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.

Before we move forward in trying to find our indirect costs, let’s make sure we are familiar with an income statement where we are trying to identify the fours basic pieces of an income statement. 

The fours aspects or pieces of an income statement are; sales (revenue), costs of goods sold (COGS), expenses (variable and fixed), and net income or profit and loss.  Note that some will refer to this income statement as a profit and loss statement.

As the cabinet maker, we will need to find those expenses that contribute to our being able to sell and install our cabinets such as special order parts, labor, special tool rental fees, and vehicle expense to include fuel. 

There might be more to these expenses in your particular business where these tips should give you ideas of what to recover in the price of your product.  Remember, that you must take into account the actual price you sell to your consumers as you might price yourself right of the market if you try to recover every expense.

It is in the section that identifies our expenses, fixed or variable, that we are going to search for those expenses that relate to the production of the product or service we are trying to sell. 

Some will refer to this section of an income statement as Sales, General and Administrative expenses or SG&A.

As the cabinet maker I am trying to find the expenses that relate to producing cabinets for a particular client or project.  I will want to search for labor expenses, varied supplies I use in the project, other random expenses that directly relate to the particular project I am trying to price. 

Remember that I cannot recover the expense of the Nextel radios I might use to communicate with the crew.  I also cannot recover the expense of the copy machine in the office.

Again, trying to recover too much expense will price us right out of the market.  We might ask how we are supposed to compete with the other guys if we cannot match their price and still recover costs.

The answer here would be to become more efficient in our production and also reduce some of our expenses or as I call it, overhead.  The equation of indirect costs divided by our direct costs gives us our overhead rate.

This equation is tricky where you will really have to get familiar with it before you put it into action.  Once we find out our overhead rate and how it affects our profitability, we will have a clearer picture as to where we stand operationally.

Once we have found an appropriate amount of expenses, we can move forward with our calculation of indirect costs divided by our direct costs.  This will give us a percentage that we call overhead factor and we can use this percentage to factor into our direct costs (COGS) one more time.

Again, we need to find our direct costs and our indirect costs.  We then divide our indirect costs into our direct costs which will produce a percentage we call overhead factor.  With that overhead factor we can then multiply our known direct costs by that overhead percentage, which will ultimately give us our breakeven number.

This breakeven number will be the number we will now know and use as our yardstick.  We will use this yardstick to price our product that we now know we cannot go below.  If we go below this price, we lose money.

For example, if we find that our direct costs for a project or a given period in our business via our income statement come to $100,000.00 and our indirect costs are $34,000.00, then our overhead factor would be 34%.

Therefore, for every $1.00 of cost, you must add .34 cents to break even where if you think about it, it makes sense.  In other words, you should now realize that every time you sell this particular product or service, you need to add 34% to this cost just to breakeven where the adding the profit to the product will come next.

So now we know that everything we price must have this overhead number of 34% added to it.  Keep in mind that this number will change from period to period, product to product.  These changes can occur as often as you like or as often as you feel the need to re-evaluate your pricing.  I recommend you review your pricing every week if not every day.

I have hired business analysts for clients in the past where all the business analysts does is analyze and dissect pricing as it relates to costs.  Some would say that the salary for a business analyst isn’t worth a full-time employee.  You determine what is best for your business.  I recommend hiring business analysts for every business.

We need to understand what we just learned.  Basically, we learned that we have to recover our overhead expenses along with our direct costs for materials.  Once we have identified what those costs and expenses are, we need to apply a simple math formula to garner our overhead rate.

Remember that your overhead rate can include costs and expenses you feel are appropriate for the price of your product or service.  Note that excessive recovery of costs and expenses might price your product or service out of reach of your consumers.  Be careful with this pricing strategy.

Finally, we now want to add our true profit.  Remember that what we thought was profit before, wasn’t really profit as we know now.  Adding profit to our breakeven costs is rather simple where all we have to do is divide our goal profit percent by its inverse number and the answer will be our sales price.

For example, if I want to make a ten percent profit on my breakeven costs of $3,618.00, I simply divide the inverse of 10% by $3,618.00.  In other words, I would divide $3,618 by .90 which will give me the selling price of $4,020.  Once I’ve done this I now know for sure that my direct costs and my indirect costs are recovered and I’ve actually made a ten percent profit on whatever this product or service is.

The great thing with this process also allows us to negotiate with our customers and compete where we may not have been able to do so in the past. 

The example here would be that my competitor is trying to out sell me with my customer by offering his product or service for $3,985.00  I already know that my breakeven costs is $3,618.00 where I know how much I can negotiate with my customer to gain the business.

This pricing strategy works in many ways to give you a competitive advantage in your business.  Use it and see what it can do for you because if you are not always rethinking your business strategy, rest assured your competitors will be.

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.