Your Price Tag
Calculating Prices and Service Rates
Does your Price Tag or Hourly Rate considering the hidden cost of doing business?
For many business owners, wanting to know the real cost of a sale can be a daunting task. The real dilemma is not knowing what to write on the price tag to be profitable and to cover potential taxes. The same goes for businesses that provide an hourly rate service.
I have seen too many business owners realise too late that they have been under pricing their goods and services or discounting with a loss. The typical approach by many business people when pricing goods and services is to add up all the direct cost and then add a Markup or Margin.
"However, this approach is wrong and does not consider the Hidden Cost of doing business."
Before I put you off, if mathematics is not your thing, there is a costing spreadsheet in the Business Toolkit that you can use.
For example, Biscuit2Crumbs (B2C), produce their own biscuits (Cookies) and their Direct Cost items for a 500g Pack of Anzac biscuits. See Figure 1.
Figure 1.
B2C then apply a 30% markup for a level of profit and covering other cost such as Overheads. See Figure 2.
We'll revisit B2C shortly, but for now, lets look at the cost in your business and why your financial reports have two cost categories. (eg. 1. Cost of Goods Sold & 2. Expenses)
Figure 2.
The Two Cost
Direct Cost, aka Cost of Goods Sold, COGS, or Variable Cost are costs that change in proportion with goods or services that your business produces. So if you sell twice as much, you can expect your Direct Cost to double. These Direct Cost are associated with the production or provision of a service. (Raw material or products, Labor, Subcontractors, Freight and other direct cost) In effect, if no production or supply of services, therefore there are no Direct Cost.
Overheads, aka Expenses, Direct Cost or Operating Expenses, is the other cost in your business. These costs are ongoing expenses to keep your business doors open. (Rent, Electricity, Insurance, Phone, Marketing, Accounting Fees, Interest, Repairs, Travel, Admin and Management Personnel and other indirect labor and cost)
With these two cost categories separated, you are now able to determine the hidden cost of Overheads in your business as a ratio to sales. Knowing this enables you to determine the true cost of your products or services and what your price tag should read.
Back to the B2C example
Last financial year, they turned over $500,000 in Sales. Their Overheads were $150,000 for the same period.
The first calculation is the Overheads (O) to Sales (S) Ratio (R). See Figure 3.
This indicates that for every dollar of income, B2C have $0.30 cost attributed to Overheads and $0.70 to cover Direct Cost and Profit.
Based on a Price of $3.25/Pack of biscuits, B2C has a $0.98 overhead cost. When we add the Direct Cost of $2.50 onto Overheads. The total cost to break-even is now $3.48. So in effect, B2C is making a loss of $0.23/Pack of biscuits. However, the real story is even worse when we used the correctly calculated Price below.
Figure 3.
Pricing with Overheads.
The Calculation method below can be easily added to a spreadsheet, or you can use the costing sheet in the Business Toolkit if the maths is not your thing.
Labor Rates
You can also use the same method to calculate your hourly rates. Just remember on-cost for your staff include superannuation, payroll tax for larger businesses, leave, leave loading etc and an efficiency factor.
For example, John earns $60,000 pa income before PAYG, * 1.095 for superannuation (9.5%) * 1 / 0.85 for ~efficiency (85%) / 1650 *billable hours per year = $46.85 / hour cost. (Note that superannuation percentage may change from figure shown in this example.)
See "Calculating Billable Hours" below for further details.
Basically, your Lowest Cost Price Tag should be the sum of all Direct Cost plus Overheads. So we can express this as:-
However, X is the Overhead's ratio of the Price or X = P.R (Same as X = P x R - A dot "." means to multiply)
Therefore, the X in "P = C + X" is replaced with P.R so we can now express this as in figure 4.
Now let's put it to work.
Figure 4.
Break-Even Price
Annual Sales = $500,000
Annual Overheads = $150,000
Overheads to Sales ratio = 0/3
See Figure 5.
The Direct Cost "C" to produce the pack of biscuits from above with $2.50
Therefore, the Break-even Price equals = $3.57
See figure 6.
Figure 5.
Figure 6.
Profit Margin Price
Add your profit margin to your price.
Assuming a 10% profit margin is required (M = 10%/100% = 0.1)
Revised Price (P) to include profit margin
See figure 7.
We now know what the profit is $3.96 - $3.57 = $0.39 per pack of biscuits.
Figure 7.
Getting The Price Right
What do you think B2C should do.... Keep the sales price at $3.25 or revise to $3.96.
"Hmmm, but what about competition and being priced out of the market?" ...... A very valid question, and here is my take on it.
Overheads could be reduced, however B2C are most likely running lean already.
The secret is to ramp up sales. In doing so, Overheads to Sales ratio are reduced, creating a more competitive price.
You have most likely seen the "cheats" method by reducing the product size and keeping the price the same. "The so-called, healthy option at the consumer's expense"
Calculating Billable Hours
Given that there are
52 weeks per year
4 weeks a year for annual leave
2 weeks a year for sick leave (Yep, your staff will use them.)
2 weeks a year for public holidays, give or take a little
1 week (Approx) long service leave per year
So that's 44 billable weeks a year.
Assuming your team works a 37 hour week that means your billable hours are 1591 per year assuming your team work at 100% efficiency.
Many businesses use 1600 hours per year.