Invest In My Idea

Business and money are practically one in the same. How much should you charge for your goods or services? Should you extend credit? How do you go about accepting credit cards? Whatever the issue, understanding the financial aspect of business is vital.

Making a Profit

Just how important is selecting the right price? It could mean the difference between success and failure. One of the most important financial concepts you will need to learn in your new business is the computation of profit and how it relates to your pricing structure. The gross profit on a product sold or service rendered is computed as the money you brought in from the sale, less the cost of the goods sold. The key is to compute accurately the cost of goods sold, which can be deceptive.

Let’s say you are going to run a childcare center. To compute your gross profit, you have to be able to figure out what it costs you to take care of each child. The way you do that is by computing all of your costs and then dividing by the number of kids you have. Costs in this sort of business might include:

•   Rent
• Food for the kids
• Utilities
• Office expenses
• Salaries and wages for you and any staff
• Payroll taxes and employee benefits
• Advertising, promotional, and other sales expenses
• Insurance and bonding
• Auto expenses
• Other expenses

Let’s say that it costs you $5,000 a month to run the show, and you bring in $8,000 a month. If you have 10 children, then your expenses would be $5,000 divided 10, or $500 per child. Now you know the minimum amount you must charge to make a profit. Because you are charging $800 per child ($800 × 10 children = $8,000), your gross profit per child is $300. Your total gross profit is $3,000.

While your gross profit is a dollar amount, your gross profit margin is expressed as a percentage. It is an equally important number to track because it allows you to keep an eye on profitability trends. The gross profit margin is computed as the gross profit divided by sales. In the example above, your gross profit would be $3,000 divided by $8,000, or 38 percent. That’s pretty darn good. Any business that makes 38 percent profit is doing something right.

Pricing Your Goods or Service

It should be clear by now that the wrong price can put you out of business fast. Finding that magic number requires careful thought and planning. In the example above, we know that you must charge at least $500 per child to break even. The trick is to come up with a price that gives you a good profit while still attracting customers.

When first opening their doors, many businesspeople have a hard time knowing what to charge for their product or service. But actually, it’s not that hard to figure out. If you sell a product, you base your retail price on your wholesale cost. If your base cost for a widget is $5, start there, then account for your overhead, and you are off.

The real trick is figuring out what to charge when you have a service business. One reason it is hard to determine is that new businesspeople mistakenly assume that their value is the same as it was when they were an employee getting paid for 40 hours of work a week. If your boss paid you $20 an hour, maybe that is what you should charge. But that’s not right.

■ Real Life Example

Jeff Hawkins is the inventor of the Palm-Pilot, his second effort at creating a hand-held personal digital assistant (PDA). His first attempt was something called the Zoomer. Priced at $700, the device was far too expensive for a massmarket consumer product. Moreover, the Zoomer had a tiny keyboard, and its hand-writing-recognition software didn’t work right. To make matters even worse, the Zoomer had drivers for printers and fax machines, making it both big and slow. Says Hawkins, “It was the slowest computer ever made by man. It was too big and too expensive.” The Zoomer bombed.

Knowing that he had to have a more reasonably priced product to succeed, Hawkins went back to the proverbial drawing board. His new product had to be small, simple, quick, and cheap. Tinkering again and again, Hawkins kept refining his ideas and, with each revision, the new PDA kept getting smaller and less expensive to produce. Finally, less than three months after Hawkins began rethinking the PDA, Palm had a mock-up of its new device that would fit in a shirt pocket and run on AAA batteries. Its four core functions were a calendar, an address book, a todo list, and a memo pad. The Palm-Pilot would come to market costing less than $300.

First, you simply cannot bill eight hours for your services every day because, even if your business is going well, you still have to hunt for business, handle administrative issues, plan, and so on. This is why you should probably charge your clients more than your last employer paid you.

For example, if you earned $25 an hour as an employee, you probably should charge $50 an hour once you are self-employed. When I worked for a big law firm, they routinely charged the client double what they paid me. That is how they made a profit, and that is how you can too. This might seem hard to do at first, but you can’t let your lack of confidence cause you to under-price your services. If the client could do what you do, he wouldn’t need you.

Think of it this way: A rental car may cost $50 a day, which works out to $1,500 a month. It is much more than you would pay per month for a car you owned, yet at times you still rent one because you have a need, and the rental company fulfills that need. It is the same when someone hires you.

Cheaper Isn’t Always Better

It is equally important to understand that being the cheapest isn’t always smart. When you use price as the only barometer for your services, then other more important things get left out of the equation—like quality, personal service, and promptness. McDonald’s can emphasize low prices because that is one of its trademarks. But if you are not a Mc-Donald’s type outfit, constantly discounting fees and prices may be a mistake.

The price of a product tells consumers what kind of value and quality to expect before they buy it. A person who can afford a Mercedes or Jaguar doesn’t mind the high price because they associate quality and value with the prices of these cars. Often, in a consumer’s mind, a higher price connotes high quality, and a low price means poor quality.

You need to ask yourself whether you are trying to increase profit margins or market share. If you are mostly interested in boosting profits rapidly,

Pricing Your Product or Service

• 1. Identify your customers. Are they upscale or middle class? Are they looking for a bargain or is quality more important than price?
• 2. Determine your gross profit threshold. Use the formula in this chapter to calculate how much money you need to charge per item to break even, and go up from there.
• 3. Be flexible. Trial and error is the key. Maybe you want to offer a volume discount to a potentially lucrative customer. See what works.
• 4. What is your service worth? Value is critical. If a customer thinks your product delivers benefits worth $15, you can’t sell it for $25.
• 5. Look at the competition. What you charge also must be measured in comparison to the product the customer is already buying. Thus, what your competition charges is vitally important to consider as well.

 Increasing Your Profit Margin

 There are two ways for you to improve your profit margin. First, you can increase your prices. Second, you can lower your overhead. Price increases require a careful reading of the competition, your business model, and supply and demand for the product you are producing. It has to be done with testing and care.

The second way to increase your gross profit margin is to lower your costs. Decreasing the costs of materials or producing the product more efficiently can accomplish this. Look for a less costly supplier. Maybe our childcare center could shop for food and supplies at a discount warehouse market instead of the grocery store. Keeping your overhead low will help keep you in business.

Whether you are starting a service business, a manufacturing outfit, a wholesaling venture, or a retail store, you should always strive to deliver your product or service more efficiently, with less cost, and at a price that gives you the best profit. The name of the game is, after all, making a profit.

 ■ Let the Numbers Do the Talking

If you don’t understand the finances of business, and many entrepreneurs actually do not, you are in trouble. Business decisions that are not based, at least in part, on a cold and hard financial analysis are decisions that can easily go wrong.

For example, assume that your business is looking to add a new product line. How do you know if it will work? Such an important decision should not be based on guesswork or hunches. Instead, you have to let the numbers do the talking. Knowing how to crunch the numbers—figuring out what it will cost you to launch the new line, how much you can expect to make, and how quickly you can reasonably expect to make it—will make the decision easy for you. Can you afford a new product line? Will your cash flow allow you to afford it? What kind of return on this investment of capital and time can you expect? Let the numbers do the talking.

That’s what Starbucks does. How does Starbucks know when to open up another store in a neighborhood? They look at existing stores and notice how long customers have to wait to have their order taken and filled and then open another in that area when the wait gets too long. They let the numbers do the talking.

That is what you must do. Can you afford that new product line? Well, what do the numbers say? If the numbers are not there, your brainstorm could be a huge mistake. And if you don’t know what the numbers are saying, it is time to learn.

 Your Customers’ Payment Options

Extending Credit

If you do decide to extend credit to customers, be picky. There are two

important aspects to a successful customer credit policy:

1.   Limit you risk.
2.   Investigate each customer’s creditworthiness.

The final financial aspect you need to deal with at this point has to do with what forms of payment to accept. This includes the creation of a credit

Once a potential customer has completed the application, you need to verify the facts and assess the company’s creditworthiness. You do so by calling references and by using a credit reporting agency or a business consulting firm such as Dun & Bradstreet. Also, most industries have associations that trade credit information. Finally, even if the client seems worthy, and even if he or she checks out, trust your gut.

Accepting Credit Cards

Your credit application might look like this:

Business name_____________________________________________ Date______________

Other names of the business ____________________________________________________

Name of owner _______________________________________________________________

Type of business ______________________________________________________________

Legal structure of the business ___________________________________________________

Business address ______________________City_______________ State_________ Zip_____

Phone no. _____________________________ Fax no. _______________________________

Email ______________________________ Social Security No. ________________________

How long in business ________________________ Dun & Bradstreet rated _____________

Trade references:

Name _________________________ Address __________________________ Ph _________

Name _________________________ Address __________________________ Ph _________

Name _________________________ Address __________________________ Ph _________

Name _________________________ Address __________________________ Ph _________

Bank references:

Name _________________________ Address __________________________ Ph _________

Name _________________________ Address __________________________ Ph _________

Credit line requested $_________________________________

The undersigned authorizes inquiry as to credit information. We further acknowledge that credit privileges, if granted, may be withdrawn at any time.

(Your credit application might also specify the credit terms, consequences of failing to meet them, late fees, and that the customer is responsible for any attorney fees or collection costs incurred at any time.)

While that is the good news, the bad news is that accepting credit cards is not cheap. Some fees you can expect to pay include:

•   The discount rate, which is the actual percentage you are charged per transaction. The percentage ranges from 1.5 percent to 3 percent; the higher your sales, the lower your rate.
•   Start-up fees
•   Equipment costs, depending on whether you decide to lease or purchase a hand-held terminal or go electronic
•   Monthly fees
•   Miscellaneous fees, including a per-transaction communication cost for connection to the processor, a postage fee for sending statements, and a supply fee for charge slips

To accept major credit cards from customers, your business must establish merchant status with each of the credit card companies whose cards you want to accept. The best place to get merchant status is the bank that already has your business. If your bank turns you down (because of poor credit or lack of credit history), ask around for recommendations from other business owners who accept plastic. Look in the Yellow Pages for other businesses in the same category as yours, and call them and ask where they have their merchant accounts.

If banks turn you down, a second option is to consider independent credit card processing companies, which can be found in the Yellow Pages. Independent accounts take longer to set up and start-up fees are usually higher.

Once your business has been approved for credit, you will receive a start-up kit and instructions on how to use the system. You can start with a phone and a simple imprinter that costs less than $30, but you will get a better discount rate (and get your money credited to your account faster) if you process credit card sales electronically. Although it is more expensive initially, purchasing or leasing a terminal that permits you to swipe the customer’s card for instant authorization (and immediate crediting of your merchant account) saves you money in the long run.