One of the questions new entrepreneurs ask is how to price their product. I think a more important question than pricing a product, is how much you get to keep. Profit targeting is when you plan your pricing to incorporated your desired profit level.
Business expenses are ether fixed or variable in nature. Knowing if your expenses fall within the fixed or variable category is important because fixed expenses affect your profit level either or not you make a sale.
Fixed expenses
Fixed costs are costs that remain the same regardless of revenue. However, a business looking to expand will see an increase in fixed cost due of new investments made. Having fixed expenses is great when you expect high revenue levels.
Fixed costs can either be committed costs or discretionary costs. A committed costs is a direct result of owning a resource or signing a long term contract. For example, signing up for a 2 year phone contract. With a committed costs, there is usually a penalty for cancelling early.
Discretionary costs
Discretionary costs arises from the business owners decisions. For example, a decision to subscribe to an online tool is a discretionary cost. The subscription could usually be canceled without penalty. A business just starting out will want more discretionary costs than fixed committed costs.
Variable expense
Variable expenses are those that vary in proportion to revenue. For example, credit card fees is a direct percentage of sales.
Profit Targeting
To compute the target profit, you will need to know your selling price, total fixed expense and variable expenses. For example Brain, Inc. is starting a new online venture. Brain Truechild the founder of Brain Inc. plans to charge a $ 125 monthly fee. Brain has figured out his costs as follows:
Variable costs
- Subcontractors: Each subcontractor will be paid $ 20 per job - variable
- Marketing expense- customer acquisition cost is estimated at $ 15 per client.
Total variable costs = 20 + 15 = 35
Fixed costs
- Website hosting fees - $ 15 a month
- Other subscription fees - $ 30 per month
- Other fixed costs - $ 100
- Owners pay $ 485 (you should always incorporate pay in any business plan, whether or not you plan to actually withdraw the cash)
Total fixed expenses = 15 + 30 + 100 + 485 = 630
Total costs = Total variable costs + Total fixed costs = 35 + 630 = 665
Analysis - Contribution Margin
Now Brain knows his fixed and variable costs, the next thing he will need to know is his contribution margin. Contribution margin is the amount each new subscriber shares to meeting fixed cost. Since, Brain pays fixed cost whether or not he gets a new subscriber, it is important to know how much each new subscriber shares towards fixed costs.
Contribution margin = Sales Price - Variable Costs
Brain's contribution margin = 125-35 = 90
Breakeven point
The breakeven point is the point where revenue equals expenses. Whatever you sell above your breakeven point is profit.
Break even cost is computed as follows:
Total fixed costs / unit contribution margin = Breakeven point in units.
Brain's breakeven point is 630/90 = 7 clients
7 clients translates to 7 * 125 = $ 875 in revenue
All brain needs to break even is to have seven (7) subscriber. Anything above that is profit.
Profit Targeting
What if Brain wants to pay himself enough so he does not have to have a job? Brains cost of living is $ 2,485 a month. He already plans to pay himself $ 485, so he needs $ 2,000 more. In addition Brain will like to make an additional $ 3,000 monthly to reinvest in his business. This is a total profit of $ 5000 each month.
The formula to compute target profit is as follows: (Fixed expenses + Target Profit) / Unit Contribution Margin = Number of units Brain will need to sell
= (630 + 5000) / 90 = approximately 63 subscribers
Brain will need 63 subscribers. Now let us see how this number works out in a profit and loss statement:
Sales revenue (125 * 63)
7,875
Less: variable expenses (35 * 63)
(2,205)
Total contribution margin
5,670
Less: Fixed cost
(630)
Profit (due to rounding up the profit is $ 40 more)
5,040
Brains marketing strategy will have to focus on building a system of building his subscription subscription revenue to 63 subscribers. The good thing is that once he gets a new subscriber, he earns revenue revenue from that subscriber which means he does not have to work at building 63 subscriber every month. If this was Brain's goal for the year he only needs approximately 6 - 8 new subscribers each month. He should probably plan for about 10% more than his analysis because he might lose some subscribers along the way.
In summary, when you break down a big goal into numbers, it is easier to see how doable it is. Business is simply a game of numbers. You just need to know how to work the numbers to your advantage.
The more you see the likelihood of a goal, the more likely you are going to see it to completion.
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