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Where Have All The Profits Gone?

Author: Larry Chester

Probably one of the hardest decisions a business owner makes is how much to charge for what they sell.  It’s a dance.  It often depends on the uniqueness of your product or service, your competition in the marketplace, and how much money you want to make.

Things are different when you provide a service as opposed to selling a product, and it’s also different if you’re a solopreneur, selling your services.  In that case, your overhead costs may be limited.  You’re selling your time, so it presents a different approach to pricing.

The Two Approaches to Pricing

Not to be overly simplistic, but there are basically two approaches to pricing:

  • Determining your costs and then marking your price up, based on a reasonable return
  • Market pricing, and then adjusting your costs to achieve a reasonable return

In both instances, your costs will be split between variable costs and fixed costs.

  • Variable costs are the costs of producing or delivering the product/service that you sell. Those costs go up based on the number of units you sell or services that you provide.
  • Fixed costs are costs that you will have to pay, no matter whether you have sales or not.

Break-Even Analysis

This is a calculation of the number of sales that you need to have in order to cover all of your expenses before you start making a profit.

The Solopreneur

For the Solopreneur, it’s important to understand what your break-even is for the work that you do.  You have to consider two different groups of expenses – your living expenses, and your business expenses.

  • Your Living Expenses

Everyone has a certain living standard that they want to maintain.  You have rent, car payments, gasoline, utilities, food, school, and entertainment to pay for.  Basically, it’s your family budget.

  • Your Business Expenses

Then you need enough money to cover your business expenses.  This would include your office rent, if you have that, additional insurance to cover your business risks, your computer(s) and other technology, and all your other expenses, like your attorney, accounting fees, and office supplies.  Add all of those up, and you have your cash outflow.  That’s how much money you need.

  • Don’t forget taxes

If you’re a Solopreneur, sales don’t give you the number you need to aim for.  It’s not the amount of money that you invoice that’s important, because you have to pay social security taxes and payroll taxes for both state and federal.  You really need to consider how much take-home pay is left after taxes.  Once you have that number, and it matches what our household living expenses are, then you add back the tax payments, and that’s what your sales need to be – to BREAK EVEN.  That’s what you need to cover your fixed costs.  Since your time doesn’t cost you any more if you work 20 hours a week or 60 hours a week, you really don’t have any variable costs to have to contend with.

The Business Owner

For The Business Owner, the calculation’s a little more complex.

  • Fixed Expenses

Calculate your fixed expenses, the cost of keeping the lights on, and the building heated.  You need to pay the expenses of insurance and employees that run the office.  This means the bookkeepers, the purchasing agents, the janitors, the receptionist, the marketing people, the salespeople.  Anyone that is not creating a product to sell is part of the overhead of the business, just like the entire executive team and the building itself.

  • Variable Expenses

So to figure out the break-even, you will need to take the amount of product that you are expecting to sell, and consider all of the costs of making it, or purchasing it, or providing the services to your customers.  You need to add up all of the costs of creating one of them – one of each of the items that you want to sell.  Include the cost of inbound freight for raw materials.  The cost of scrapped raw materials, the cost of items that got damaged during the manufacturing process.  You need to consider the payroll that you’re paying to every single employee on your production floor, including the time that they spend on vacation, or on company holidays, and the time they spend eating lunch.  That’s all part of the cost.

  • Anticipated Sales

Once you have that information, you need to consider how much you think that you can sell them for.  Pick a target for initial planning.  What is the price of other similar products in the marketplace?  Remember that what we’re considering here is the sale price of the item not to the ultimate consumer or business.  We’re talking about the selling price to your distributor or wholesaler.

  • Calculate Your Gross Margin Dollars

With that price in hand, subtract the cost of manufacturing each of them from that selling price.  That’s your Gross Margin.  Determine how many of those you are confident that you’re going to be able to sell the first year.  Multiply that quantity by the Gross Margin for that product.

Now, that is your variable profit, and it had better be a positive number. The old joke in MBA programs across the country is “don’t worry, we’ll make it up on volume.”  But the reality is that the discounts of manufacturing in large quantities don’t reap as many savings as everyone thinks with their initial planning.

  • Determine Your Net Income

Take your variable profit, and subtract your fixed expenses.  That result is your net income.  If it’s not a positive number, if your total Gross Margin doesn’t cover your fixed expenses, you have a problem that has to be solved.  You need to eliminate that deficit, or your company will fail.

How to Make Your Company Profitable

Here are four approaches to eliminating the deficit and turning your company profitable.

  1. Reduce your manufacturing costs,
  2. Raise your prices
  3. Sell more product
  4. Reduce your fixed costs

Each of those would be a topic for another time.  But the story here is that as a business owner, you need to understand your numbers. Not just the big, important numbers on the income statement:  Sales, Gross Margin, Sales Expenses, Operating Expenses, Net Income, but the numbers behind those numbers.  Make changes today that affect profitability tomorrow.

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