During the negotiations, the buyer had asked what his actual cost per kilogramme was and he couldn’t answer.
Although you don’t need to be an expert in accounting and finance to run a business, having basic knowledge of the numbers will help you make the right decisions. In this US dollar era, accurate calculation of costs is essential in order to reach correct pricing decisions.
Such decisions have to made carefully because pricing that is too low can be fatal to a small business, while prices that are too high will chase away customers.
CALCULATING COSTS AND BREAK-EVEN POINT
The starting point in pricing decisions is to know your costs. There are two types of costs, variable and fixed. Variable costs are those costs that are directly associated with producing a product and which vary with production volumes, such as the cost of day-old chicks and stock feed, which is directly related to the number of chickens reared.
A very useful figure to know is the variable cost per unit, which is found by dividing the total variable costs by the number of units produced.
Fixed costs remain the same whether you increase or decrease production, such as rentals for your premises, or administration salaries. For example, if your fixed costs (rent, salaries etc) amount to US$10 000 per year, and you produce a total of 8 000 chickens per year then you have to allocate US$1,25 (US$10 000/8 000 units) to each bird.
Fixed costs become lower as your production units increase.
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Your selling price must cover both the fixed and variable costs. If variable costs (chicks, feed etc) are US$2 per bird, then your total cost per unit amounts to US$3,25. Selling your chickens at any price above US$3,25 means that your total costs are covered, while a lower price will result in a loss.
An important decision making tool is the break-even point analysis. This is the level of sales necessary to at least cover all your costs. Your break-even point can be determined using the following steps:
Find contribution margin per unit by deducting variable cost per unit from selling price (Contribution Margin = Selling Price – Variable Cost).
Find the contribution margin ratio by dividing the contribution margin per unit by selling price per unit (Contribution Margin ratio = Contribution Margin per unit/Selling Price per unit).
Find break-even sales volume by dividing fixed costs by the contribution margin ratio (Break-even Sales Volume = Fixed Costs/Contribution Margin Ratio).
The break-even tool will help determine the minimum quantities that you have to sell in order to cover fixed costs. In other words, if you cannot sell that minimum number, then the business is not worth doing.
Some new businesses start operating at levels below the break-even point while gradually growing sales. This is fine if the entrepreneur has adequate cash to cover the fixed costs in the meantime. However, continuing to operate below the break-even point will accumulate losses until the business collapses from lack of cash.
A simple Excel break-even analysis tool can be downloaded at my blog (http://chichonip.wordpress.com). The tool is useful for quickly calculating not only the break-even point but also the profit generated at different quantities of sales.
One of the keys to succeeding in small business is to understand the numbers. High performance entrepreneurs will invest their time and resources to learn how the numbers work.
This will prevent errors in pricing that could cost you dearly, as well as allow you to make informed decisions about starting, expanding or downscaling your business.
One of our training workshops in April will cover finance and accounting essentials for entrepreneurs and managers who don’t have such a background and want to empower themselves with such knowledge.
Phillip Chichoni is a business planning consultant who works with SMEs and entrepreneurs. His e-mail address is [email protected].
