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PocketWatch On February - 22 - 2011

This is the ninth in a series of articles that will hopefully educate readers and illuminate the process of doing business in a simple to understand, nuts-and-bolts way.

To read all the articles in this series, click on any of the following:

In past articles we have developed a planning tool that will now allow us to look into the future and create a scenario for the business that can be tracked and follow.

The Financial Plan as a crystal ball…

In Part 8 of this series, we developed a financial picture of the company’s past performance.  It looks like this:

If you refer to Part 8, you will see the formulae for each of the rows above and how the numbers were developed.  Now we can actually begin to plan!

Are you planning to add equipment at some point in the coming year?  Plug in that purchase in the correct month umder G&A.  Adding a person or two down the road?  Add the monthly costs in COGS Labor or Administrative labor in the months where that additional cost will occur.  Thinking about adding a product or service?  Add the additional anticipates sales to Sales in those months where they are appropriate and the additional COGS as well.

All these questions and more can be plugged into the base model and you can see what happens to Gross Profits and Net Profits.  Using Excel or a similar spreadsheet program is a very useful tool to use, since you can keep the original base map of the business and make a copy to use as a “what if” planning tool, seeing how changes affect your business model instantly.

When you work with this tool, you need to be looking at your Business Plan as well.  Your Business Plan (that you should be updating every year) needs to reflect what you are planning to do as a strategy, and the Financial Plan you are manipulating using this tool is how you intend to get there by the numbers and not guesswork.

Overhead… Headache or a simple calculation?

One of the most common questions clients have asked me is “How do I figure overhead in my pricing?”  It’s a good question, because buried in that question is the realization that there is this big chunk of money that affects the business and has to be accounted for, but it is apparently confusing as to how to account for it properly.  Most small companies deal with this question through some sort of hit-or-miss addition to the direct costs of a product or service, hoping that they end up with something left over they call “profit.”

Well, that may work, but it is guesswork and supposition, and if there is one thing I try to teach is that guesswork, supposition, and “feel” will eventually get you into trouble.  Let’s look at Overhead (G&A Expenses) and develop a numbers-based approach to deal with it properly.

Markup – Not getting what you think you are getting

Most small and medium sized businesses use “markup” as a way to deal with Overhead.  If something costs $5 to make, they “mark it up” 100% and sell it for $10.  If a service crew goes out and installes an HVAC unit, and the total costs are $5,000 including equipment, travel, materials and labor, the markup may be 30%, making the price to the customer $5,000 x 1.3 = $6,500.  Makes perfect sense.  However, what is really happening?

That 100% markup on a $5 item only yields a 50% “profit.” 

That 30% markup on $5,000 only yields a “profit” margin of 23%! 

How did THAT happen?  Where did the rest of it go? Easy…. divide the actual sales dollars by the actual dollars remaining after markup to see what the “real” margins are when you use markup.

5 / 10 = .5 or 50%

1500 / 6500 = .23 or 23%

The point is, markup can be misleading and never yields what you might think it does.  There is a better way…

Calculating the cost of overhead…

One of the main reasons I went through great pains to develop the base business model and the financial plan is to get real numbers for COGS and G&A.  Those numbers are critical to help us price your product or service, and wil allow you to further analyze your business and business model.

Let’s see how to calulate the effect of overhead on costs the right way.

It’s actually quite simple…  Divide your G&A dollars for the year in your Financial Plan by your COGS dollars in the Financial Plan for the year.  You will get a ratio or a percentage.  Using the example plan above, you get:

$108,540 (G&A) / $134,045 (COGS) = 0.81 or 81%

Ok, you may ask, but what does that mean?  It means that G&A is 81% of the size of COGS.

Ok, you may further ask, why do I care?

Good question!  Think about this:  If I know the actual cost of producing something – labor costs, materials, supplies, shipping, packaing, etc. – I have a real number in dollars, right?  Let’s say that number is $100.  If I know that G&A or Overhead costs are 81% of the value of COGS, can’t I just add $81 to that $100 and come up with an overall REAL cost of $181 ($100 x 1.81)?  Hmmm…. can’t I do that with ANYTHING if I know the real costs and the overhead ratio? The answer is, absolutely!

Pricing made simple… or is it?

Now that we can get decent numbers for COGS and a calculated G&A cost, we can just add something for profit, and we have a price!  Well, yes and no.  Let’s look at it a little more closely…

If we have COGS at $100 and the overhead ratio is 81%, our costs for the item are $181.  If we simply do a markup, we are back in the same boat as before.  We are a little better off in the sense that we have a good number to plug in for Overhead, but the problems with simple markups is still the same.  As you may suspect, there is a better way.  I call it Planned Profit Margin.

What is Planned Profit Margin?  As the name suggests, what we are trying to get to is a real profit margin that is planned rather than accidental through markup.  Let’s say we want a reasonable 15% net profit on that item.

In marking up an item that costs $181, we add 15% of the costs to get a price. So, we get:

$181 x .15 = $27.15 + 181 = $208.15

A 15% profit, right? No… 27.15 / 208.15 = .13 or 13%

We slipped 2% there, didn’t we?  It may not seem like much, but 2% of sales over time can be a lot of money.  Let’s do it the right way…

The right formula to use is this:

$181 / (1-.15) = $181 / .85 = $212.94  (The true costs divided by the reciprocal of the margin we want.)

What we have done is to establish a REAL 15% Net profit on an item that cost us $100 in COGS, accounted for Overhead, and calculated a true 15% Net Margin.  If we do this same thing for each and every item or service we sell throughout the year, what should we see at the end of the year?  We should meet the Planned Profit Margin of 15% Net that should be in our Business Plan and our Financial Plan.

Now that we have the tools necessary to analyze and price things, next time we will look at the tactics needed to accomplish your goals.

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Please contact me offline at microconsulting@aol.com with anycomments, suggestions or ideas for future articles that you may not want to share here.

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Written by PocketWatch

I am a small town boy from northern Wisconsin, who grew up in the quintessential American family. Dad was a carpenter, mom stayed home, two brothers and a sister. Our politics, and we were political, was always Democrat. My dad always said all you had to do was to look at what each side was fighting for, and it was easy to see, even as a kid, that Republicans were all about big money and rich businessmen, whereas the Democrats were more about social solutions. I spent 6 years in the US Army in the VietNam era as an electronic instructor for NSA, worked as a Field Engineer for a computer firm based in Massachusetts, spent another few years building paper mills around the world for a firm from Washington state, drove long haul truck for a while, did 10 years of servitude in NYC for a large multinational market research company as the Business Manager, spent some more time on the road as a Business Consultant, and the last bit as the Business Manager for a manufacturing firm here north of Houston. I am trying to start up my own consulting firm using all my experience to help small and medium sized businesses stay out of trouble versus waiting until they get into trouble. No one teaches people how to properly run a business. Business schools and MBA programs really don't. There are very basic nuts and bolts that are either assumed or are ignored, and like the house built on sand, businessmen and entrepreneurs ignore these solid foundations at their peril. (Now retired and doing some substitute teaching at a couple of small K-12 schools here in northern Wisconsin. Living in a small hamlet of 340 people, quiet, peaceful, serene.)

8 Responses so far.

Click here to leave a comment
  1. TheLateGrardini says:

    Looking forward to the interview next Tuesday PW!

  2. Abbyrose86 says:

    This was a real good one PW. As you and I discussed before so many don’t realize their real COGS and start out at the wrong place.

    • PocketWatch says:

      Thanks, Abby.

      I just hope people are following along. Not many comments, so I don’t know if I lost everyone with all the math, but, as you can see, it all comes back together. There is a real purpose and reason why you have to go through that maze, because you get to here… planning and pricing based on fact, not fancy. Or, as I call it, fact-based business versus faith-based business.

      ” alt=”Smiley” border=”0″ />

      • Abbyrose86 says:

        I’ve read them all PW….I just haven’t commented on all of them!

        I like that fact based business! What a concept!

        There is more to it all than many realize. What amazes ME is how many managers and executives don’t realize all this either!

        I actually had an argument on pricing once, with an executive that boggled my mind! He actually told me, that our costs don’t matter….I’m like what? OF course they matter!

        We might sell under those costs (temporarily) in order to get a volume customer and/or to drive sales, but that doesn’t mean our costs don’t matter! We are simply making the decision to lose money on one customer in order to make money in other areas.

        He really didn’t get that! It boggled my mind!

        • PocketWatch says:

          Abby -- similar thinking to “deficits don’t matter.” It’s all about principles and stances and emotion with these guys, not about facts and figures. They despise “bean counters.”

          I once witnessed a 3-hour screaming match between a company VP and a department manager. The manager had increased sales by 300% over the previous year, and costs had only gone up 200%. Pretty damned good, right?

          The VP was furious! Why? Because the annual budget had only so many dollars in it for expenses for that department, and he had gone beyond that number by 100%… that was all she was focused on, because she was terrified about having to explain this unbudgeted increase in her expenses to the Board, and didn’t have a clue how to rationalize it.

          It was one of my OMG! moments when I realized just how abysmally stupid most so-called business people are, even in a billion dollar multi-national. And this woman was on the Finance Committee!

          Grrrrrrrrrrrrrrrrrr!

          ” alt=”Smiley” border=”0″ />

          • Abbyrose86 says:

            OMG is right PW!

            I, too, as I said, have encountered the same exact type of thinking…it never fails to boggle my mind!

            HOW do these people get these jobs?

            I can only come up with nepotism or other nefarious methods…because they certainly aren’t getting there based on knowledge, understanding or ability!

            • KB723 says:

              Abby I was just passing by and had no intention of logging in. However I saw this comment and had to reply.

              Nepotism, I was just saying the same thing the other day. Corporate America now seem to be just that.

              You don’t need much experience, you just need to know or be related to someone, it’s the same here where I work. In 5 years I am the ONLY person hired here that was not friends with or related to someone…


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