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Understanding The Cost of Operations Outline

The document discusses understanding costs of operations for transportation and warehousing businesses. It explains that fixed costs must be paid monthly regardless of income, while variable costs fluctuate based on conditions. The document also discusses net profit margin and operating ratio as ways to measure costs and efficiency.

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Mehrez Assidy
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11 views3 pages

Understanding The Cost of Operations Outline

The document discusses understanding costs of operations for transportation and warehousing businesses. It explains that fixed costs must be paid monthly regardless of income, while variable costs fluctuate based on conditions. The document also discusses net profit margin and operating ratio as ways to measure costs and efficiency.

Uploaded by

Mehrez Assidy
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Understanding the Cost of Operations

Part One: Introduction


New businesses in the transportation and warehousing industries experience a high failure rate. In
particular:

• 25% fail in their first year


• 35% fail in their second year
• 60% fail in their fifth year

The most common reasons that small business fail are (1) lack of capital, (2) Inadequate management,
and (3) poor business planning. All of which relate to knowing your cost of operations. A business can
make money but still fail because their costs are beyond their income. It is critical to know your costs and
to continually search for ways to reduce, or control, those costs. Without this knowledge, how will you
know what you need to earn in order to cover your costs and pay yourself?

Controlling your costs is often more profitable than gaining new business. Always remember, “This is not
a money made business, it is a money saved business.”

If two carriers receive the same rate, the carrier with the lowest expense is making the most money. In
the next segment, we will discuss two types of costs, fixed versus variable.

Part Two: Fixed vs. Variable


To understand how much it costs you to drive your truck down the road, you need to breakdown your
overall costs into two distinct segments, fixed and variable. Let us first start with fixed.

Fixed Costs must be paid every month regardless of miles or income, such as truck and trailer payment,
insurance payment, plates, permits, etc. The lower a carrier’s fixed costs are, the easier it is for them to
make a profit. If a carrier lives on the edge of their income, it eventually will catch up with them, especially
if they encounter unexpected health issues, market or regulatory changes, or an accident.

It is important to be practical when purchasing a truck or trailer, or when deciding your scope of operation
in order to keep fixed costs down. It is also critical to have adequate cash flow. An owner-operator should
have 30 to 60 days or more of cash on hand, or working capital, to pay for costs to cover ongoing expenses.

Another option to consider is to obtain a business line-of-credit (LOC) for emergency situations. A LOC
allows the borrower to take out money as needed until the borrowing limit is reached. This way the
borrower only owes interest on the amount they draw, not the entire credit line. While this grants
flexibility, be aware of potential problems, such as higher interest rates and severe penalties for late-
payments.

Variable Costs fluctuate according to conditions, thus they are costs that a business has more control
over, such as fuel, meals, tolls, tires, repair and maintenance, and miscellaneous items. A company can
increase its net profit by decreasing its total costs or expenses. However, fixed costs are more challenging
to reduce. Most companies will seek to reduce their variable costs. Hence, decreasing costs usually refers
to decreasing variable costs. It is critical for businesses to give themselves flexibility in their budgets to
cover variable costs.

A carrier might be able to reduce their variable costs through items such as aerodynamics, a portable
refrigerator, preventative maintenance, an auxiliary power unit, etc. Nevertheless, it is important to
consider the return on investment. Meaning, will the item pay for itself and help the carrier to become
more profitable? If so, how quickly will the carrier receive a return? These are other items to consider
when reducing costs.

Next we will discuss net profit margin and operating ratio.

Part Three: Net Profit Margin


A net profit margin, also known as a contribution margin, represents the point at which revenue received
per mile equals the costs associated with driving the truck down the road. A carrier might utilize the net
profit margin to determine how much they need to earn for each mile they operate.

A carrier can calculate the margin by simply subtracting the amount they earn per mile to deliver any
given load by the variable and fixed costs associated with the delivery (Gross Revenue − Variable Costs –
Fixed Costs = Net Profit).

If a shipper offers to pay an owner-operator $1.50 per mile in order to deliver a load, and the owner-
operator knows that their variable costs are $0.92 per mile and fixed costs are $0.38, then their gross
profit will be $0.20 per mile ($1.50 - $0.92 - $0.38 = $0.20). Thus, a carrier knows how much revenue and
net profit they can earn for each mile of the delivery and how much they can earn if they decreased their
costs of operations.

To determine what percentage of the revenue is contributing to the owner-operator’s profit, they only
need to divide the net profit by amount earned per mile (Net Profit ÷ Gross Revenue = Contribution Margin
Ratio). Utilizing the example above, the owner-operator would divide the net profit per mile ($0.20) by
the gross revenue per mile ($1.50) to determine that 13% of their expected revenue is contributing to
their net profit. In other words, the carrier will net $0.13 for every dollar of revenue they generate. Net
profits increase when the contribution margin increases.

A business can make money but still fail because their costs are beyond their income. Next, we will discuss
the operating ratio and how it can help you control your costs. “This is not a money made business, it is
a money saved business.”

Part Four: Operating Ratio


A business can make money but still fail because their costs are beyond their income. Again, controlling
costs can be more profitable than gaining new business. You can use the operating ratio to measure how
efficient you are at keeping your costs low [(Total Operating Expenses ÷ Total Operating Revenues) × 100
= Operating Ratio].
The smaller the ratio, the more efficient the carrier is at generating revenue versus total expenses. A high
operating ratio indicates that expenses are increasing in relation to revenue, while a low ratio indicates
that either expenses are decreasing, revenue is increasing, or some combination of the two.

If an owner-operator incurred $16,000 in operating expenses in the previous month (including paying
themselves), and earned $17,000 in revenue, their operating ratio is 94 ($16,000 ÷ $17,000 = 0.94 × 100
= 94).

A motor carrier’s operating ratio must fall under 100 to realize a profit. The more successful, larger,
carriers will have an operating ratio around 90. Owner-operators will want to keep their operating ratio
around 95. In other words, an owner-operator needs to make at least 5% net profit, or better, to succeed.

There are other ratios to consider when calculating your cost of operations which can help give you a
more accurate and complete picture of what an owner-operator will need in order to both start and
maintain a successful business. These are discussed in Truck to Success.

Ultimately, the cost of equipment, supplies, fuel, and materials are constantly changing and can have a
huge effect on an owner-operator’s cost of operations. With the information presented in this series, an
owner-operator now has more power to negotiate or renegotiate their rate because now they have a
target to shoot for.

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