When running a micro business what do you think is the most important factor in determining the level of business needed to make a success of it?
Simply put it’s your “Breakeven point”
What is a Breakeven Point?
A breakeven point is the point at which all costs are covered. Anything above that is going to be profit.
Here’s an example.
Let’s say there are two people working in the business (in addition to the business owner). The weekly cost of running the business could be as follows:
|Salaries||£1000 (Paid on the number of hours worked, let say 60 hours @ 16.67 ph)|
|Rent and rates||£300|
|Variable overheads||£200 (e.g. advertising, stationery and so on…)|
Let’s assume the business owner needs £750 a week to live.
This means his business needs to make a total of £2,250 per week (which is £1,500 costs + £750).
This makes the weekly breakeven point of his business £2,250 with anything above that bringing profit.
What Costing Methods Are There?
In order to price a product or a service correctly it’s imperative to first know its cost.
There are a variety of costing methods depending on the type of business, but fundamentally they can be restricted to the following three types:
1. Total absorption costing (TAC) is a method which entails accounting for the full cost of manufacturing a product. This would include not just the cost of materials and labour, but also all other overheads (whether ‘fixed’ or ‘variable’). So for example rent, rates, stationary, etc are “absorbed” into the final cost of each manufactured unit.
2. Activity-based costing (ABC) is a costing methodology that identifies activities in an organization (rather than manufactured units) and assigns the cost of each activity to products according to the actual consumption of that activity by each product. For example, the cost of the activity of a bank teller can be assigned to each type of transaction (the product in this case) handled by the bank teller by measuring how long each transaction (the cost driver) takes at the counter and then by measuring the number of each type of transaction.
3. Marginal Costing (MC) is similar to ABC, but it assigns only the cost of materials and labour to each product or service. Fixed and variable overheads such as rent or stationary are not absorbed into the cost of each product or service. It can be defined as the change in the direct cost that arises when the quantity produced changes by one unit. That is, it is the cost of materials and labour needed to produce one more unit of a good.
Marginal costing is definitely my favourite form of costing when it comes to pricing specific products and certainly the one that should be adopted by most Micro Business Owners.
How much should the Business Owner charge his clients?
But it’s not enough to know your costs. You also have to take into account how much income you want your business to generate.
Therefore you also need to consider how much you will charge your clients in order to generate the type of profit levels you desire.
Let’s say that we have three different products. For example as an accountancy firm every week I may do 20 Tax Returns for Self-Employed, 5 Tax Returns for High Earners on PAYE and 2 Financial Statements for Limited Companies. Do I charge on an hourly rate or on a fixed price or a combination of both?
The first thing to do is to assign the cost of producing these products to each one. This would include the cost of labour (there are no materials involved) and other overheads. On the assumption that in total staff work 60 hours a week (let’s say that hourly paid staff spend 35 hours on Tax Returns and 25 hours on financial statements), the 3 costing methods listed above would be applied as follows (Please note that the business owner is a fixed overhead as he will take the same salary with no reference to the hours worked):
1. Absorption Costing
|Number of hours||60.00|
|Cost per hour||£37.50 (see activity based costing)|
2. Activity Based (calculated by cost x product)
|Total cost (Includes all overheads and the salary’s owner)||£2250.00|
|No. 20 Self-Employed Tax Returns (30 hours x £37.50 ph)||£1125.00||£56.25|
|No. 5 PAYE Tax Returns (5 hours x £37.50 ph)||£187.50||£37.50|
|No. 2 Financial Statements (25 hours x £37.50 ph)||£937.50||£468.75|
3. Marginal Costing (calculated by cost x product)
|Total hourly paid staff (exclude the business owner)||£1000.00|
|No. 20 Self-Employed Tax Returns (30 hours)||£500.00||£25.00 (Rounded)|
|No. 5 PAYE Tax Returns (5 hours)||£83||£16.60 (Rounded)|
|No. 2 LTD Company Financial Statements (25 hours)||£417.00||£208.50 (Rounded)|
As you can see, with marginal costing, only the cost of hourly paid staff is distributed over each product (unlike the Activity Based Costing where fixed and variable overheads are absorbed into it). The advantage of this method is that variations in the cost of variable overheads or fixed costs will not affect the unit cost. By distributing only the salary of hourly paid staff to work out the cost, the cost of each product remains always the same from month to month. This favours the decision making process and I explain this below.
Who Decides What the Final Price Is Going to Be?
The market decides what the final price is going to be.
So having worked out the cost you could add a mark up of say 40% to determine the profit of each product. This is not advisable as the market may not like it. So coming back to the marginal costing method I would apply the following system:
|Self-employed Tax Returns (£100 each)||PAYE Tax Returns (£75 each)||Ltd Co. Financial Statements (£1,200 each)|
|Total Gross Profit||£3775.00|
Fixed overheads and variable overheads
|Rent & Rates||(300)|
|Business owner’s salary||(750)|
|WEEKLY NET PROFIT||£2525.00|
As you can see by using Marginal Costing as a method, decisions can be made quickly and more accurately. For example although PAYE Tax Returns are bringing the lowest contribution to the Net Profit, nonetheless eliminating this income stream would reduce the gross profit margin, unless of course staff can be re-allocated to something else. If the staff cannot be re-allocated because there is no enough work in the other areas, it may be best to leave things as they are.
On the other hand if the price for the preparation of PAYE Tax Returns could be increased to £100, PAYE Tax Returns would be more profitable than Self-Employed Tax Return as they cost less to produce. This all highlights the importance of really knowing your numbers (and why accountants can be so valuable to micro business owners).
Vary importantly too, an increase in fixed or variable overheads or a change in the business owner’s salary does not force the business owner to re-cost everything. He knows that he is making enough profits to cover a substantial increase in overheads. So he may decide to employ another person to improve the administration side of things for future expansion.
Costing is an art. In the end though, it is the market that dictates your final price.
It may be that the best thing to do is to set a fixed price for each product, but charge on a time bases (as per the total absorption costing method outlined above) on everything which is outside the standard service.
Let’s not forget however, that the main objective of the micro business owner is to price competitively and still give value for money.
Today’s Micro Action
Take some time to consider your products and services. Do you know what each actually costs you to provide? Could it be that your pricing is losing you money rather than positioning you for success? Review your own costings, see where you need to make changes and which products and services are your most profitable – ensure you spend the most time and effort promoting your most profitable products and services.