The absolute measure of what something is worth is whatever someone is willing to pay for it. The lower the price of anything, the more people you’ll find willing to buy it. It makes sense then that pro forma costing needs to start with the market price. The price that customers are willing to pay.
There’s a hunter gatherer mentality that prevents people from putting sales first.
For any business to be successful, it has to make a certain profit margin per item sold, and it also has to sell a certain volume of those items. Every unit sold has to pay for it’s own cost of goods and contribute to the overhead costs of running the business.
Here are a couple of tables showing the right way and the wrong way to approach costing:
The Right Way To Cost
When you read the market, the sale price can’t really change much. If the numbers don’t work to produce a profit then you have to find a way to squeeze the fixed and the variable costs.
You might have to find a cheaper supplier to buy from. You might have to lease a smaller building than you were planning on. The key thing to remember is that there are very, very, (one more time) very few products that have the ability to defy what the market says they’re worth. The ones that do utilize a large portion of what seems like profit to market the product and build branding.
Why The Wrong Way Is Wrong
Inexperienced business people often start with their variable costs. They add in the fixed costs. Determine the amount of profit they’d like to make. And then they come up with a sales price.
And then nobody buys because the price is too high.
At this point, since they’re on a roll, they decide to make the next mistake. Having already gone forward and built an infrastructure with high overhead, AND committed to variable costs from suppliers that are badly negotiated and too high, they lower the sale price.
The profit erodes and the first thing to get cut is the marketing budget. Which doesn’t help sales. Sometimes when a company gets into this position, every unit they sell is more money lost. It’s a downward spiral.
How And When To Cost The Right Way
When you’re constructing a business plan, that’s the time to look at all this. After you jump in, you have a lot less control over lowering your fixed overhead costs. Costing to work with the market is one reason why it’s essential to stay true to the numbers when you’re constructing a business plan. Numbers don’t lie, unless you put rose colored glasses on.
This is also the reason that smart businesses put sales before purchasing in the grand scheme of doing business. Failing to read the market and missing the target results in lack of sales and bad purchasing; the number one and number two reasons why businesses fail.