One of the biggest hurdles entrepreneurs face is undervaluing their product/service or overvaluing the need for an expense. That sounds simple enough but the raw data behind it can get a bit complicated. Time is money, so I’m going to try to simplify this for you guys. Whether you’ve been in business for years or haven’t even sold your first product/service yet, a good cost price analysis has exponential value (literally increasing value with every sale). If you’re short on time, jump to the case that fits your business (product related vs. service related).
Hi, my name is Joe. And I work in a button factory. One day, my boss says, “Joe, are you busy?” I said, “no”. “Then push this button with your right hand”
Did anyone else sing that campfire song as a kid? Just me? If you don’t know the song check it out!
A cost price analysis is exactly like it sounds. It categorizes and calculates the costs associated with your product/service and how much profit you are making at the price you are charging (or plan to charge). Sounds simple right? Except, you might be looking at your bank account wondering where on earth that profit you swore you calculated disappeared to. If you’re reading this and feeling more like Joe with hands and feet working away while the money just goes into and out of your bank account…you’re in the right place.
Since Joe is the button pusher, not the boss, I think we need a name for our business owner. Let’s call her Jane.
The Case of the Button Factory – Product Related
Like most business owners, Jane knows the cost of a single plastic button can be calculated by determining how much material (plastic) is used and how much that plastic will cost her. She may even remember to include the cost of packaging and shipping a set of buttons.
- $0.50 for the plastic that gets melted down and molded into a set of 3 buttons
- $0.10 for the pretty plastic bag they go in
- Shipping paid for by the customer so not a “cost” to Jane
Jane uses this calculation to set her price at $1.00 for 3 buttons. This would give her a profit of $0.40 right?
What about Joe?
Selling buttons is the only way the button factory makes money. The cost of those buttons is NOT the only expense the Button Factory has to pay. Joe has to get paid for all that button pushing right? What about the factory he’s standing in and the equipment he’s pushing the buttons on? Let’s continue with our case study and assume the following facts:
- Joe makes $12/hr pushing all these buttons
- Joe and the equipment can make approximately 90 buttons an hour
- The factory rent is $1,500 a month (Jane got herself a hell of a deal right?)
- The equipment was $30,000 with a 5 year expected life (the “use” cost aka depreciation is $500 a month)
- Jane pays an accountant $500 a month to handle the bookkeeping
If Jane left her price at the original $1 for 3 buttons, she would actually lose $2,500 in a month. In one month the Button Factory has:
- $4,800 in sales (90 buttons an hour is approximately 14,400 buttons in a month
- $2,880 in Plastic and Packaging (4,800 sets at $0.60 per set)
- $1,920 to Joe’s Paycheck (4 weeks of 40 hours at $12/hr)
- $1,500 for Factory Rent
- $500 for Machine Depreciation
- $500 for Bookkeeping
To properly price her buttons, Jane actually needs to add up ALL of these costs and determine her real price per set of buttons. With a total cost of $7,300 and 4,800 sets produced, Jane would need to price each set of buttons at $1.53 to break even. Alternately, Jane could look for ways to cut the cost of each button (materials, time/efficiency, cheaper labor, etc.).
This example doesn’t even begin to calculate the potential for faulty buttons (waste) or unsold product (inventory). It’s also just a single product and single employee example. And if you’re the button pusher without paying employees, you better be calculating YOUR paycheck in there too…or you won’t have one. That leads me right into my service providers.
The Button Business Coach – Service Related
I always tell my service related business owners to think in terms of $ per hour. Instead of putting in direct materials, you are putting in time. So let’s assume Jane got SO good at button making she decided to start teaching other button factories and (for the sake of simplicity) stop making buttons. Jane’s facts have changed slightly.
- Jane pays $20/month for her domain and website hosting
- The office Jane now rents instead of her factory is $500/month
- Jane’s new laptop cost $900 with an expected life of 3 years ($25/month depreciation)
- Jane dedicates an average of $500/month to marketing and advertising
- Jane spends about $100/month in self-education to stay up to speed on her business
- Jane spends an entire week with each client inspecting their factory, teaching their team, and offering her insight
To stay competitive, Jane decided to charge $1,000 per client. If she sticks with this price, her monthly earnings as a Button Business Coach would be $2,855 ($4,000 in sales less total monthly cost of $1,145). This means Jane is making less than $18/hour. When you run this calculation for yourself, you have to ask…is that equivalent to the value I add through my services? Is it competitive with other service providers in my industry? If it’s not, you’ve got two options…raise the price or lower the cost!
Don’t Try This at Home
Or do…if you really want to. These are both super simple examples, the more products/services you have the more complex the calculations can become. A good CPA or Virtual CFO could even help you forecast varying results at different price points and quantities. You can use this analysis to build out your business plan and goals. You can leverage the analysis to decide which product/service you want to focus on selling the most. And once you’ve set those goals, we can help you stay accountable to them and look back at your actual performance in relation to them. No matter how you use it, a cost price analysis is a necessity for every business.