One of the most difficult areas for anyone setting up a business is setting costs. For those just starting out, it can seem to be an endless struggle with cash flow. In reality, your costs must be set according to a complex range of factors.
To set your costs, you need to know your market, know your own costs, and know where you want to set yourself within your market.
Your first step should be market research and business analysis to determine:
- Competitors’ costs. Although not every business relies on underpricing competitors, it is helpful to know where you sit in your industry.
- Your market. Businesses offering luxury goods and services can set prices higher above cost than budget businesses.
- Industry conditions. The Global Financial Crisis has taught all businesses that broad industry factors can have a personal effect.
- Break-even point. Your break-even point is the minimum income you need to cover all of your costs.
Once you have an understanding of the background of your business, you can choose to calculate fees based on a ‘cost + profit’ basis or on what you believe the market will pay. Other factors to be taken into account include discount deals, loss leaders (products that are sold below cost but bring in more business), and the psychological effect of price breaks, where a customer might hesitate to buy something for $10.05 but be happy to buy at $9.95.
Find your break-even point
Knowing your break-even point is useful even if you operate in an industry with set fees, as it enables you to calculate the minimum workload your business requires.
To calculate this sum, you need to know your fixed and variable costs. Fixed costs are fairly easy to determine, being items such as rent, rates, insurance, wages and licences. Variable costs are more difficult to itemise. They are any costs that increase as your sales increase, such as materials, commissions, freight and wages for casual staff.
Adding these costs together will give you only a basic idea of your general annual break-even point. To calculate how much in sales you will need per year, you need to perform a few quick calculations:
- Contribution margin per sale, which is how much profit made. For example, a product that costs $1 to make and sells at $2 has a contribution margin of $1.
- Contribution margin ratio, which is the percentage of profit you accrue calculated by dividing the contribution margin by sales price. For the above example, the contribution margin ratio is 0.5.
- Sales volume, which is the amount of sales you will need to make to break even. Calculate this by dividing your fixed costs by the contribution margin ratio. In the example above, if the company had fixed costs of $50,000 the sales volume is $100,000 in sales, or 50,000 sales. This covers the fixed costs and the costs of each item.
A break-even calculator can make the process a little simpler. Here are a few to try out for yourself: