By Diane M. Calabrese / Published August 2023
Egg prices rose, and many people decided to add some laying hens to their yard. Soon enough, most of the novice hen keepers realized there’s a lot more to home-fresh eggs than a few hens. The hens must be well fed for starters, so there’s the cost of food.
Yes, the poetic notion that laying hens scurry around the yard eating nuisance insects and thus doing double duty builds on a tiny element of truth. But hens need to be fed well to produce quality eggs. They also need a comfortable, quiet hen house.
Add the expense of food and shelter and fencing out the neighbor’s cat, and it soon becomes a lot cheaper to buy eggs at the grocery store. In short, what non-business owners do not understand about the cost of doing business makes them vulnerable when they decide to take a DIY approach or when they leap into launching a company.
Know the cost of every component that goes into providing a product or a service. That’s the only way a price can be set high enough to make a profit.
We explore the break-even point in the next section. But first let’s get some advice from a veteran member of our industry.
Cost of goods sold [COGS] is the place to begin, says Jim O’Connell, CEO of Pacific Bay Equipment Service and Sales in Modesto, CA. “The pricing process has to start from the end—in other words, what do you need your net profit to be?”
Net profit is a must if a business owner plans to take compensation and build reserves. “So, from that aspect look at COGS, operating costs, and all other expenses related to the business, factoring in the costs of collecting your money if the customer is on terms or the cost of credit card processing if they pay with a credit card,” explains O’Connell.
The factoring in of all costs literally means “all” costs. “For inventory parts include the cost of freight as well as the cost to store them on your site,” says O’Connell. “Every square inch of your store costs you money, so if an item takes up a large amount of space, what does that cost you?”
Even experienced business owners can overlook a cost center—particularly a new one—when setting a price. “One big one we overlooked for the first couple of years was the cost of freight on our inventoried parts,” says O’Connell.
How was it overlooked initially? “We had a process for shipping outbound parts and would charge the customer for that, but we neglected to factor the cost to bring the parts into our store,” explains O’Connell.
“Also, another huge factor is the credit card processing fees that we are charged, but we did not charge the customer,” explains O’Connell. “We corrected both of these issues.”
Consultants abound who can offer suggestions on optimal price setting, or how to set a price for maximum profit. We ask O’ Connell whether he has ever sought advice from one.
“I have not been to a seminar or used a consultant for pricing,” says O’Connell. “We have consulted with other business owners in the same industry to come up with what we consider a good general model to start from to achieve the net profit we want.”
O’Connell’s company is like most established businesses today in that it is situated in both the real world and the virtual world. Some companies exist strictly as online sellers, and they present a unique form of competition.
How does O’Connell compete with online sellers when it comes to pricing? “We do not even try to compete,” he says.
“Most online resellers have very little knowledge of what they have for sale, so it is very common to get an incorrect part,” says O’Connell. Knowledge—expertise in all dimensions of each product (or service)—is a component of a sale.
“Our staff is trained in our industry to be able to ask the correct questions so we can supply the correct item for you,” explains O’Connell. “We have brick and mortar stores, so obviously our overhead is much higher.”
With higher overhead, prices must be higher. But built into the higher price is the assurance a customer gets that they have exactly what they need.
“The other consideration is that you can walk into our store and walk out with the part you need in most cases, thus not having to wait a few days to receive your part,” says O’Connell. Both accessibility and reliability are factors that buyers weigh in their appraisal of the value of a product (or service).
The U.S. Small Business Administration (SBA) offers a primer on the break-even point for a business. The primer, which is available at SBA.gov, includes a calculator to establish the break-even point.
There’s nothing profound about the calculations, but the use of the calculator does force owners to confront the true costs of doing business.
It’s too easy for start-up companies that provide services to underestimate the cost of doing business. For example, they neglect to factor in all the costs associated with vehicles and equipment.
Beyond the initial purchase, there are maintenance and replacement costs. There is fuel or power, and there are fluctuating costs for both.
Identifying the break-even point enables a business owner to set targets for revenue. In turn, those targets will indicate how prices should be set.
The break-even point analysis may become a harsh indicator that the model for the business cannot work without modification. Consider a power washing contractor in a market where residential homeowners will simply not pay more than price X for cleaning, yet providing service at that price would mean the contractor works at a loss on residential properties.
A contractor can work harder to explain to prospective customers the value of his or her service, sell more services to each customer, or add commercial cleaning. All the possibilities, though, add to the cost of doing business.
Take the time to do a break-even analysis. It’s the surest path to maximize gain (profit) and minimize pain. Pain comes in the form of realizing an expense has been missed or prices are set too low.
Here’s what doesn’t work on the low pricing side of the equation: Do more low-priced jobs to compensate for the low price. Yet that’s an approach many new service providers try.
As SBA notes, emotion plays a big role in the decisions that new business owners make. A genuine analysis of cost centers makes such direction by emotion impossible.
Washing twice as many houses in a week to take in twice as much revenue is not a plan. More washing means more wear and tear on equipment and vehicles. Then, there are the personnel. Doing more at a low price can never make up for pricing below the break-even point.
True, many businesses try the loss-leader approach. They lure a customer with an unsustainably low price and then try to sell other products or services to make up the difference. That takes time and an array of other products and services with cost centers of their own.
Skip the emotion. Start at the beginning: fixed costs.
Fixed costs include space (leased or owned), insurance, taxes, interest on loans, depreciation, and salaries. Think of fixed costs as those that are predictable on an annual basis (with some exceptions, given there are always unexpected blips such as insurance or tax increases).
Then, there are variable costs. They are not entirely unpredictable, but they fluctuate. Among them are internet and phone, repairs, fuel, and power. There are also other costs that emerge.
The semi-variable costs also include materials and labor not anticipated in the day-to-day model of business. In the “other” category might be the request for a special coating on a deck. Or, for a distributor, it could be a customer that wants customized changes to equipment.
Variable costs include things like credit card fees charged to vendors, the time it takes to straighten out a fraudulent charge, a storm or other natural disaster that shuts down a business for a time, and so on. A good estimate of variable costs is necessary to cushion the break-even point.
Ten percent above the break-even point is the true break-even point given the vagaries of the marketplace and the world in which it’s anchored.
No analysis is too detailed when trying to compute a break-even point. Manufacturers must account for storage space as well as for raw materials and components. Distributors must consider hours of operation. Every owner must factor in the cost of security and marketing.
Once the break-even point is established, the sale price—for each product or service—can be determined. It must be high enough to return a profit with the profit goal the purview of each owner.
Eggs again serve as a good reminder. This time it’s baskets, as in 2023 single service and single product lines are like putting all your eggs in one basket: risky.