Did you know the average profit margin for a small business ranges from roughly 2% to 13%? That means for every $100,000 in sales, a business owner makes somewhere between $2,000 and $13,000. Sure, there are some that make more than that and others that are not profitable right now at all. But, on average…it doesn’t seem like a lot does it? Can you imagine how your business decisions might be impacted if you thought you were making $100,000 but really you were making $2,000? That’s just the big picture view of the perspective I want to help you change today.
Want to know the difference?
Revenue does not equal net profit. To use these terms interchangeably as “my company makes ____” is disastrous for your management decision-making. Revenue is a reflection of what someone has paid you for a product or service. On its own, revenue does not take into account the cost (time or money) that goes into that product or service.
Net profit is the sum of all revenues minus all expenses. Profit margin is the calculation of net profit divided by revenue. Sounds pretty simple right? Except, your business has a variety of expenses. If you read the previous blog about expense audits, you learned some of your business expenses are essential (necessary to do business), non-essential (not necessary but definitely add value), or not needed. Today, we’re going to dig a little further into those essential costs.
We need to understand the relationship between these essential costs and the revenue they do or don’t produce. In accounting, we call these direct and indirect costs. A direct cost has a direct relationship with a revenue producing product or service. The fragrant coffee beans used to produce the espresso in your steaming hot latte from the local coffee shop is an example of a direct cost. If the coffee shop runs out of coffee beans, they can’t make the latte and therefore can’t sell it to you. An indirect cost is still essential to keep the business running but it doesn’t increase or decrease a specific sale. If missing or unpaid, you probably can’t operate the business as you normally would…or you have to get VERY creative. Indirect costs are the “keep your lights on” kind of costs…literally. It’s your electricity bill, your internet bill, your employee paychecks.
So what’s a cost price analysis? It calculates the profit from a specific product or service at an individual level.
Price – Direct Cost – Allocation of Indirect Cost = Profit by Product/Service
Who Cares About Cost Price Analysis?
I almost titled this section “who cares about profit” but anyone reading this knows that answer. Right?!?! Profit gets you paid! The same answer applies to cost price analysis.
You deserve to make a great living doing what you love. To do that, you have to review each product/service through the lens of net profit. You can’t just look at what it takes to make the product or provide the service. What does it take to sell it? What does it take to have a place to produce or serve? This takes on a whole new meaning with my service based clients. In a service offering, there are very few materials and direct costs. Your time is your material. So, we add a third dimension to this puzzle – Time. How much time do you spend on each service? How much money do YOU make with each project?
Price – Direct Cost – Allocation of Indirect Cost / Hours Spent on the Service = Hourly Take-Home Pay
How Low Can You Go
A profit squeeze is inevitable. When you cut costs and get creative with your creation process, you get to increase profit margins by charging the same price for a product/service that costs less to make/provide. The increased profit margin is almost always temporary, the competition catches up eventually. When they do, the competition often lowers their prices in an attempt to get more sales. You have to be prepared to decide how low you can go. At what point is the product/service no longer profitable.
Dig Into the Data
You should know by now that I am always going to point out the importance of data. You can only make things better if you know where they stand now. Do you know how many clients I see that are barely getting by because their product or service is just breaking even after all the costs are allocated? A clear and transparent understanding of what each product/service is making (net profit) helps you decide where and how to focus your efforts. The highly profitable products might be worth spending more money to market and attract more customers. The less profitable, or those losing money, need some serious thought on cost cutting and innovation. This step is part of the 4 corners in my framework for a reason. Your business decisions are only as good as the data used to make them. You need this data in your arsenal.
Want to know how to DIY a Cost Price Analysis?
I highlighted the key formulas throughout the blog. Putting this into action is as simple as applying them to each product/service. Don’t forget to allocate those indirect costs. I thought about including some examples but I already gave some amazing examples in Price to Be Profitable. Whether you sell a product or provide a service, the sample calculations are there. Just remember, you want to work through this on an individual product/service level.
Revenue is NOT what you’re making, it’s what you’re selling. You deserve to be making a profit.
If this seems overwhelming or you just want help with applying the concept to your unique scenario, I’m just a phone call away! Well an appointment and a video call 😊 Schedule your free consult here.
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