PRICING, BREAK-EVEN AND MARGIN
Through running my own business or in the role of Head of Finance in various companies, I’ve learnt that the success or failure of a business will depend on a small number of critical areas of financial management. Additionally, I’ve attended many workshops for business owners where one of the frequent topics to be raised is the difficulty in pricing, break-even calculation and margin. I hope that the advice below will prove useful to you in this key aspect of your business management.
I think that, for most businesses, this is the toughest area to get a handle on. Not only are there so many influencing factors that are external to the business but, in a business that sells a wide range of products or services, the determination of the margin on even one of them can be very challenging.
Every business will have costs that are not affected by the level of sales. These are called fixed costs. In your business, a good way to identify them would be to ask yourself what costs arise in the business even when it’s closed, say on Sundays. So, the building needs to be insured; there’s rent arising for that Sunday and there would be a rates bill. You, as the owner-manager, draw a salary spread over every day of the month and you might have administrative staff. You could also factor in a level of business-related travel, stationery and telephone because these expenses do not change very significantly as sales activity varies.
Having established the value of the fixed costs in the business, you will accordingly have determined the level of gross profit or margin you need to generate from your sales so that your business can cover the fixed costs and therefore break-even.
It is important to bear in mind that the business might have loan or lease repayment commitments and these will also need to be funded from the profitability of the activity. Accordingly, in establishing your break-even gross margin, you will need to ensure that these payments can also be covered.
When you have eventually arrived at a number for a minimum gross profit, the next step is to decide what products or services in your offering that will contribute to that margin figure. Every product or service will have input costs. This could be the cost of the item bought from a supplier with the intention of resale. It might, in a manufacturing environment, be the costs of the raw materials including freight and there will be associated manufacturing costs such as energy and packaging.
It gets a little bit tricky when you need to consider if your manufacturing payroll costs move with sales activity. In my experience, some minimum production payroll costs will be needed irrespective of activity. The production supervisor is required at all levels of activity. There will also be a minimum headcount for production to run smoothly. So, it is important to classify those non-variable costs as part of the fixed costs of the business even though they are directly involved in the production process.
It is only by allocating the variable costs of the sales activity to the various products that you can really establish the necessary sales price and consequent margin needed from those products or services so that, by selling sufficient volume, you will generate the target gross profit.
It isn’t easy to get this right but it is an exercise that your business needs to develop to increase profits.