• What costs do I need to consider – and what’s the difference between start-
up, fixed and variable costs?
• How much do I need to sell to cover my costs and draw a living from the
business?
• Is my business likely to be profitable in the future?
• How much should I be charging for my product/service?
SETTING YOUR PRICE
Having looked at the idea of PRICE from a marketing perspective, it is also
necessary to consider price from a financial or costing perspective.
Some businesses make the mistake of looking at what price is being charged by
others and simply setting their price at the same value. After some time it becomes
apparent that the product or service is being provided at a loss and this puts the new
business venture in difficulties.
Below are some notes on how to cost your product or service. Firstly a distinction
between two different types of cost; Fixed and Variable.
UNDERSTANDING FIXED, VARIABLE & START UP COSTS
FIXED COSTS
The definition of a fixed cost is one which does not vary in total when the level of
output by the business does vary. In other words, when the Sales level within a
business increases, fixed costs in total, would not increase. It also follows that when
the Sales level in a business decreases, the fixed costs would not decrease.
An example of a fixed cost for a business making a product such as a bakery would
be the business rates. For a business producing a service such as massage therapy
would be any costs associated with the rent or ownership of premises, insurance,
and costs associated with the ownership of equipment.
As fixed costs are not dependent upon the level of output (sales), they are often
expressed as being per period of time, for example annually, weekly or monthly.
VARIABLE COSTS
Variable costs are those which DO vary as a total cost to the organisation when
output (number of items or services produced) varies. In fact a true variable cost will
vary in exactly the same proportion as the output.
In other words, as sales increase the variable costs increase.
An example of a variable cost for a bakery would be the cost of flour.
In a service business, there are often fewer variable costs. Often the main variable
cost in providing a service is the cost of wages for an employee working directly in
providing the service. Other variable costs in a service business would be anything
directly ‘used up’ during the provision of the service. For example with massage
therapy, oil may be used and there may be the cost of laundering one or two towels.
Variable costs should be able to be expressed per item of output or sales. If this
proves to be very difficult, you may need to classify such costs as fixed.Some costs have both fixed and variable elements. These are semi variable costs.
WHAT ABOUT WAGES/LABOUR?
If you are employing someone, this is obviously a cost to the business. Whether it is
fixed or variable will depend on the nature of their terms of employment. Consider
the following scenarios;
Employee paid a basic wage for 37hours per week-Fixed or variable cost?
Employee paid a set amount per item produced (e.g. per therapy treatment or per
floral wreath) -Fixed or variable cost?
Employee paid for number of hours worked but no minimum hours guaranteed (e.g.
housekeeping staff paid to service holiday accommodation only when let) -Fixed or variable cost?
WHAT ABOUT YOUR OWN ‘WAGES’/LABOUR?
If you are a sole trader or trading as a partnership, your own earnings are not a cost,
they are a withdrawal from the profit, and are called ‘drawings’. However, when
looking at variable costs in order to price your product or service, you should include
a realistic figure for any direct labour involved to make sure that you are costing and
pricing your product realistically.
Your price to the customer must obviously be higher than the variable cost of
producing it!
Consider what would be the ‘going rate’ for direct labour in your business.In determining your price to the customer, it is useful to include an element for direct
labour, however, when calculating break even, you need to consider your earning
needs separately.Consider your own income needs from the business.
START UP COSTS
This term really relates to those expenses incurred prior to the business starting to
trade. Examples would be the initial stock, membership of a trade organisation,
purchase of a patent, company registration, or purchase of equipment needed to
start.They are not really costs distinct from fixed or variable, but just expenses occurring in
Month 0 before trading starts in Month 1. They would be shown as such on a cash
flow forecast.
UNDERSTANDING BREAK EVEN ANALYSIS
The difference between the Sales in a business and the variable costs is known as
the ‘Gross Profit’ (or the ‘Contribution to Fixed Cost ’). A simple example of gross
profit would be in a shop where the gross profit is the difference between the sales
price and the cost of an item.
A gross profit percentage is used to show this difference as a percentage of sales.
For example:
A shop has sales of $7,000 during a month. The cost of buying the goods for resale
is $2,450. This means that the gross profit is $ %
Sales 7,000 Less variable costs 2,450 = Gross Profit 4,550
To calculate the gross profit as a percentage of sales, we use the formula
Gross profit $ DIVIDE by Sales x100 =% Gross Profit
$4,550/$7,000 x 100 = 65% as Gross Profit
The same calculation is used for a business making a product. For example
A chair maker sells a particular type of chair for $180. The variable costs of
producing that chair (timber, glue etc) is $54. What would be the gross profit and the
gross profit %?
Break even occurs when
Total Sales Income = Total Costs (both fixed and variable)
This means that neither a profit nor a loss has been made. This is useful in looking
at how realistic the possibility of covering the costs is – any sales above this figure
will start to provide a net profit.Net profit (or loss) is what results when Fixed Costs are deducted from the Gross Profit.
The method used to calculate the break even level of sales is as follows:
Step 1 - Note down an example of a sales figure or anticipated selling price (per hour
or per sq m or however you will price based on your knowledge of the market).
Step 2 - Note down the variable costs of producing that sales value (including any
employed direct labour, if truly variable, but excluding your own labour).
Step 3 – Calculate your GROSS PROFIT
Sales Less Variable Costs = Gross Profit
Step 4 – Calculate your GROSS PROFIT PERCENTAGE using the formula
Gross Profit $/Sales $ x 100
Step 5 – Calculate the break even level of sales using the formula below
Break Even Level of Sales = Fixed Costs$/GrossPoint% x100
EXAMPLE
A therapist offers many different treatments, and charges between $25 and $30 per
hour. She finds it difficult to estimate her variable costs per hour because each
treatment varies. However, she has managed to estimate from typical treatments
that when her sales are $600, her variable costs (for laundering towels, use of oils
and lotions and disposable items) are $60.
Following the steps below, calculate the break even level of sales if her fixed costs
(for rent, insurance and subscriptions) are $900 per year.
Step 1 - Note down sales figure
Step 2 - Note down the variable costs of producing that sales value
Step 3 – Calculate GROSS PROFIT
Sales $ Less Variable Costs $ = Gross Profit$
Step 4 – Calculate GROSS PROFIT PERCENTAGE
Gross Profit $/Sales $ x 100
Step 5 – Calculate the break even level of sales using the formula below
Break Even Level of Sales = Fixed Costs $ x 100GP%
Sales Less variable costs = Gross Profit Less fixed costs = Net Profit
Note that although only she only needs to turnover $1,000 per year to cover her
costs, this would not include any income for her.
EXERCISE
An upholsterer carries out customized work. She estimates each job based
on the cost of materials to complete the work. To find the amount to be
charged out to the customer, she multiplies the amount it costs by 2.5 (two
and a half). So that when her material costs are £100, her sales price to the
customer is £250.
The upholsterer’s fixed costs are £1,800 per year. Calculate the level of sales turnover needed for her to break even.
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