Category: Uncategorized

Preface: Although there is not an exact formula to guide a business owner or manager through the process, asking the right strategic questions before every hire is always advised.

Help Wanted (Segment III)

Credit: Jacob M. Dietz, CPA

Advantages of Employees

One advantage of having employees, if the laws and taxes are complied with, is the safety and peace of mind of doing things right. You do not need to worry that the authorities will justly punish you for evil doing.

Another benefit can be a tax deduction. Under the federal tax system, there is a 20% Qualified Business Income Deduction that sometimes needs wages for it to take effect. The deduction is complex, and all the complexities of it are beyond the scope of this article.

Another advantage of an employee is that you may have greater control over when they do the work, and how they do the work. For example, if due to a scheduling conflict you need to move a job up two weeks, you may be able to rearrange the schedule of your employees so that they can do the work. If you are depending on a subcontractor, it may be harder to get them to rearrange their schedule.

Also, if you are finicky about what materials to use and how to do it, it may be easier to oversee an employee. While you could stipulate in a contract how a subcontractor works, you may find it easier to train employees more specifically than subcontractors.

 

Disadvantages of Employees

One major disadvantage of adding employees is the payroll taxes and insurance and filings that can come with payroll. One way of handling these administrative burdens is to hire a bookkeeping employee to do that. Another way is to outsource the payroll to a firm that handles much of the compliance and filings for you. Both options cost money.

Another disadvantage is that if you do payroll taxes wrong, there could be penalties. Outsourcing your payroll to experts can help minimize these risks.

There is also the potential to violate labor laws. That is beyond the scope of this blog and you can consult with an attorney for more information.

Checklist Before Hiring New Employees

Before hiring employees, consider going through a checklist.

1. From where will the money come to pay the employee (new sales, cost savings, etc.)?
2. Will there be additional overhead that comes with the employee (tools, taxes etc.)?
3. Will there be additional administrative work and compliance issues?
4. How will the new employee affect the bottom line?
5. How many hours of work do you have available, and for how many hours does the potential employee want to work?
6. Are there any legal issues or risks? Consider consulting with an attorney if there are risks.

Hiring employees comes with both advantages and disadvantages. Although there is not an exact formula to guide a business owner or manager through the process, asking questions before hiring can be wise. If the business knows how it will pay for the employee, it can make it easier than if the business hires an employee and cannot make payroll. Count the costs before putting out the “Help Wanted” sign.

This article is general in nature, and it does not contain legal advice. Please contact your accountant to see what applies in your specific situation.

Preface: Counting the costs accurately requires appropriate knowledge and expertise. The ability to ask the right questions are a quintessential value of business advisors, because with that question you often have opportunity to formulate an effective and right answer. Example: Doubling or tripling “fish on the line!” usually begins with a question too. 

Help Wanted (Segment II)

Credit: Jacob Dietz, CPA 

New Employee to Replace Subcontractors

Pay new employee by efficiencies Another situation may arise when a company wants to hire an employee to do work that a subcontractor was doing. In that situation, cost savings may pay for the new employee.

Imagine a remodeling company that specializes in remodeling bathrooms. In the past, they always subcontracted the electrical work. Now, they add an electrician employee team to do that. Even though there may be no increase in sales to pay for the new employee, they may save enough money on subcontracting work to pay for the new employee. An employee will likely have a lower per hour rate than a subcontractor.

There are other costs from an employee, however, in additional to the hourly rate. For example, the employer may be paying employment taxes, tools, uniforms, etc.

In the electrician example, the remodeling company could perhaps get by with less tools when they subcontracted out the work. If they bring the electrical work in-house, then they may need to make some tool purchases. The company can run some calculations on what those additional costs would be per working hour.

Consider Number of Hours to be worked

With a subcontractor, the remodeling company can structure the relationship so that the subcontractor only helps on jobs on which they are specifically contracted. If the remodeling company does not have any jobs currently running on which they need the subcontractor, then they do not pay the subcontractor a dime. Sometimes that can be done with a part-time employee as well, but the employee may want to work at least a minimum number of hours per week.

If that is the case, then the employer may pay him even if he is not doing the type of work that they would want him to do, if that work is not currently available. If that happens frequently, then the remodeling company may want to increase its calculation of what the employee is costing per hour for electrical work. To have the employee available to do wiring, they may need to pay that same employee to sweep the shop floor and sort screws occasionally.

When replacing a subcontractor with an employee, consider how many hours you have available, and how many hours the new employee will want to work.

Preface: Business is booming for John. He works almost all the time. He wants to spend less time working in his business and attend to some responsibilities outside work. What should John do?

Help Wanted

Credit: Jacob M. Dietz, CPA

“Help Wanted.” Many businesses are hiring these days. Should you hire? If you hire, how will you pay the employee? That answer will vary from business to business and situation to situation, but a general understanding of possible pros and cons of employees, and how to pay for them, may help prevent the unpleasant circumstance of having an employee and wishing you did not have one. This article explores some of the reasons to hire, some of the ways to pay the cost of employees, and some of the advantages and disadvantages of hiring.

New Employee to Assist Owner

Pay new employee from current profits First, let’s look at hiring a first employee to assist an owner, and how to pay for him. Imagine John has his own business, a handyman services company. John travels to homes and fixes faucets, installs shelves, replaces showers, and many other services that homeowners like to outsource. John’s business is a single-member LLC, and he does all the work himself without any partners, subcontractors, or employees.

Business is booming for John, and he has more work than he can handle. He works almost all the time. He wants to spend less time working in his business and attend to some responsibilities outside work. What can John do?

One option is to hire his first employee to help him. If John hires a new employee, how will John pay for him? For John to pay the employee, the money needs to come from somewhere.   If John is working significantly more hours than he wants to and is making significantly more income than he needs, then John may be able to keep the same volume of sales and just hire a part-time person to take some of the earnings and some of the hours. For example, if John would like to work 20 fewer hours per week, and has enough excess income to pay a part-timer, then he could hire a part-timer to work some of John’s hours so that John could work 20 fewer hours per week. This arrangement frees John up to focus on his other responsibilities.

It may be hard to find a part-timer who will do quality work for 20 hours per week. Also, some business owners may not have 20 hours of available work and the corresponding profits to hire a new employee. What can a business like that do?

Pay new employee by increasing sales Assume that John only wanted to cut his hours by 5 hours, and that the part-timer he hired wanted to work 25 hours. Based on John’s current earnings, he could only pay the new part-timer for 5 hours per week.

If John has sufficient working capital (short-term assets left over after subtracting short-term liabilities) in his business, and potential customers, then John may be able to hire the new part-timer and add new customers and projects to help pay for him. The new customers may not come in fast enough to immediately pay for the wages of the new employee, but John’s working capital, if it is sufficient, may help him get through those lean times of waiting to increase sales. It can be less stressful if John has sufficient working capital to draw on, and if he is realistic about how fast the new sales will come in. If John has no working capital on which to draw, and if the sales do not come in quickly, then John may find himself in the unpleasant circumstance of struggling to pay his employee and vendors.

End of Segment I

 

Preface: The art and science of the process and set of procedures used to estimate the economic value of a (business) owner’s interest in an enterprise can be likened to an auction for rare collectibles; opinion and values often marginally vary. To achieve a transaction of an enterprise at a set price, two types of contributions must occur 1.) ample enterprise liquidity for business owners, 2.) appealing business opportunity to employ assets for an enterprise investor(s).

Profitability and Business Valuation:  Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value (Segment IV)

Credit: Donald J. Sauder, CPA | CVA

A restrictive buy | sell agreement is another prime example of why a business valuation could merit a reasonable discount for lack of marketability. An investment asset with lower liquidity has a necessary discount to account for the uncertainty and time commitment to successfully transact the organization. This is the driving purpose of marketability discounts. Marketability discount rates can range from ten to fifty percent depending on the marketplace.

In addition to lack of marketability discounts in valuation, minority discounts can to be necessary for adjusting business values if an interest lacks control of the following: set management compensation, make cash distributions, elect or appointment management, set company policy, or make capital expenditure decisions.

The marketability and minority discount features are commonly omitted in non-accredited valuations and therefore result in a skewed appraisal. Valuation discounts require comparisons to market data and the marketplace environment the accurately determine fair and applicable discounts. Accredited appraisers have the required and necessary valuation tools and market analytics to prepare and substantiate fair market business values more accurately.

Valuation analysts should be appreciated for the reasons included expertise required to accurately analyze fair and adequately documented appraisal value, i.e. the valuation report. This encapsulates appropriate capitalization rates, marketability discounts, minority discounts, goodwill premiums, and other factors that are often elusive to the untrained eye.

A bona fide business appraisal includes all documents for an independent analyst to calculate from comprehensive report data, an independent value for the business.  Accredited reports provide clear analyst representations of the business value at the appropriate date of appraisal, including financial statements, analysis, narrative and detail of valuation model and capitalization rates.

The Market Approach to Valuation

Market approaches to valuations apply prior market transactions to determine an enterprise value based upon metrics such as sales multiples or seller’s discretionary earnings multiples. Again, business appraisals should have at least two comparison approaches to triangulate business value accuracy and reasonableness, i.e. market approach and income approach are two common value double checks.

Why is an appraisal a value prophecy? An appraisal is a prophecy to the future value of cash flows of a business to prospective buyers whether that buyer is an internal or external party. Just like stock prices of publicly traded businesses range from day, so do business values for private enterprises. Value range, based on cash flows from operations, risk profile of the investment environment, and characteristics of the business asset.

When an appraisal is necessary for estates, gift taxes, buy | sell transitions and other pertinent business valuation purposes, obtaining an objective, conflict free appraisal requires in-depth expertise and an understanding of specific business industries.

The art and science of the process and set of procedures used to estimate the economic value of a (business) owner’s interest in an enterprise can be likened to an auction for rare collectibles; opinion and values often marginally vary. Yet with appropriate models for financial market participants to determine the price(s) they are willing to pay or receive as a value to achieve a transaction of an enterprise at a set price, contribute to enterprise liquidity for business owners, and a business opportunity to employ assets for enterprise investors.

Preface: Selling a privately held business requires, time, effort, and cost to initially locate a bidder through to finalizing a successful transaction. The liquidity of the investment is a key attribute that reflects the value premium with an applicable discount.

Profitability and Business Valuation: Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value (Segment III)

Credit: Donald J. Sauder, CPA | CVA

What is a Right Rate of Return?

At the heart of all business valuations is a marketplace rate of return on a business “investment”. This is often either a mathematical divisor or a multiplier. If you are investing in a bank certificate of deposit, rates vary from bank to bank. So likewise do dividend rates from business to business, and net earnings also fluctuate. For instance, if you invest in dividend stocks, what is your expected rate of return on the investment? Always, the higher the risk, the higher the rate of investment return on that asset. Managing the entire chess board of investment rates of return, (a.k.a. investment yields) is the Federal Reserve in the United States.

When an assessment of value is generated on a business, immediately generated is a correlating assumption as to how the credit markets will provide liquidity both for investors and consumers in the future. Liquidity and velocity of money are indicators to economic stability.

Correspondingly, in stable economic conditions, business valuations are higher than in recession conditions. This difference includes, among a multitude of factors, the access to credit for buyers, purchasing power of customers, and the effective rate of return on the investment in that higher risk business environment.

Higher investment rates of return result in lower business value, and lower rates of return result in higher business value because of the investment yield on the business assets. Determining the appropriate rate of return on a business is the work of financial market participants. For instance, valuations can sometimes use an addend approach for a capitalization factor, such as a risk-free rate e.g., Treasury bonds, adding on an equity risk premium rate, with a size premium rate addition, and then frost an industry and company risk premium rate for a summed market rate of return on the investment.

Capitalization rates when they are multiples are a certain percentage. For instance, a three-times multiple is essentially a 33% rate or return for the investment, and a four-times multiple is a 25% rate return. The rate is obtained when dividing one with the multiple. So, a 20% capitalization rate is a five-times multiple of cash flows.

Normalized net income, EBITA, or operating cash flows, and tax effective adjustments and extraordinary earnings or expenses are all part of valuation. Yet appropriate capitalization rates on those earnings can lead to many varying opinions among business valuators.

What about Buyer Discounts?

One precisely misunderstood feature of business valuation is necessary and reasonable discounts for lack of marketability and lack of control or minority interests. Simply capitalizing normalized earnings is not the final value of a business. Too often overlooked among entrepreneurs, there are substantial differences between business ownership of a publicly traded business and that of a private enterprise as an investment. Selling a privately held business requires, time, effort, and cost to initially locate a bidder through to finalizing a successful transaction. The liquidity of the investment is a key attribute that reflects the value premium with an applicable discount.

When valuing a business with a potential and ready buyer, it does not change a fair market value of an enterprise. Fair market value is the price at which two bidders would agree to both purchase the business. When you bid on an asset at an auction, the final bid is not fair market value. It is the second to last bid supposedly because you could immediately sell the purchase for that price in the marketplace. Only you bid that final sales price for an auction asset, and therefore, the asset doesn’t hold that value to any other marketplace participants, other than to your final bid. Does the highest bidder always win?

Preface: Goodwill is never a fixed rate calculation with an accredited appraisal. Goodwill calculations are more multidimensional than discussing with college professors how to assess individual student’s relative EQ during a lecture on 10 A.D. history.

Profitability and Business Valuation: Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value

Credit: Donald J. Sauder, CPA | CVA

Factor B is the business’s excess earnings that result in premium valuation from a rate of return on investment from the intangible assets cash flows of management decisions, employee activity, patents, processes, etc. Excess earnings are the net revenues above the ceiling of equity market rates of return on the tangible assets. For example, if a business produces substantial earnings above equity risk premium rate of return on tangible assets the business can appraise for a higher value, because it is a profitable investment grade asset. The key term is investment grade asset.

Economic and industry growth are also added to the goodwill equation with Factor C including the organizations ability to attract new customers and create more products, increase top-line sales volume, and strengthen cash flows. Of note is that recurring revenues  have higher goodwill multiples than transactional revenues, i.e. a bicycle shop has a different economic and industry growth characteristic than a farmer’s market stand, or a car wash.  Therefore the goodwill factors are for these reasons traditionally unique from industry to industry with an expert appraisal value.

Goodwill is never a fixed rate calculation with an accredited appraisal. Goodwill calculations are more multidimensional than discussing with college professors how to assess individual student’s relative EQ during a lecture on 10 A.D. history!

The Type of Goodwill Matters

Let’s look for a moment at the following picture of personal goodwill. Personal goodwill is from relationships developed between customers or suppliers and a business. The value that it adds for appraisal purposes is certainly controversial for many valuation analysts. One such legendary example of personal goodwill valuation is the Martin Ice Cream Co. v. Commissioner.

In Martin Ice Cream Co. v. Commissioner valuation negotiation with the Tax Court, the final ruling was that intangible assets encapsulated in the shareholder’s personal relationships with key suppliers and key customers were not assets of the shareholder’s corporation. Why? Because there was no corresponding employment contract or non-competition agreement between the selling shareholder and the corporate entity.  In this case, the shareholder, Arnold Strassberg, had developed personal relationships with his customers over a duration of approximately twenty plus years.  For the background, in 1974 the founder of Haagen-Dazs asked Mr. Strassberg to assist with his ice cream marketing expertise and relationships with supermarket owners and managers to introduce Haagen-Dazs ice cream products into supermarkets.

The tax court essentially ruled that the goodwill was not a corporate asset because while at the corporation, Mr. Strassberg was instrumental in the design of new ice cream packaging and marketing techniques; there were no legal contracts for his services on behalf of corporate operations.

This tax opinion, can reduce the value of a certain corporate stock appraisal because it is personal goodwill and not corporate goodwill, yet that value is still an asset. This area of tax law is best deferred to experts, because it is a double-edged sword in business appraisals depending on if you’re a buyer or a seller.

Preface: Anyone with a keen interest in history is familiar with the Tulip Mania in Holland. We can learn much from business history looking at enterprises during the Tulip Mania with regards to keeping business valuations in perspective for privately owned businesses today, and further elicit gems for consideration in accurate appraisal values from a proper perspective.

Profitability and Business Valuation: Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value

Credit: Donald J. Sauder, CPA | CVA

Introduction

As a process and set of procedures used to estimate the economic value of a (business) owner’s interest in an enterprise, business valuation is both an art and science. It is governed with models for financial market participants to determine the price(s) they are willing to pay or receive as a value to achieve a transaction of an enterprise at a set price. Yes, those financial market participants can be independent certified appraisers; and opinions are entitled to non-accredited business owners too.

Euphoric business valuations like euphoric investments, are as realistically permanent as the Dutch Tulip Mania. During the Dutch Golden Age the people of Netherlands had money up and down the social class. It was the richest country in Europe from the country’s great success in commerce and global trade. The aristocrats figuratively had money burning holes in their pockets, and so did the middle-class merchants, artisans, and tradesmen. With that extra cash, they had richer door man opportunities  to enjoy both leisure and investments.

At that time in the Netherlands, as has been for millennium, neighbors talked to neighbors, shopkeepers with candlestick makers, and dentists with booksellers. Tulip speculation was one such drawing conversation topic. Anyone with a keen interest in history is familiar with the rest of the story of the Tulip Mania in Holland. The point is that we can learn much from business history in Holland during the Tulip Mania with regards to keeping business valuations in perspective for privately owned businesses today, and further elicit gems for consideration in accurate appraisal values.

Few would counter argue this fact– we are in a business Golden Age. Since the long forgotten 2008 economic malaise, many entrepreneurs in management positions have minimal if any experience guiding an organization during monsoon conditions in the economic climate. Yes, it is the “Good old Days”.

Is the Question a matter of Goodwill?

Often, the most controversial feature of business valuation is goodwill. Many business owners have a realistic assessment of what their business assets are worth as tangibles, e.g., the computers, equipment and machinery you can see, but business goodwill is subjective. As the cherry on top of business value, goodwill is always a subjective value given to the intangible assets of a for-profit enterprise. Further, the true value is only verified with an exact balance at sale of a business interest.

Goodwill has multiple factors in a business appraisal. Let’s first look at Factor A: the going concern value of the goodwill. That is, the probability of the business continuing to produce net income effectively following the transferring of ownership in the capital of tangible assets , employees, and management.

This going concern factor assesses the appraisal value with the business continuing as a successful going concern after the transaction. The greater the probability of the going concern success feature in the business from systems , processes, location(s), name recognition, web reviews, customer loyalty, and transition guidance, the higher this component of goodwill.

Unfortunately, too many businesses have not invested in developing standard operating procedures or developing seamless transition plans years in advance to maximize this Factor. Their businesses are managed will less than optimal efficiency and hence resulting in reduced goodwill appraisals. Yet, the enterprises that have invested appropriately, should expect a premium valuation appraisal. An experienced valuator can assess this rather effectively and efficiently  from accurate cash flows, narrative, and analytical procedures.

End of Segment I

Preface: Did Nathan Jacobson thank his schoolmasters? We may never know. Math is good for school students, but it may be even more important in business success. If you’re an entrepreneur, consider writing a thank you note to your former math teacher today.

Math in the Workplace (Segment III)

Credit: Jacob Dietz, CPA

Price Increase Based on Percentage of Old Price

Now, let’s look at a price increase based on a percentage of the old price, with no change in cost. Last year, John’s cost of sales was 70%, his gross profit margin was 30%, his overhead was 15%, and his net income was 15%. He decided to increase prices because John’s advisor noticed that his income was below the benchmark for his specific industry. John’s advisor said he should be getting a 20% net profit in his industry, and he advised John to raise his prices 5% to increase his net profit from 15% to 20%.

The plan sounds good, but will it work? If John does the math, he will realize that the math does not work. If he raises prices by 5%, then a product that formerly sold for $100 will now sell for $105. That would change his cost of sales from 70% to 66.7% ($70/$105) and his net income from 15% to 19% ($20/$105.)

Why does it work that way? When calculating a net profit percentage, the net profit is divided by sales. Even though he would be making $20 on each sale, it would be $20/$105, which is 19%, not 20%. The increase in sales price therefore makes the additional $5 a smaller percentage of sales.

Price Decrease Based on Percentage of Old Price

Now, let’s assume that instead of raising prices, John decided to decrease prices because he is in a price-sensitive market and his prices are currently a little high. John’s cost of sales was 70% last year, and his gross profit margin was 30%, his overhead was 15%, and his net income was 15%.

John decreased his prices by 5%. Therefore, a $100 item’s price changed to $95, but the cost remained steady at $70 (now 73.7% cost of sales), overhead remained steady at $15 (now 15.8% overhead) and net profit dropped to $10 (10.5% net profit percentage.)

Therefore, the net profit dollars dropped by $5, but the net profit percentage dropped by only 4.5%.

Additional Takeaways from Pricing

If the prices are changing based off the old price, with no change in cost, then John may want to ask himself what he is trying to accomplish. If he is trying to reach a certain percentage, such as 20% net profit, then he may be disappointed if he only raises prices by 5%.

On the other hand, if he is trying to raise his net income from $15 to $20 for the unit that was selling for $100, then a 5% increase in price should do it.

Although the 5% drop in sales only led to an approximately 4.5% drop in net profit percentage, do not be deceived into thinking it was a small effect on net profit. At first, that may look like his profits only dropped by 4.5%. His net profit percentage decreased by 4.5%, but that is only his net income percentage. His actual profit dollars (assuming no change in volume) decreased by roughly 33% ($5/$15).

Why is there such a significant decrease in net profit dollars? If the sales price decreases, with no other changes, then that decrease in price drops straight to the bottom line.  His previous net income was $15, but now it is only $10. In some situations, however, the volume will change which can make up for the loss.

Math is more than a School Subject

If you are involved with pricing in your company, do the calculations when changing prices. Math is good for school students, but it may be even more important with a business. Consider writing a thank you note to your former math teacher.

This article is general in nature, and it does not contain legal advice. Please contact your accountant to see what applies in your specific situation.

 

Preface: The inscribed square problem, also known as the square peg problem or the Toeplitz’ conjecture, is an unsolved question in geometry: Does every plane simple closed curve contain all four vertices of some square?  The problem was proposed by Otto Toeplitz in 1911. As of 2017, the general case remains open.

Math in the Workplace (Segment II)

Credit: Jacob Dietz, CPA

Pricing based on Costs When Costs Decrease

Assume the situation is the same as the above example, except John discovers that his cost of sales decreased by 5%. He decides to recalculate his prices.

He uses $66.50 as the cost, and he calculates a sales price of $95 ($66.50 divided by .7.) His sales price is $95, his cost of sales is $66.5 (70%), his gross profit is $28.5 (30%) and his overhead is $15 (15.8%) and his net profit is $13.5 (14.2%)

What just happened? Because John calculates his sales to earn a 30% gross profit, there was no change in the gross profit percentage, but there was a change in the gross profit dollars. 30% of $95 is $1.50 less than 30% of $100. John decreased both his gross profit and net profit by $1.50, and he dropped his net income percentage to about 14.2%.

Takeaways from Pricing

How can John use his knowledge about the effects on profitability of price changes and cost changes? If John’s costs increase, he may not be happy at first. If he can increase his prices using the same divisor (.7 in John’s case) on the new costs, however, John’s net profit can increase if he keeps selling the same quantity.

On the other hand, let’s assume that John faces fierce competition on price, and he cannot keep the same divisor of .7. In that case, he may be able to maintain the same net profit. For example, assume that his costs went up 5%, from $70 to $73.50. If John kept his normal divisor, he would then divide $73.5 by .7 and sell it for $105.  That would lead to the $16.50 profit instead of the $15 profit. If John could not raise the price $5, however, perhaps he could raise the price by $3.50 to $103.50. That would keep his net profit at $15. The calculation is the $103.50 sales price less $73.50 cost of sales less $15 overhead leaves a $15 profit.

At first glance, John may decide he makes enough profit at the $15 net profit even if he does not face withering competition on price.  He may decide only to raise the price to $103.50 instead of $105 because he will still come out the same at $15.

Or will he come out the same? Even though his net profit would still be the same, his cash position may not be the same. He is making the same net profit as before the cost increase, but his cost of sales jumped. If John carries significant inventory, then that additional cost of sales may hurt his cash balance. Each item that use to cost $70 now costs $3.50 more, or $73.50.

Preface: If you are involved with pricing in your company, do the calculations when changing prices. Math is good for school students, but it may be even more important with a business. 

Math in the Workplace (Segment I)

Credit: Jacob M. Dietz, CPA

Did you ever sit in a math class and ask your teacher “how will this help me in real life when I have a job?” Do you currently wonder how a change in price will affect your net profit or your net profit percentage? The math of a change in price can get complicated. This article explores price changes assuming the same volume of units will be sold. If the number of units sold changes, then it can get even more complicated. Hopefully this article will help demonstrate how math applies to real jobs.

Pricing based on Costs When Costs Increase

For this article, assume John runs a business and sets pricing. When preparing his price list, he realizes that his cost of materials jumped 5% from the year before. His overhead stayed the same. He decides to raise his prices 5% to keep his profits the same. That sounds simple. Is it really that simple?

First, let’s look at how the numbers worked for John’s business last year. Last year, his cost of sales was 70%, his gross profit margin was 30%, his overhead was 15%, and his net income was 15%. For every $100 that John sold, $70 went to cost of sales. Of the remaining $30 gross profit, $15 went to overhead and $15 went to the bank account as net profit.

John calculated his pricing based on costs last year. He took his cost of $70 and divided by .7 to calculate his sales price at $100.

Can John keep his calculations the same, but include the higher direct costs, and get the same profitability? John puts $73.50 into his calculation as the cost of sales (the $70 after the 5% increase.) John divides his cost of $73.50 by .7, and he calculates $105 as the new sales price. His price increased by 5%, which is the same percentage as his cost increased.

“What just happened? By using the same divisor (.7) to calculate his price based on cost when his cost of sales increased, John increased his gross profit, and kept his gross profit percentage the same.”

If John sells the product for $105, with the cost of sales at $73.50, his gross profit per sale is $31.50, or 30%. His net profit is $16.50 ($31.50 gross profit less $15 overhead), or 15.7%.

What just happened? By using the same divisor (.7) to calculate his price based on cost when his cost of sales increased, John increased his gross profit, kept his gross profit percentage the same, and increased both his net profit and net profit percentage.

Because John calculates his sales to earn a 30% gross profit (by dividing by .7) there was no change in the gross profit percentage. Since the sales price increased, however, John’s 30% gross profit percentage is now 30% of $105, not 30% of $100. That additional $5 in sales leads to a $1.50 increase in gross profit, which flows down to the bottom line as a $1.50 increase in net profit.

End of Segment I. To be continued.