Will it float?
Hopefully by this point, you have 50 business ideas. There are probably a couple that you are gravitating towards. Pick one that you think that you can do with the resources (time, money, skills, etc.) that you have available.
When selecting your business, you should also consider the economic concept of scarcity. Scarcity is the concept that human’s desires and needs are infinite, whereas our ability to produce goods and services are finite. A good’s or service’s price is partially determined by the availability of the product or service. For example, if there are a lot of window washing companies in town, the price will be lower than in a town where there is only one window washing company. This is also the reason that land is cheaper in the country than in the city — there are more people in the city trying to buy land.
Many businesses require some type of licensing. A catering business, for example, may require a food-handling certification and an approved commercial kitchen. The food-handling certifications are generally easy to get, and commercial kitchens are often available for rent for an hourly charge. Determine what certifications you might need, and decide if you still wish to pursue this business.
Financial statements are an important part of any business. These are used to determine the health of a business. You also must keep accurate records for tax purposes. Therefore, we are going to begin to learn about financial statements this week as a foundation for your business. Once you understand what a Cost of Goods Sold (COGS) is, begin to determine your price point for your product or service.
Remember that any labor involved in creating the product is a cost that must be calculated separately from your profit margin, even if you will be the one doing the labor! This is so that as your business grows, you can afford to hire that labor out without a drastic increase in price. Cost of labor can, at times, be difficult to determine. Here are a few questions that can help:
- Will the employee be working full time or part time?
- Is the labor skilled?
- Will the labor be local or overseas?
Elance.com and similar websites can help you to determine labor costs. Just make sure that you are checking labor costs for the area where you will hire (if the labor has to be local, don’t check prices in Bangor, India — check prices near where you live). Estimate how many products can be produced in an hour and divide your hourly labor cost by that number to determine the cost of labor for each product. If you are doing a service business, assume that you will have a minimum charge of 1 hour.
Overhead costs can also be difficult. Right now, you will probably be working from home. But what about in 2 years? Will you need a place for staff to work? Will you need a receptionist to answer phones? If so, you will need an office. For now, it’s probably best to assume that 30% of your product cost will go to overhead. If your competitors are charging $100, it is likely that $30 of that is going to overhead costs.
To summarize, if you have a product that costs you $5 in parts and $5 in labor, and you want to make $5 in profit, you will need to charge about $20-$21 to cover your costs and hit your profit point. If your competitors are charging $25, consider charging $27 and bringing extra value. Buzz words such as ‘hand crafted’ can increase perceived value and result in more sales, even though your product costs a little bit more.
This extra perceived value is what is known as a “unique selling proposition” (USP) and is very important to your marketing. If you have not determined what makes your product better or more valuable (i.e., why is your mousetrap better?), now is the time to figure it out!
Additional pricing help:
A good place to start your pricing is to look at your competitors (other businesses in your market, which will be businesses in your immediate area or online) and determine what they charge. Let’s take a look at why.
Market prices are determined by the law of supply and demand. As you can see from the charts below, when the quantity supplied is low and demand is high, price is high. Likewise, when the quantity demanded is low and demand is low, price is low. The third chart showing the equilibrium price is the point at which profits are maximized, when supply and demand are equal. It is important to note that these charts assume perfect competition, which we do not have in a real-life environment. However, supply and demand is still a useful tool for seeing why we utilize other companies to set our prices. By looking to these companies, it gives us an idea of the ideal equilibrium price in a perfect environment.
In a perfectly competitive environment, a price war will occur. This drives the equilibrium downward as the firms compete for market share. Ultimately, firms in a perfectly competitive environment
Action Steps:
– Decide on a business
– Investigate what licensing you might need
– Read chapters 1-5 of Financial Statements
— Read Sowell, Chapter 1: What is Economics
– Determine your Unique Selling Proposition
– Determine pricing for your product/service
- Determine COGS
- Determine time requirements and hourly value (cost of labor)
- Determine overhead (administrative costs… 30% of retail product cost is generally a good estimate)
- Determine desired profit margin (amount left over after all expenses have been paid)
- Check against competitors
- If price is too high (more than 10% higher than competitors), figure out how to save money to reduce costs and lower your price
- If price is too low, increase price (your price must be high enough to communicate value)
Discussion Questions:
How do manufacturing labor (or service performance) costs affect the price of the product?
When it becomes necessary to hire out labor, either to manufacture the product or perform the service, it will affect your bottom line. Calculate your profit margin if you failed to take into account those costs.
What is scarcity?