Pricing For Profit

In last Month's article, we considered the different types of cost in your business. Click here to review the article.

In this article, we consider how the fixed/variable cost relationship is used to support making basic business decisions.

We use an example to illustrate the different cost/revenue/profit relationships. In our example business, costs for the past year are categorized to give the following cost structure :

 
 Sales Revenue           $1,200,000
 Variable Costs          $  650,000
 Gross Profit            $  550,000
 Fixed Costs             $  400,000
 Net Profit              $  150,000 
 
 

From these figures, we can work out some useful ratios :

The Markup, or the percentage you increase cost-of-sales by to get to the sales price, is the most useful. It is calculated by simply subtracting Variable Costs from Sales and dividing by Variable costs.

Markup = ($1,2m - $650k)/$650k = 84.6%

If, in your business you negotiate on price, it is useful to know how much you can afford to give away. And the relationship between Fixed and Variable costs tells you this.

Your Gross Profit has to at least cover your Fixed Costs for you to make a profit. So, on average, your Markup must be no less than Fixed Costs/Variable Costs. In the example :

Break-Even Markup = $400/$650 = 61.5%

Pricing at a 61.5% markup for the full year would mean that Fixed Costs of $400k would be recovered. But there would be no profit.

If you are finding that your Markup is regularly falling below your Break-Even Markup, you business is probably heading for a loss. And you need to take corrective action.

Employing another person, leasing new equipment and embarking on an advertising campaign all increase your monthly Fixed Costs. Knowing how much you have to sell to cover extra costs like these, helps you decide whether the expense is worthwhile.

You do this by dividing the additional cost by your Gross Profit Margin. First you need to work out your Gross Profit Margin.

GP% = (Sales - Variable Costs)/Sales = ($1,2m - $650k)/$1,2m = 45.8%

So if the business employs a new member of staff at an annual cost of $23,000, additional sales for a year needed to cover the extra cost is :

Increase in sales required = $23k/0.458 = $50,218

In this example, employing the extra resource will only be worthwhile if it generates more that $50,218 in sales.

Remember that employing the extra person may not have a direct affect on sales. But the required additional sales could be achieved by people who are released from time consuming non productive tasks by the new person.

This is a simple and very handy calculation. Work out your Gross Profit percentage and use it in this way to support resourcing decisions.

Next month, we consider the concept of Operating Leverage and how your business profitability responds to changes in volumes and prices.

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