Would you work for free?
In these economic times, many people have lost high paying jobs and are turning to entrepreneurship to replace that salary. As that happens, you have people who have a skill or talent, but may not know the ins and outs of managing the financial outcome of a business. Too many entrepreneurs today are heard saying “I’m working for free!” You wouldn’t work for some other company for free, so why work for your own company for free? If you work for free in the beginning, it makes it harder to work for pay later. Let’s talk about how to avoid this. The topics that I think help you avoid working for free are pricing, expenses, break-even point and profit. If you don’t know what these are, you can’t possibly make sound financial decisions.
Pricing is sometimes the last thing a business establishes. That sounds reasonable. After all, you need to know your associated costs before you can accurately figure a profit margin, right? Associated costs aren’t just the costs of the materials but also the associated wages. This isn’t the wage that you would have made in the job you lost, but what you would pay a skilled person to perform the work you, as the owner, are performing now. If you are selling a product where you would have to hire someone else to fabricate a piece of the final product, you would pay them and include that wage in your associated cost. So why wouldn’t you pay yourself for the time you are fabricating the same product? You should!
What happens if you choose to set your price based on your competitor’s price? This can be very tricky! It sounds like a good idea, but their cost may be considerably less than yours because of a buying agreement or a skill they have that you will have to outsource. The competitor could be making a comfortable margin where your company will not make much profit at all. Even worse, they may not be making any profit at their prices! Set your price to cover your costs and be prepared to explain what differentiates you from your competition.
Let’s say you bid a job based on what you think your associated costs would be and then the cost ends up higher. You can’t go back to your customer and ask for more money, so you just made less profit on that job. Less profit means you have less money to pay your fixed or overhead expenses, such as rent, electric, advertising, etc. It becomes equally important to watch your cost of expenses and keep those as low as possible. If you started your business with limited capital, this lower profit may impact the funds that you have available for marketing your product.
Now let’s talk break-even point. According to dictionary.com, break-even point is the level of operation at which income from sales equals the invested cost, resulting in neither profit nor loss. This is very important to be able to determine the sales required to meet a target profit. It’s better to establish value for your product and get the price its worth than to increase your price down the road. Break-even is more easily demonstrated through sales units.
Your fixed costs $50,000
Unit Selling Price $50
Unit Variable Cost $30
Unit Contribution Margin $20
To cover your fixed costs or to break-even, you would have to sell 2500 units. This is the point when you begin to show a profit.
So let’s talk profit. It isn’t a dirty word! All successful businesses make a profit. What is the right profit ratio for your company? Do your research and determine the standards for your industry. A comfortable margin for many industries is 40%. It’s a good starting point and it is what you would be working with, if you use the prior example and divide the Unit Contribution Margin ($20) by the Unit Selling Price ($50).
My final thoughts on the subject are:
1) know when you break even and
2) if you’ve made any of these mistakes in the past, it’s not too late to fix them to grow your bottom line.