Pricing for ProfitBarry Gupton – Mountain Bizworks

William Lyons – Bluebird Farm

What determines our pricing?

•Market FactorsCompetition, Demand etc.

• CostHow much does it cost me to produce it?

Benefits of knowing our Costs?

• Better decision making!• Pricing (ensure adequate profit margins)• Product mix optimization• Ability to improve or reduce costs/unit• Communicate with customers more effectively• Confidence

Business Financial Management Process

1. Good Record Keeping 2. Proper Accounting 3. Good Information 4. Informed decision making 5. Improved performance

• Small business owners need to know some basic accounting in order to be able to manage their finances properly

Financial Statements• Profit and Loss (P&L) aka Income Statement• Profitability (Sales – Expense = Profit)

• Balance Sheet• Business Value (Assets – Liabilities = Owner Equity)

• Statement of Cash Flows• Budgeting (Cash In – Cash Out = Change in Cash)

Business Model

Business Inputs Outputs

Resources into business Products/Services Sold

Performance/Success = Difference between Outputs and Inputs

Business Model with P&L Statement• Time Period• P&L equation:

Sales- COGS (Variable Expenses) Gross Profit- Fixed Expenses (Overhead) Net Income (Net Profit)

Types of Expenses• Costs of Goods Sold (COGS) aka Variable Expenses• expenses consumed with each additional unit of production• Direct costs of production

• Fixed or Overhead Expenses• often monthly types of expense, insurance, rent etc.• defining characteristic: not directly related to sales volume

• Start-up expenses• One time expenses needed before business can open• Start-up expenses and asset investments should be allocated into fixed

expenses (called: depreciation expense)

Financial Business ModelStrategic Decisions• Pricing• Volume• Costs

Break Even Analysis

• Profitability analysis of business model

• Types of B.E.P. Analysis:• Volume• Price• Gross Revenue

B.E.P. Volume

• Time Period (annual, monthly etc.)

• Let’s us know volume we need to sell in order to break even

• B.E.P. Volume Equation:

Total Fixed Costs / Gross Profit per unit = BEP sales volume in

units

Note: Gross Profit per unit = price per unit – COGS per unit

BEP Volume ExampleGupton Goat Dairy Annual BEP volume analysis• Start-Up Expenses

$1500 - Milking Shed and Stand$700 - Goats$800 – FencingTotal Assets = $3000

Depreciated 10 years: $3000 / 10 years = $300 annual depreciation

BEP Volume Example• Total annual Fixed Costs

• $300 - Fencing, Barn, Goat Assets Depreciation • $500 – Supplies (medicine, minerals, repairs, hay)

• Variable Costs per Unit (½ gallon milk)• $1.50 – organic feed• $ 1.00 – packaging, labeling

• Price per Unit• ½ gallon milk price - $10

BEP Volume Example• Fixed Costs / Gross Profit per unit = BEP volume

• $800 / ($10-$2.50) = 107 ½ gallons annually$7.50

• I have 2 goats that produce for 5 months • Estimated production : 300 ½ gallons

BEP Price• Used to determine what price would = break even profitability

• Useful when production or sales volume is known

• Fixed Expenses + (volume x COGS per unit) / volume = Break Even Price

BEP Price Example

• Fixed Expenses + (volume x COGS per unit) / volume = Break Even Price

• $800 + (300x$2.50) / 300 = $5.17 per half gallon$750

• Calculate Profit = ($10-$5.17) x 300 = $1449 $4.83

Business Model

Business Inputs Outputs

Resources into business Products/Services Sold

Financial: $ Expenses/ Costs $ SalesNon-Financial:

Owner Labor and time Non $ personal benefits “free food” Effort, personal risk Community impactLand, other assets Environmental impact

Analyzing the Business Model • Take into consideration all business inputs and outputs

• Looking at just one non financial input:

1 hour of my time per half gallon for milking, packaging and distribution

Profit of $1449/300 hours annually = $4.83/hr.

Pricing for Profit: Part 2• How do we evaluate profitability for multiple products/services in one

business?

Enterprise Budgeting?

• Cost accounting• Overhead allocation

“if management wants to know the true cost of manufacturing an individual item, it is essential that the manufacturing overhead be allocated in a precise and logical manner”“In short, the financial statements can be considered as accurate even with improper allocation to individual products, but management's needs dictate that (1) the allocations of manufacturing overhead be truly accurate and (2) that the nonmanufacturing costs be accurately assigned to individual products”accountingcoach.com

Overhead Allocation?

• Spreading all the overhead to our different product classes / profit centers / revenue streams • Purpose: to estimate net profitability per product class • In Other Words: This is the way we figure how much it costs us to

produce a “lb.” of this or a “bunch” of that

Methods to Allocate Overhead?

• How do we figure out how much overhead to assign to each product class in our business?

• Cost Drivers or Activity Based Costing• By Gross Sales $ (not usually recommended)• Direct Labor Hour• Direct Machine Hour• Amount of land used (common in organic agriculture)

• Overhead allocated per bed ft., or acre etc.• Many other ways possible

Overhead Allocation Example

Tomato Crop on Diversified Organic Veggie Farm • Fictional Example, please excuse my arbitrary numbers

• Tomato gross sales for season 2600lb at $9,000 • Total COGS or Direct Costs for Tomatoes $400 (cost of transplants etc.) • Tomato Crop Gross Profit = $8600• 2,000 Bed Feet total on farm• 300 bed ft. - single crop of tomatoes in a season• Farm annual overhead $50,000• 300/2000=.15 or 15% of total bed space devoted to tomato crop• $50,000x.15= $7,500 overhead allocated to tomato production• Tomato Gross Profit of $8,600 – $7,500 = $1,100 Estimated Tomato Net Profit • COGS $400 + $7,500 allocated overhead = Total Estimated Tomato Costs

$7900• $7900 / 2600lb produced and sold = $3.04 total cost per lb of tomato

Overhead Cost Drivers?

What does “logical manner” mean when determining overhead cost drivers?

It needs to make sense that the cost driver more or less “drives” the consumption of overhead resources

Example: land rent overhead allocated per qty. of land used per crop is logical

Overhead Allocation

• Possible to use multiple cost drivers to allocate overhead• Can use different drivers for different groups of overhead• Method can also be used to allocate direct costs associated with

multiple products

• Barry Gupton – barry@mountainbizworks.org