a certain amount of money that I need to make to cover all my bills, not only from a cost for my business, but all my bills at home. And then anything above that is kind of my gravy, my cushion. Another way of looking at margin of safety. Okay, if my sales are less than plan, at what point do I start operating in Los? I give you a definition actual sales in this case, 120,000. Let's break even sales 100,000 now. I also put it in terms of units. You may want to look at it in terms of units. Okay. For example, if your cushion is 500 units and there's 52 weeks in a year, essentially what you're saying is if I just sell about 10 MAWR units a week, the break even. I'm gonna make my profit goal. Let me do that again. There's a difference. Here are 500 units between break even in my profit. So one way of looking at it is if I just sell 500 divided by about 50 weeks. If I just sell 10 more units a week, I can get from my break even in my profitable in units. So if you want to look at in units, you can If you want to look at it dollars, you can Okay, jacket. So I have a question about, like, the break even. And when you're coming up with that dumper, would your break even number include the salary that you would pay to yourself? Are you including that in your profit? Yeah, and I used That's a great question. I used the example of the guys who started the pizza business and two of the brothers were sold envelopes and one was a golf pro. My recommendation is that you include in your break even number as a fixed cost, some satori sort of salary for yourself. Yes. Now some people don't do that. And they say, I'm gonna look at my profit and I'm gonna consider my profit to be my compensation to myself. I think you should build it in, because again, if you build it in and that's a fixed cost, then that profit is really profit. Because now you've already paid yourself. Now that's really extra money, so to speak. Okay. Other questions on that as a corporation as well. Aziz. Still proprietor? Sure. Well, you can do these calculations for any type of corporate business formation salary now, the tax consequences of that, I would have I would talk to a C p. A. About because is it w two income? You know, you need to talk to a C. P. A. About that. Other questions on that I'm writing smaller cause I'm trying not to use up so much selfish paper here and flip this thing all the time. How much money do you need to make after tax? Now I have this conversation with people a lot, people who are just talking to me about business or whatever, because I look at income after tax. Okay, so here's what I mean. Let's look at the definition question. Given a rate of tax on income, how much profit do I have to earn to generate the same amount of after tax income given a rate attacks? And I've been having discussions with people here this week. I know California State tax. Pretty high tax rate. How much profit do I have to learn to generate a certain amount of after tax income? In other words, I'm trying to distinguish between your profit and what you actually get to keep profit and what you actually have to keep one of the conversations I have with the producers. He talked about his account recommending that he would hold about 40% from his pay from his 10 99 and his freelance income to pay his taxes. Figuring 25% 30% federal tax rate, you know, 15% stay, 15% state and local, you know, withhold 40%. This is that relates. That conversation about withholding relates to this slide. Okay. Oh, here comes some algebra. I think it's the last algebra of the day that's on a slide. Okay, we've got a fraction in the numerator. The top, it says on the left the desired after tax income. How much is it that you want to make after taxes? In the example I have on the board, the individual wants to make 50,000 after tax. The denominator is one minus the tax rate. Now, here's a way of thinking about it. I'm gonna call this tax impact. If you think about your income is a pie and 40% goes to taxes, you're only you're only keeping 60% right? So if you're trying to figure out how am I gonna make $50,000 this is the $50,000. This is going away. That's what I'm trying to say. So because there's a chunk of this coming out for taxes, the portion and blue has to be bigger because you're not making the whole pie. You're only making 60% of the pie that's in blue. It visually, if that helps you. Okay, so what we're saying is that a 40% bracket, this individual has to make $83,000 to have $50,000 after tax. I had this conversation with somebody about education. Um ah, young family. A guy who has young kids was talking to me about college, and he was talking about saving. And how much does it cost of scholarship and all that? And I said, Well, with the way you should really look at it is is to take the amount of money you think this college is gonna cost and divided by one minus the tax rate. Cause that's how much money you need to earn. Then pay taxes to get the money that you want for college. Okay, that was something he wasn't familiar with. And he was like, Ok, now I get it. It's about how much I earn less the taxes. That's what I have in my pocket. All right, Ross. Josh, I'm sorry. Yeah, I was gonna ask about this and how related to contribution. Profit contribution margin. Um, where you, uh Yeah, I would keep those concepts separate. Let me write. What contribution margin was on the board. Yeah, I would keep those separate. I'm gonna put see barge in for contribution margin, which we defined as Oh, there's going to quiz at the end. Does anybody know what the number is? I'll give you credit for this question. All right. We said sales minus variable cost was contribution margin. And then I went on to say and I can understand why. Why? Someone might think this relates to that issue. We said whatever's left goes to cover two things. It goes to cover fixed cost. Does he remember what the remainder is? Profit. Now, I guess. Excuse me, Josh. Now that I think about it more, I could relate this to that formula because that profit number is gonna have tax attracted out of it. I think that's what you're getting at. Yeah, you're right.