Most businesses operate with the idea that profitability is a natural occurrence or that the challenge of developing profitable products or services is so simple that there is never a need to review pricing processes.
Often times I hear business owners, CEOs and even CFOs touting their business success due to profitable performing products and services where I often wonder what their true understanding of pricing is as it relates to profitability.
Sure all business wants to be profitable and all business believes they are actually profitable, but there is a large percentage of businesses out there that do not understand the concept of profitable products or services.
A truly profitable product or service must at least breakeven in preparation for profitability. Understand that the most common definition of breakeven is the point at which a product or service does not win or lose.
In other words, a product or service that has the ability to breakeven actually has no loss or gain either way. We need to understand how to add the percentage of profitability onto the known breakeven number which is where we will really get our profit.
The term of breakeven is also often used in production and fabrication where one can determine the number required to be produced to breakeven.
For example, if I were a manufacturer of joist hangers, I would want to know how many joist hangers I need to produce to cover my raw materials costs otherwise known as breakeven, where all the joist hangers I produce after that known number would be profit.
Contractors are a good example here where most contractors will factor in all of the raw materials costs of each project and add what they believe is an acceptable percentage of profit.
The error here is that contractors mistakenly factor in their labor costs into what they believe is their profit margin when at the end of a project they really don't profit what they think they should because the project took too much time to complete via labor expenses.
Unfortunately for most contractors and most businesses, that perceived percentage of profit that is added to the raw material figure is in fact just a perception of what they believe to be profit.
Smaller contractors and smaller businesses that operate as sole proprietors and are in fact truly operated by one person, really don't have to worry about the actual calculation of breakeven and proper pricing as much as the other businesses.
The key to proper pricing for profit is to capture three important parts of the pricing equation. The first being direct costs. Those are costs that you pay for in order to sell what you sell.
For example, if I am a cabinet maker I will have to buy the wood, the screws, the nails, the wood glue etc in order to produce a cabinet. Those are my direct costs. Some might define this as plain old inventory.
Next I will have to factor what is known as indirect costs such as other expenses that directly relate to the production and sales of those cabinets. I can also take into consideration those expenses that I also incur as a result of delivery and installation of the finished product such as labor, fuel, parking fees, etc.
In large scale manufacturing some businesses incorporate what is known as Activity Based Costing (ABC), where every aspect of production that is involved in the production of a product is taken into account and recuperated in the price of the product.
As a small business, I do not recommend trying to recuperate every aspect of your costs where sometimes we may price our product out of range of our consumers. This process of recovering costs in the price of our product is dangerous if not managed properly.
There are only certain expenses you can recover in the price of your product without making the price of the product so high and out of reach that no one will buy your product.
For example, as the cabinet maker we do want to recover the cost of installation via labor on each cabinet installation where we cannot recover the advertising expenses that got us that client in the first place. Advertising is a normal expense of business.
If we go back to the example of producing joist hangers, we will want to recover the cost of the sheet metal along with the cost of each employee that actually works on the production of joist hanger. This is another example of Activity Based Costing.
Remember that there is a difference between direct cost and indirect costs. Direct costs are those raw materials costs and indirect costs are those expenses we spend to make the products we make.
Direct costs and indirect costs now only gives us two of the three parts needed to properly calculate pricing. Next we need to figure out our overhead costs, or our overhead percentage rate.
This part is simple where all we need to do is divide our indirect costs into our direct costs which will give us a percentage. The trick here is to capture the appropriate amount of indirect costs. Remember, indirect costs are those additional expenses that allows us to produce the products or service we offer.
Based on previous articles I have published, we should be familiar with our income statement which will give us the number we are looking for when we try to find our indirect costs. As mentioned earlier, our indirect costs are those expenses that we incur to produce our product or service.
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