Friday, March 17, 2006

How do I understand price structure in business?


Since I do not know the type of business or what is truly behind the question let me start by providing you with information regarding how payroll and equipment effect the pricing structure of goods.

Studies have shown that successful companies have a total payroll expense of 20%-30% of there gross sales. There are those more labor intense markets that occasionally show 35%. There are also those low labor companies that come in at 15%. For the sake of argument we will use 25%. This would mean a company must gross 4 times its total payroll cost in order to turn a profit and thereby be successful.

Payroll cost is made up of a number of factors.
Social Security
Employee portion
Employer portion
Medicare
Employee portion
Employer portion
Federal unemployment
State unemployment
Workers Compensation Insurance
Employees Portion (minimal)
Employers Portion (Substantial Averaging $5/$100 paid)
Local Taxes (Transit, City, County, etc..)

Not to mention Benefits and Insurance packages that may or may not be part of the companies total payroll expense. These could include:
Health Insurance
Dental Insurance
Vision Insurance
Life Insurance
Supplemental Insurance
401k
and other fund function accounts.

On the average for every $.25 paid in straight payroll the company pays out of pocket $.31 (Plus Benefits and Insurances). For example: An employee earns $10/hr worked. The companies true out of pocket payroll for this employee is $12.40/hr (Plus Benefits). That is a 36% increase in cost per employee per man-hour.
As an employee that would mean that you would need to make 5.5 times your payroll every hour for the company to stay afloat. That same $10/hr employee must earn the company $50/hr so the out of pocket payroll percentage would be 24.8% and we still haven't accounted for the benefits.
So when you go down to the local garage and they tell you the rate is $55/hr to work on your car, you know that the average payroll is $11/hr. You can further bet that they don't have all the latest and greatest equipment at this rate or the best help and technicians. Since the average payroll for an auto mechanic in 1998 was $13.16/hr, you probably wont get the top techs unless the labor rate is closer to $66/hr.
As you can see by my example that you now are able to calculate anyone wage and cost to the company based on simple and easy to get data.

We can further extrapolate to equipment. Every piece of equipment in a company must earn the price of replacement in five years. If you pay $100,000 for a piece of equipment it will need to earn a minimum of $20,000 each year plus the operator cost. This falls into a similar category as payroll with 5 times being the minimum requirement for a company to stay in business. If the equipment lasts longer or can still offer comparable production after this point it would be profit. If your maintenance and operator keep this piece of equipment in top shape you do have some room to price adjust and give discounts to top customers and cash payers. Utilizing a second shift increases overall wear but the cost to operate factor is far less and profitability far higher.

Generally speaking a piece of equipment needs to earn its value each year. This would allow enough money to pay overhead, utilities, labor and such that would go into keeping it going. If a $100,000 piece of equipment earned you $100,000 in business each year you would be at break even. In order to turn a profit you would need to exceed its value. Also recognize that in addressing this pricing we may have equipment that can not achieve its value but necessary for your trade. Other more sell-able equipment will need to make up for this. It may be best to think of total value of your equipment and therefore total annual earnings necessary to break even.

I hope this helps you better deal with money management and employee cost considerations as you move into a management position. The bottom line is what makes business. Failure to understand and utilize this as a tool will greatly hamper your effectiveness. Now that you know you are well armed and have increased chances for promotion. You can have bottom line discussions with higher management and better understand your department budget and performance.

I think that this will give you the tools you need to make these types of decisions as well as get a better idea of how your money is working for you in other areas.
I have consulted for businesses for a number of years and this is one area that lacks understanding. I would not be surprised if this is a major wedge that causes many businesses to fail. We want to be fair and competitive. These have costs and need to be recognized. If we as employers as well as our employees clearly understood these principals, the business world would be a far better place.

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