Experienced business people will know the answer to this, but it’s still worth doing a check every 3-6 months to make sure your profitability is still on track and that nothing has changed.
Less experienced entrepreneurs may not be tracking pricing and margins, and wonder why they aren’t making as much as they thought or need to.Here are three calculations to check:
1.Actual direct costs
What is the cost of providing your product or service?
Product costs can include all components of the product, whether raw materials, packaging, and production or the cost of buying completed product from a producer or distributor.
In addition to that you may have freight and distribution costs and other costs directly associated with the creation of those products.
Services are typically delivered by people or digital delivery.
• Whether a product or a service, you need to record every cost directly associated with the creation and delivery of those products and services.
The margin is the difference between your product/service price and your cost.
This can be calculated on a unit basis, by product, by client or customer.
• For example, if you charge a client 50K a year to deliver a service, and it costs you 40K over the course of the year, the margin overall is 10K (20%).
• Alternatively, if your total sales are $1,500,000 for the year, and your direct expenses were 75% ($1,125,000) then your margin is the difference: $375,000 (25%).
The margin needs to be enough to cover your overheads (also called indirect expenses).
The are all the costs not associated with creating the product or service, but incurred as a result of running the business. Typical overheads are rent, utilities, accounting and legal costs, cleaning, marketing expenses and so on. Also included in here would be any people who are not directly connected to producing or delivering the product or service such as account managers, sales people, admin support, finance etc.
• Calculate what your overhead expenses are each month, or ideally take a full year calculation from your previous year’s P&L.
• For example, if your total sales for the year were $1,500,000 and your overheads were $400,000, then the overheads are 26.7% of your sales.
• Based on the above margin example, this means you would not be making any money and would have cashflow problems.
Direct costs: $1,125,000 75%
Margin: $ 375,000 25%
Overheads: $ 400,000 26.7%
Profit/Loss: $ – 25,000 – 1.7%
What to do?
- Raise prices )
- Reduce direct costs ) these two steps will increase your margin
- Reduce overheads to a lower percentage than your margin
• Annual price reviews with clients and customers is an important part of this exercise, to make sure that you continue to keep your pricing in line with any increased labour or component costs.
• Regular checking of your margins and overhead percentages will keep your business in good shape.
It’s all about the numbers!