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:
have calculated the exact quantities of ingredients required to make your product. For example, if you are making pineapple juice, what quantities of pineapples, sugar and other ingredients are required to make a kilogram of juice? Make allowances for wastage. Some of the agricultural products you buy will not be suitable for processing. When you peel fruit prior to processing, this can remove much of the weight. You may need to buy 100 kg in order to get 80 kg of processable fruit;
recognise that some of the processed product will not reach the consumer. It may, for example, get spilled during bottling. In Figure 5 it is assumed that you will need to produce 10500 litres of fruit juice in order to sell 10000 litres;
have an approximate idea of the cost of utilities (gas, electricity, water) used for your processing;
estimate not only the price paid for ingredients but also the cost of buying them, for example costs of visits to farms;
give a cost to all ingredients even if you grow some on your own land (the cost should be the price you could get if you sold those ingredients fresh). Otherwise you could end up processing produce that it could be more profitable to sell in the local market or to other processors;
take into account the different packaging sizes you will be offering and the fact that revenue and costs will vary according to the size;
take into account miscellaneous costs, such as licences. Disposal of waste material (e.g. fruit peelings) can also be a significant cost;
build into your calculations the costs of factory buildings and equipment. The easiest way to treat these is simply to divide the cost of the investment by the number of years you expect it to last. (This should be part of your research - see Chapter 7). Thus you may divide the cost of a building by 25, the cost of a delivery vehicle by seven or the cost of a simple food mixer by three. Also, dont forget that buildings and equipment have servicing, maintenance and insurance costs and these need to be included in your calculations. As you will have probably borrowed money you should not forget to include interest and loan repayments;
calculate your staffing requirements and the cost of that staff;
take into account any significant start-up costs, such as technical consultancy services or market research costs. These are unlikely to be repeated every year so it would bias your feasibility calculations to charge these as annual costs for the first year. Consider apportioning such start-up costs over three to five years.
Figure 5
Simple profit and loss account
calculation
Total annual revenues |
$ |
||
Estimated revenue from annual sales of fruit juice |
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||
|
6 000 litres in one litre bottles |
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4 000 litres in 0.333 litre cartons |
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TOTAL REVENUE |
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minus transport, delivery and payment collection costs |
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(a) net revenues |
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Annual costs |
$ |
||
Building and equipment costs: |
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||
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Factory cost ÷ 25 |
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Truck cost ÷ 7 |
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Other equipment costs ÷ 4 |
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TOTAL ANNUAL ASSET COSTS |
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Start-up costs ÷ 5 |
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Maintenance and servicing costs for factory and equipment |
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Estimated cost of fruit to produce 10 500 litres of juice |
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Estimated cost of other ingredients, including wastage |
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Estimated cost of utilities |
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Packaging costs: |
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Labour costs |
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Interest and loan repayment |
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Other costs (e.g. licences) |
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Taxation provision |
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(b) total annual production costs |
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Promotional costs including costs of producing free samples |
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(c) total annual costs |
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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. Dont 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 years 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%
Dont 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 |
Month |
Month |
Month |
Month |
Month |
Month |
Month |
Month |
Month |
Month |
Month |
Month |
Month |
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 |
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|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(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 months 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:
when you have to spend money for equipment, raw materials, rent, etc;
when you have to pay your employees;
when you are able to begin processing, when you can make your first deliveries, and when you can expect to be paid. At the time you carried out your market research, you should have discussed payment terms with potential buyers (see Chapter 5).
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:
what if my competitors reduce their prices and I have to sell at prices 10 percent lower than I planned?
what if the price I have to pay for labour goes up by 10 percent?
what if the raw material prices are 20 percent more than I expected, and I can only buy 80 percent of what I planned?
what if sales are 30 percent less than I expect?
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:
what if factory construction is not finished in time for the fruit production season and I have to delay processing for a year?
what if there is a strike at the bottle factory and I run out of bottles? How will this affect my cash flow?
REACHING CONCLUSIONS
The issues discussed in this chapter should enable you to:
calculate the likely profitability of your proposed agroprocessing venture, on an annual basis;
review your financing requirements, to ensure you have adequate cash available to keep the business running (i.e. cash flow);
work out the return to your time and capital;
work out how much you need to process, in order to cover your fixed costs;
decide on the best approach or approaches to price setting;
consider the risks associated with your plans, by carrying out a sensitivity analysis.
You should then be in a position to reach some conclusions, such as:
my fruit juice business is likely to be profitable. However, there are a lot of risks that could jeopardise that profitability and I need to consider these carefully;
everyone likes my jam and retailers are happy to sell it. I am sure that my business will be profitable. However, I may run into cash flow problems because I have to pay for the fruit, the jars, other inputs and the label design and printing a long time before I will be paid for the jam. Perhaps I need to make arrangements with my bank in case I need a loan in a hurry;
my forecast of yoghurt sales is too close to my break-even point. I can easily produce more but I need to work out ways of increasing my sales first.
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. |