Making a profit

Welcome to Making a Profit
  • What do you need to consider when working out direct costs?
  • What should your pricing strategy be?
  • What overheads should be taken into consideration? At what point do you start to make a profit?

You probably want to trade overseas because it offers great potential for growth. More customers will bring more turnover. But how can you ensure they will generate more profit?

Direct costs tend to be slightly different when you are selling a physical product against a service.
It may help to check the box below to indicate which you sell. If you sell both you can check both boxes:
Are you selling a physical product or a service?

 

Direct Costs Associated With Physical Products

Look through the lists below. Again, it may help to check the costs that will be applicable to you.

Remember set up costs may need to be amortised across each unit – for example if you have a base cost for research and development or tooling you will probably want to amortise this i.e. write the cost down over a period of time. It is recommended that you speak to your accountant about the best way to do this.

 

 

Direct Costs Associated With Service Products:
Your Direct Costs fall broadly into Five categories – the important thing is that you do not leave any out of your calculations. Look through the lists below, check the costs that will be applicable to you. Remember set up costs may need to be amortised across each unit – for example if you have a base cost for research and development, or tooling this will need to be amortised. You might want to consider how you are going to calculate the numbers – will you work out costs per unit or over a timescale. For example you might write down tooling over 3 years. It is recommended that you speak to your accountant about the best way to do this.

Considerations Around International Pricing

You need to make a profit and there are only three ways that you can do that; – you can sell more units (which will invariably increase costs as stock holding and overheads often increase in line with sales), you can reduce costs, or you can increase prices.

So, how will you decide what you will charge? There is a range of different approaches. Read through the brief descriptions below and consider how you might approach your pricing overseas.

Market Perception Model:

One approach is to think about what the market will pay – what could you charge and still be perceived as good value by the customer. Your conclusion might be very different to the UK. Would you be able to charge more? Or might you need to charge less? In certain markets around the world British products command a premium price as they are perceived to offer higher levels of innovation, reliability and quality than locally available alternatives. Consumer or end-user preferences will also play a role as will local economic conditions. How might you want to reposition your product overseas to take account of these influences?

Value Based Model:

This is where you might base your pricing on the value that the product or service delivers to the customer. For example if you are providing a service that saves your customer a certain amount of money per year (and you can realistically demonstrate and evidence this) you could base your pricing on the concept of giving the customer a level of return on their investment.

Competitive Pricing Model:

A common approach for businesses entering a new market is to look at the competition and price at a level which is a little bit below it. This can be valid if you see price as a really important element in getting your sales – if you aren’t able to invest in the right sales materials for example, or if you are not confident that you are able to create the market perception you would ideally like to achieve. However, don’t embark on this unthinkingly. Challenge yourself (see market perception model above) to double check your strategy.

Businesses that are very well funded and seek to dominate a market do use competitive pricing as a strategy to gain market share in the early stages, but this approach is beyond the scope of most SMEs. Successful high value brands clearly illustrate that in many market sectors customers do not make a buying decision based on price. If your product is clearly a commodity you may have to consider popular price points unless you can demonstrate a unique selling point that provides the added value to command a more premium price point.

The Percentage Model:

You can develop a financial model that shows predicted income, predicted direct costs and overheads. Once you have done this you can adjust the pricing and see what effect that has on profit. This is a very useful exercise as it shows the “price effect”. It also gives you the opportunity to decide on your ideal level of gross (and net) profit. A clear idea of what is an acceptable return for your business will help you to be confident about your pricing approach and to filter out customers (and markets) which do not meet your expectations.

The Cost Plus Model:

Charging more overseas does not necessarily mean that you will make more profit – direct costs can be higher overseas and this will obviously have an effect on your profitability. It may be that you HAVE to charge more to make the same amount of profit that you do in the UK. Consequently, some companies set their pricing on a “cost plus” basis – i.e., they work out their costs and then mark these up by a certain amount to deliver a set level of profit. – this is known as a “mark up” – this is also sometimes measured in percentage terms – some companies “mark up” by a percentage, others mark up by an amount.

NB the difference between mark up and margin– the percentage margin is the percentage of the final selling price that is profit. A mark up percentage is what percentage of the cost price you add on to get to the selling price.

Used in conjunction with other methods, carefully making your ‘cost plus’ calculation ensures that your business will cover its costs and achieve the profit level you require.

Control:

Some of the costs of exporting may be outside your control; the impact of currency fluctuation is an obvious example, but there may also be raw material costs that fluctuate or tariffs and taxes that change. When you consider your pricing you will want to build in a level of safety that protects you against these kinds of fluctuations. There are ways that you can completely protect your business – by pricing in sterling, and by shipping ex-works (i.e. the buyer collects from you and takes all responsibility after that) you will protect your own situation, but that will in turn leave your customer exposed which may not be acceptable to them.

In summary, there are three major things to consider when deciding on your pricing:

  • Does your pricing model allow you to make an acceptable profit with an acceptable level of risk?
  • Does your pricing model deliver value to your end-user customers?
  • Does your pricing model allow your trading partners to make an acceptable profit?

 

 

 

Overheads are operational costs they vary from business to business.

There are two types of overheads –

Fixed Overheads:

These are contractual costs that occur at regular intervals – these may include items such as rent, lease contracts and, of course, salaries. The danger of fixed overheads is that they are constant regardless of the income that is being generated to cover them. It is worth considering that every time that you add another fixed overhead to the business you are creating a bigger “monster” that you have to feed. The higher the level of fixed overheads the less flexible the business is.

Variable Overheads:

As the name suggests, these are costs that can be adjusted at will – they allow the business to operate more flexibly.

Your business model will determine the level of fixed and variable overheads that you have to meet. If you are working directly with customers your variable overheads will tend to be higher. You will be paying for sales and marketing costs, for example. If you are working with an in-market partner you will probably be able to pass at least some of these costs (and risk) over to them.

When you add an overhead, it often attracts additional costs. For example, if you take on a sales person, it is not just the salary, national insurance and tax that you have to consider, you may need to provide that person with hardware such as a laptop, or sales presentation material, or a means of transport. Then there are the operational costs to consider; the travel costs, subsistence, relevant insurance cover, on-going training – it all adds up. A salesperson on a £20,000 salary package could end up generating £40,000 in overhead.

If you stick to the same route to market and business model overseas that you do in the UK, some of these overheads could become unacceptably high; for example, to set up a sales operation across Europe not only requires significant levels of working capital, but it also leaves the company very exposed if sales are not generated at an acceptable rate to cover the costs. A Europe-wide sales operation could also require a considerable level of stockholding.

Offset Through Collaboration:

Does your company need to engage in all of the activity that is creating direct overheads – for example, do you need to employ people to handle the logistics in your business, or could you outsource this work to the local Chamber of Commerce or a Freight Forwarder.

Offset To Trading Partners:

Could you engage a trading partner such as a distributor to provide marketing services, a sales team and a stockholding facility? Whilst you will have to make provision for the Partner to have sufficient margin to cover the associated costs and still make a profit, this approach takes risk away from you, and ultimately provides a more scalable model.

Offset To Suppliers:

It may be that you outsource some parts of your operation, only paying for things as you need them – using the flexibility of your suppliers. For example, if you are a manufacturer, do you want to invest in machine tools for every component of your product, or will you use the plant that can be provided by your suppliers as part of their commitment to your trading cycle. (Remember, when you sell, they sell, so you may want them to take some of the risk).

Much as you might want to keep controlling everything as you grow it may not be possible. Are you going to be in a position to hold stock for the world? Can you fund sales and customer support across all of your target countries? If your overheads become too high you may well hit a “glass ceiling” as you run out of cash.

A good exercise here is to consider what your business would be like if you received an order tomorrow that doubled your turnover – where would the bottlenecks be? What then if the business halved in size six months later? A business model that is using third party resources is much more likely to be able to respond to this sort of fluctuation and make the most of opportunities as they arise.

Whilst you may pay more for outsourced services, or giving a Distributor more may have an effect on your margins, you may want to consider whether you would prefer to have 100% of £1000 or 50% of £1000,000.

Your Business Model:

With all this in mind, you might want to think about of your own overheads and consider how you may set up your business model to control these as you grow. 

Making the Financial Case

Check the financial viability of your business proposition by using a break-even chart. Work out the answers to these five questions:

  • How many units do you need to sell to reach break even? If you are a service company your units might be hours or days.
  • When do you estimate you will reach your break-even point i.e. when will you be selling enough to cover your overheads?
  • What is an acceptable net margin?
  • How many units per annum do you need to sell to achieve this?
  • Finally what do you estimate the impact on the cashflow in year one to be?

tip

Check out The Value Chain Exercise, The Pricing Effect Tool and The Financial Planning Tool in The Tool Kit.

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