Previous Page Table of Contents Next Page


8 Will your business be profitable, and at what prices?

Main points in Chapter 8
Will your business be profitable, and at what prices?

Having completed research into the market and having considered the availability and cost of all production inputs, including equipment and buildings, you are now ready to carry out some basic calculations and work out what prices to charge.
The chapter considers ...

Before starting a venture it is essential to calculate its profitability

WILL YOU MAKE A PROFIT?

Throughout the previous chapters this guide has stressed that it is not enough just to identify a potential market for your products. You must be sure that you can supply that market in a way that is profitable for your enterprise. Most products can be sold if their price is low enough. However, if the price is too low you will not make money.

By now, your research should have given you a good idea of the prices your products can be sold for in the shops and the prices that the shopkeepers or wholesale distributors are prepared to pay you for them. You should also have a clear indication of the costs of the inputs, including the raw material, utility, equipment and packaging costs. With this information you should now be able to make some profitability or feasibility calculations.

A WORD OF WARNING

When calculating the profitability or feasibility of your planned venture you must include the full cost of everything you need in order to process your products, even if some things, such as processing equipment, are subsidized or even provided free of charge by a donor, an NGO or the government. At some stage you will have to replace that equipment and pay the full commercial price for it. Therefore, you need to know from the beginning whether your activity is likely to be commercially profitable or is only profitable because it is being subsidized.

Feasibility studies can range from the very basic to the very detailed. As the purpose of this guide is mainly to advise on market research techniques we shall not discuss the more complex types of study. The “Further reading” section at the end of the book gives some sources of more detailed information about carrying out such studies. If you are planning to borrow money from a bank to set up your venture you will need to have detailed discussions with the bank to find out what information it requires in order to make a decision on whether to lend you money.[14]

Profitability calculations

In order to calculate profitability (see Figure 5) you should:

Figure 5
Simple profit and loss account calculation

Total annual revenues

$

Estimated revenue from annual sales of fruit juice



6 000 litres in one litre bottles



4 000 litres in 0.333 litre cartons



TOTAL REVENUE


minus transport, delivery and payment collection costs


(a) net revenues

Annual costs

$

Building and equipment costs:



Factory cost ÷ 25



Truck cost ÷ 7



Other equipment costs ÷ 4



TOTAL ANNUAL ASSET COSTS


Start-up costs ÷ 5


Maintenance and servicing costs for factory and equipment


Estimated cost of fruit to produce 10 500 litres of juice


Estimated cost of other ingredients, including wastage


Estimated cost of utilities


Packaging costs:


Labour costs


Interest and loan repayment


Other costs (e.g. licences)


Taxation provision


(b) total annual production costs

Promotional costs including costs of producing free samples


(c) total annual costs

Annual profit

(a) minus (c)

Return to time and capital

Once you have calculated your likely profit, two further calculations are required before you can decide whether it is worthwhile to go ahead with your venture:

1. If you are the owner of the business, then you must calculate the return to your time and that of family members who work without wages. Make a realistic estimate of the number of days you and your family expect to work. Don’t forget to include the time spent buying the raw materials and selling the products and any bookkeeping you have to do, as well as time spent on processing and marketing. Then divide the profit by the number of days. Is this profit per day attractive to you? Could you make more by taking a paid job somewhere? Perhaps the daily rate for a paid job may be less but you could do that throughout the year, whereas your processing business will only keep you occupied for three months. Could you make more by doing a different activity?

2. If you use your own funds to finance the business, is this a wise use of your money? Could you earn more by simply depositing it in the bank? To make this decision you should work out the return to your capital invested. From your calculated profit in Figure 5 subtract the amount of money you could earn from an alternative activity and then calculate the percentage rate of return on your investment, as shown below:


$

Estimated profit for one year’s operations

9 000

Estimated income from paid job

7 000

Additional benefit from processing

2 000

Capital invested $10 000
Percentage return on capital
[(2 000 ÷ 10 000) × 100] = 20%

Don’t forget that there are always risks associated with going into business. In order to compensate you for taking these risks the percentage annual return in the long run should be more than you could earn by putting your money in the bank and the return to your time more than you could get by working elsewhere. In the short run, however, you should be willing to accept lower returns, in expectation that your business will eventually expand and profitability will increase.

CASH FLOW

If it looks like your processing plans will result in a good profit, you are almost ready to proceed. However, you also need to do an analysis of your cash flow. This is to ensure that the cash you plan to put into the business, or that you plan to borrow from the bank, will be enough to meet your needs on a continuing basis. Will you spend all your available cash before you are earning any revenue? Will you be able to pay your bills? Will you be able to buy your ingredients from farmers and other suppliers? If not, you are likely to have problems, even though your earlier calculations have convinced you that the business will be profitable. Poor cash flow is one of the major reasons why companies all over the world run into problems.

Figure 6
Cash flow analysis


Month
1

Month
2

Month
3

Month
4

Month
5

Month
6

Month
7

Month
8

Month
9

Month
10

Month
11

Month
12

Month
13

Month
14

Cash available

10 000

4 000

700

1 100

2 500

2 900

4 300

6 200

10 300

9 700

9 100

8 500

7 900

5 800

Income



4 700

4 700

4 700

4 700

4 700

4 700






















(1) Equipment

4 000














(2) Fruit


2 000

2 000

2 000

2 000

2 000

2 000







2 000

(3) Staff

200

200

200

200

200

200

200

200

200

200

200

200

200

200

(4) Bottles

1 000


1 000


1 000








1 000


(5) Ingredients

500

500

500

500

500

500







500

500

(6) Utilities


300

300

300

300

300

300

100

100

100

100

100

100

300

(7) Loan repayment 300


300

300

300

300

300

300

300

300

300

300

300

300

300

Expenses:

6 000

3 300

4 300

3 300

4 300

3 300

2 800

600

600

600

600

600

2 100

3 300

Cash balance

4 000

700

1 100

2 500

2 900

4 300

6 200

10 300

9 700

9 100

8 500

7 900

5 800

2 500

The simple cash flow analysis in Figure 6 assumes that you have borrowed $10 000 from a bank to put into your business. Repayment starts immediately at $300 a month. It assumes that you use your own building at no cost, but the equipment you need costs $4 000 and you must pay for it before it is delivered and installed. Before you can start processing you will have to buy bottles. The minimum quantity that the bottle company will supply will cost $1 000 and will last you two months. Again, you will have to pay cash. A month’s supply of other ingredients will cost $500. An employee will cost $200 a month and will need to be recruited for training a month before production starts. You will need to pay $2 000 a month for fruit* and your monthly sales revenue is expected to be $4 700. You estimate that you will be able to buy fruit for six months and you will not be able to store it for more than a few days so you will only be processing for six months.

* For the sake of simplification we assume in this example that the price of fruit will remain unchanged. This is unlikely to be the case, however.

In doing a cash flow analysis you need to work out:

You must pay attention to your cash flow. Otherwise, you could run out of money to buy raw materials.

A WORD OF WARNING

Although it is important to ensure you do not have cash-flow problems and do not run out of money, you should, at the same time, be careful not to borrow more money than you really need. If too much is borrowed there is a risk of losing all the profit to repay the loan. Consider increasing your contribution as the owner. For larger ventures, consider finding a partner who can put money into the business. Alternatively, consider whether you and your family could increase your inputs in order to reduce costs of employing labour, so lowering your finance requirements.

As the owner of the business you may want to take out some of the profits; be careful that you do not take out so much that you run short of cash for the next processing season!

The cash flow analysis shown in Figure 6 indicates that although you have $10 000 available and are only spending $4 000 of this on equipment, you will come dangerously close to running out of money at the end of the second month. If there are any delays in receiving payment from the shops you supply or if the price you get from selling your product is not as much as you expected, you may not have cash to buy enough fruit from farmers. In turn, you will not be able to make enough processed product, your revenue from sales will go down and you will have to close your new business. In this example, therefore, it would be wise to increase slightly the amount of cash you have available. To get a clearer position of your cash flow at the beginning of operations you could do the projections on a weekly rather than monthly basis

When you are processing fresh produce, you can only do this for as long as you can buy and store that produce. For the rest of the year you will not earn revenue but you will continue to have some costs. You need to have cash available to meet these costs and to prepare for processing in the following year.

Fixed and variable costs

Some of your costs are fixed. This means that you have to pay them whether you are processing or not. These costs include rent, loan repayments and interest, permanent staff costs (as opposed to temporary employees hired only when you are processing) and fixed utility charges.[15] All other costs are considered variable costs. This means that they change according to how much you produce, how much you pay for your ingredients, the cost of utilities, etc.

As you have to pay the fixed costs no matter how much or how little you produce and sell, you need to be sure that you will sell enough processed product to cover those costs. Consider the following ...


$

Revenue from annual sale


of 5 000 litres of fruit juice

3 000

Variable costs

2 000

Gross profit

1 000

... this looks like a profitable venture: you are making 50 percent profit on every litre of juice sold.

However, when fixed costs are taken into account the picture can look very different ...


$

Revenue from annual sale


of 5 000 litres of fruit juice

3 000

Variable costs

2 000

Gross Profit

1 000

Fixed costs

1 200

LOSS

200

... from this it is clear that while you are covering your variable costs very well, you are not producing enough to cover your fixed costs.

If you can double your production and sell the juice at the same price the picture changes ...


$

Revenue from annual sale


of 10 000 litres of fruit juice

6 000

Variable costs

4 000

Gross Profit

2 000

Fixed costs

1 200

NET PROFIT

800

Now you should work out the break-even point for your venture. This is the quantity you need to produce and sell in order to cover your fixed costs. This is calculated as follows ...

Fixed Costs ÷ Gross Profit per unit of sale

In our example this is ...

$1 200 ÷ $0.20 (i.e. $2000÷10000) or 6 000 litres

This is the break-even level of production and sales. More than 6 000 litres will give you a profit, less than 6 000 litres and you will make a loss. If you can easily expand production and sales above 6 000 litres then you are likely to run a profitable business. If increasing production much higher than 6 000 litres is likely to cause problems you should reconsider your plans.

The break-even point can also be stated as a percentage. Taking into account the fact that raw materials may only be available for a few months every year, how much could you process and sell in a year? If the maximum you could produce is 20 000 litres, then the break-even percentage is 6 000 ÷ 20 000 or 30 percent. The lower this percentage the greater the scope you have for increasing production and making your business more profitable.

SETTING THE PRICE

The different ways of setting prices include:

Market-based pricing

This sets prices at the level already found in the market and, of course, can only be used when there are similar products already on sale. You need to look at the competing products with regard to their price and quality. What do your tasting tests tell you about the quality of your product and how it compares with others already available? Using market-based pricing you should aim to set the price of your product at no more, and probably less, than brands of similar quality. Where you are competing with well-established brands marketed by large companies with a big advertising revenue, you almost certainly have to set your prices at a lower level than those brands even if tasting tests indicate that consumers prefer your brand. You should certainly not be charging the same price as brands that you believe are of higher quality because consumers will definitely continue to buy those brands.

Competitive pricing

Competitive pricing involves setting prices at a lower level than those of your direct competitors. This will, you hope, lead to increased sales. Any price difference must, of course, be large enough to influence consumers’ buying decisions as just a small price difference may have no impact on your sales. You need to discuss this with retailers and get their ideas regarding prices that will attract people to buy your product. When you have decided on a competitive price you then need to estimate what impact this will have on your total sales and repeat your profitability calculations using the new figures.

For example, using the fruit juice example on pages 100 and 101, assume that you reduce the price from $0.60 a litre to $0.55 a litre and that your sales rise from 10 000 litres to 12 000 litres ...


$

Revenue from annual sale


of 12 000 litres ($0.55 × 12 000)

6 600

Variable costs [$4 000 × (12 000 ÷ 10 000)]

4 800

Gross Profit

1 800

Fixed costs

1 200

NET PROFIT

600

In this example you have increased your sales by 20 percent, but the lower price means you are worse off. You would have to increase your sales to almost 13 500 litres before you benefit from the price cut. This illustrates the value of doing a sensitivity analysis (see below) and the need to be careful before trying to compete on price. You also need to consider that lowering the price too much may not necessarily make your product more attractive to consumers. People often associate low prices with low quality and if quality is more important to them than price they will not purchase a low-priced product.

Introductory pricing

This is short-term, competitive pricing for the purposes of introducing your product onto the market. It is very difficult for new products to be accepted by consumers who are already used to, and enjoy, existing brands. If you pursue a policy of introductory pricing, you may lose or make very little money in the short term, but in the long run this should increase customers’ familiarity with your products and eventually increase your sales and your profits.

The next calculation uses the first fruit juice example, with the following assumptions:

Then ...


Jan-Mar

Apr-Dec

Total


$

$

$

Revenue from sale




of fruit juice

2 500

7 200

9 700

Variable costs

2 000

4 800

6 800

Gross Profit

500

2 400

2 900

Fixed costs

300

900

1 200

NET PROFIT

200

1 500

1 700

Prices for different sizes

If you sell juice in one-litre bottles and half-litre bottles, you should not sell the larger bottles for twice the price of the smaller bottles. The larger the container the lower the price per litre (or kg) of contents is the general rule. The smaller container almost certainly costs more than one-half the cost of the larger bottles. Also, the cost per litre of filling the smaller bottles, putting them in boxes and distributing them is much higher than for larger bottles. You will need to work out these costs.

Geographical pricing

You need to consider whether your product should be sold for the same price everywhere or whether you could vary the price. One reason for varying the price could be the high transport costs you may incur in getting to remote areas. However, another reason could be that consumers are more affluent in some areas than others and you may thus be able to charge a slightly higher price.

Cost-plus pricing

This pricing technique starts with the calculation of your variable production costs per unit. To this should be added an amount necessary to cover fixed costs at the production level you expect as well as an amount to cover the profit that you want to make. While cost-plus pricing can perhaps be used for a new product that is not presently available in your area, it is not of much value when there are competing products. If you set a price that is too high people will not buy your product.

UNDERSTANDING THE RISKS

All business ventures involve risks. A wise entrepreneur cannot completely avoid such risks but he or she can develop an understanding of what they are. The best way to do this is to carry out a sensitivity analysis, which tests how sensitive your profits are to price and cost changes.

A sensitivity analysis is done by making different assumptions to those you used in your basic profitability and cash flow calculations. It is best to recalculate on the basis of a set of “what if?” questions, such as:

All of the above are very possible occurrences. There are further, less likely, risks, but these are also worth considering, particularly in relation to your cash flow.

Examples include:

REACHING CONCLUSIONS

The issues discussed in this chapter should enable you to:

You should then be in a position to reach some conclusions, such as:

You should now be in a position to make a final decision about whether or not to go ahead with your plans.

Good luck!


[14] Pages 93-95 of the FAO publication “Guidelines for small-scale fruit and vegetable processors” (see “Further reading”) outline the points that need to be covered in a Business Plan.
[15] Most utility providers charge a nominal monthly fee whether or not you actually use any water, electricity, etc.

Previous Page Top of Page Next Page