When someone asks you, or you ask yourself, what your “profit” is on a product, on a project or on a job, how do you respond?
To help understand the question better, consider the following theoretical example:
You sold your last (remodeling) job for $12,000. You used $4,000 in materials and 250 man-hours of people you pay $20 per hour wages to.
If you were asked what you made on this job how would you respond? Would you say:
A) $12,000
B) $3,000
C) Other ___________ (fill in)
In the example above:
If you chose A, you equate profit with sales revenue. Hopefully by now, most of us have been cured of that error (but not all of us I’ll bet!).
If you chose B, you equate profit with the difference between sales and direct costs. Direct costs are those that we pay for the materials we sell or install plus what direct labor costs us. In the example, there were $4,000 in material costs and $5,000 in labor costs (250 x $20). The “profit” was, therefore, $12,000 - $4,000 - $5,000 = $3,000.
Really? What about that nasty little thing called overhead?
If you chose C) and tried to fill in another number, that’s interesting because the fact is not enough information is given to answer the question properly!
We have NO IDEA OF WHAT OVERHEAD is in the example above; let alone how to account for it in our pricing.
Components of a Price:
We can build up a price from its components using information already established in our financial statements. A price can be constructed from its four components as follows:
Direct Cost of Materials
+ Direct Cost of Labor (Plant, Construction, Delivery, Commission or Other)
+ Overhead Absorption (on a proportionate basis to sales) (Indirect Costs)
+ PROFIT
= Sales Price (either unit price or sales dollars)
Normally, we can establish or estimate the Direct costs fairly accurately. But what about Overhead? The simple way to do this is as follows:
Go back to your Income Statement and separate costs (if not done by your accountant – and often they aren’t) into Variable or that which is related directly to sales volume (materials, purchases, direct labor, freight, delivery) and Fixed, typically not related directly to sales volume (Advertising, Computer Expense, Insurance, Office Wages & Salaries, Officer’s Compensation, Payroll Taxes, Rent or Mortgage Interest, Telephone, Utilities, Waste Management and others).
Ratio Fixed Costs to Variable Costs (over a reasonable period, say 3, 6 or 12 months). This is your OVERHEAD FACTOR. If the ratio is .25 for example, it simply means you need $0.25 (25 cents) to absorb overhead for every dollar spent on direct costs.
Now, let’s go back to the example above and assume their OHF to be .25 (25%). Further let’s say they are looking for a 15% NET Profit on sales (to match their budget). The price then is:
Direct Costs - Materials: $4,000
Direct Costs – Labor: $5,000 (250x$20/Hour)
Total Direct $9,000
Overhead Absorption: $2,250 (.25 x $9,000)
Total Costs: $11,250 ($9,000 + $2,250)
Profit $1,985 (estimated)
Price to Make 15%: $13,235 ($11,250 + $1,985)
Profitability Check: Profit%=Profit/Sales=$1,985/$13,235 = 15% √
But they actually sold the job for $12,000, so their real net profit at the bottom line was = ($12,000-$11,250)/$12,000 = $750/$12,000 = 6%.
But, You Say, I Can’t Price That Way, the Market Won’t Bear It!
Nevertheless, this is the way to relate pricing to bottom line profit, either actual or proposed. If you can’t achieve the price that results in a reasonable (and budgeted) profit, then you, as owner/CEO/President MUST: lower the cost of your products by better purchasing or more efficient manufacturing, lower your overhead, change the markets in which you participate or change the offer (more value).
Just like ignorance of the law is no defense, neither is lack of knowledge on how to price for profit an excuse to accept low profitability.
The arithmetic above only tells you WHAT you have to do, not HOW. The how is left to your business and marketing plans.
Robert A. Normand is Executive Director of the Institute for Small Business Management (http://www.isbminc.com) and author of "Entreprenewal!, The Six Step Recovery Program for Small Business" (http://www.entreprenewal.com). Mr. Normand has served as principal management consultant for more than 100 businesses ranging from $500,000 to $50,000,000 in annual sales and has owned and operated several small businesses of his own in diverse industries. Mr. Normand’s small business philosophy is premised on the belief that small business management skills can be developed by busy entrepreneurs using readily available information, tools and procedures not found in business schools or formal degree programs. He can be reached by telephone at 941-330-0889 or by mail at 3751 Almeria Avenue, Suite A4, Sarasota, Florida 34239.
[tags]pricing, profitability, fixed costs, variable costs, financial statements[/tags]
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