What value would it be if I could know up front that I will make money, or for that matter, survive, over this slow period we are in now? Ignoring price pressure in these slow times for the moment, we must understand that the components of the cost of goods are materials, direct labor and overheads.
Labor and materials costs
In slow times, material costs can be negotiated down and figured to the cent for a given job. Direct labor and costs associated with it can be calculated from experience and given an hourly number. Labor hours required should never be taken at more than 80 percent of the hours actually worked and paid for a given job.
The total of these costs for a given job are defined as variable costs or cost of sales, depending on who is doing the naming. This amount varies wildly within our industry and depends on all kinds of factors, from the product itself to the market and even the general business climate.
Having said all that, this figure could be as low as 25 percent of the sales price and as high as 60 percent. What is important is that you know what this number is for your business! Once you know this, and every effort should be made to do so, you can start to make intelligent decisions as to what business strategy to follow at any given moment.
This brings us to overheads, often called fixed costs or burden, which need to be added to obtain the total cost of a given job. Burden is comprised of your salary and that of other salaried staff plus social costs, rent, insurances, utilities, maintenance, insurance, transport and consumables, just to name the most important ones.
Here, once more, this amount varies wildly within our industry between 20 percent and 40 percent of sales. But the total cost in your business can be established readily to within a dollar for a given period. It can be expressed per man hour by simply dividing the monthly amount by the total net productive hours generated. And this is the Achilles' heel as we shall see in the next hypothetical case.
Putting numbers to work
Let's say we have a business creating $1 million in sales per year. Our cost of sales, comprised of material and direct labor, amounts to 50 percent and the burden amounts to 20 percent. In this scenario, we have 30 percent left for perhaps sales commissions, discounts, advertisement, installation and profit. These amounts can cost as much as 15 percent of sales, typically leaving a 15 percent profit in normal times. Probably a good business model!
However, if the sales drop to half due to the slowdown and overhead burden, which was lean to begin with and can't be reduced, becomes 40 percent of sales, then we are facing a loss. If, in addition to this, prices you can charge are depressed by current market conditions, things will turn out for the worse.
This example allows us to reduce prices up to 15 percent to retain sales volume. At that level we would not make a profit but we could stay in business until the tide turns.
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