Bio
I’m Monty Dimkpa, Director
at MDS – www.montydimkpa.com – a company that provides professional &
affordable copywriting services, free
business advice for small
businesses and sales/development of small business
software. Follow me on Twitter: @MontyDimkpa
Get more tutorials on production
economics, small business dynamics, project costing, product costing, budgeting
and more at www.montydimkpa.com/learning
Now, back to the
tutorial:
1. Something gained, something lost
PROFIT = TOTAL SALES – (TOTAL PRODUCTION COSTS + TOTAL
NON-PRODUCTION COSTS) Equation 1.1
Before you can sell something, you have to make
something – your product. Your
product is created at a cost. This must figure into your profit equation
and won’t show up on accounting programs or spreadsheets.
Now, let’s break it
up.
2. Total production costs
Production costs
relate directly to the production of
your good/product. They are: material
costs & plant costs.
Material costs relate to the total cost
of materials required to make a unit product, while plant costs include
your labor costs and machine costs.
TOTAL PRODUCTION COST (TPC)
=
MATERIAL COST (MC) + PLANT COST (PC)
Equation 1.2
3. Material Costs
How much does it cost
to make a unit of your product?
You’ll need 2 variables: material cost
per unit quantity (MCQ) and material
quantity per unit product (MCP).
MATERIAL COST (MC)
=
∑ (Material Cost Per Unit Quantity (MCQ) x Material
Quantity per Unit Product (MCP)) Equation
1.3
MCQ = something like
$2.50 per lb of material, or 86c per liter of material.
MCP = something like
1 lb or 2.5 liters.
4. More on Material Cost
As you may have
noticed, material cost is a cumulative
function. This is because several
materials typically go into making a unit product. Here’s what I mean:
Let’s say we want to
make lemonade – we need lemons, ice
cubes, and sugar. That’s 3 materials
and 3 separate material costs which we
must add together to get our total
material cost (MC). Good luck getting an accounting program to do that for
you!
5. Plant Costs
What is a plant? No, a plant is not that herb
growing in your backyard. In production
economics, a plant consists of labor and machines used to create a good/product. So to arrive at your total
plant cost, you must know your labor
cost and your machine costs.
PLANT COST (PC) = LABOR COST
(LC) + MACHINE
COSTS (MCs) Equation
1.4
6. Estimating Labor Cost
Labor cost
is simply how much it costs you in terms
of paid wages, to produce a unit good/product.
LABOR COST (LC) = Wage Rate
(WR) x Staff
Strength (N) Equation 1.5
In some cases, different groups of staff are paid a different wage rate. In situations like
this, the total labor cost (LC) becomes a cumulative
function.
LABOR COST (LC) = ∑ (Wage
Rate (WR) x Staff
Strength (N)) Equation 1.6
Again, no accounting
program or quick profit calculating spreadsheet will detail your production
economics like this. You need a targeted business solution.
7. Estimating Machine Costs
Machine costs include
machine operation costs (in terms of
power/fuel requirements), machine rental
costs and machine maintenance costs
(if they apply). Symbolically:
MACHINE COST (MC) = MACHINE
OPERATION COST (MOC) + MACHINE RENTAL COST (MRC)
+ MACHINE MAINTENANCE COST (MMC) Equation
1.7
Unlike other costs, machine costs are best expressed as
functions of time. They are time-dependent.
So we speak of rates – machine operating rate (Rmo), machine rental rate (Rmr) and machine maintenance rate (Rmm). All rates are expressed as $ per hour.
The equation for
machine costs then becomes:
MACHINE COST (MC) = PRODUCTION TIME
(T) x (machine operating
rate (Rmo) + machine rental rate (Rmr) + machine maintenance rate (Rmm)) Equation
1.8
Production Time (T) is the time it takes to produce a unit of your
good/product.
8. Taxation and your Business: the Tax Factor
Depending on what country you do your business in,
taxation can be a very serious issue. Sometimes you are required to pay a per-head tax on each item you produce,
other times you can be required to contribute
a portion of your sales income as tax.
You must account for taxation when
calculating your business profit. However, tax is not always incurred.
Sometimes businesses may choose to “shake off” the effect of taxation by artificially increasing prices to
retain their normal profit level after taxation. This is called transferred tax or positive tax.
PR. After Tax (ph) = P x CP x [(1 ± tax %) x (1 + markup
%) – 1] – TNPC
PR. After Tax (s) = (1 ± tax %) x [P X CP x [(1 + markup
%) - 1] – TNPC]
CP = cost
price, P = throughput, TNPC = Tot. non prod. Cost Equations
1.9a, 1.9b
Throughput, P, should
be as close to the true demand as possible, but not greater.
9. Sales, Selling Price & Cost Price (or Unit Cost
of Production)
The cost price
variable is central to your profit and is denoted by CP. It is simply equal to the sum
of your production costs per unit product:
COST PRICE (CP) =
MC + LC + MCs Equation
2.0
SELLING PRICE (SP) =
(1 + markup
%) x (MC + LC
+ MCs) Equation 2.1
SALES (S) = THROUGHPUT
(P) x SELLING PRICE (SP) Equation 2.2
Given a
production-determined cost price, a selling price for a product is arrived at by applying a markup. Too
much liberty should not be taken, however, in applying markup as this increases shelf price to a point where the
product sales and profit suffer. Markup values of 35% - 45% are typical.
10. Total Non Production Costs
These are the final
costs you consider before selling your product. They are mostly one-time costs that are not incurred during production. Good
examples are transport cost to
distributors, additional packaging
costs, and promotional costs.
WARNING:
Always keep these costs under control as they counteract profits (serve as a
counter-profit).
11. The Profit Equation: The TRUE Estimate of Your Business Profit
Many accounting programs or spreadsheet packages for business profit simply do not have the capacity to interpret
profits in the way this guide has explored: we have taken a ground-up approach,
and arrived at an equation that covers all the bases and ‘leaves no stone unturned’.
Basic accounting programs
take a plus and minus approach – but
don’t go in depth to calculate iterative components or show you how to.
They just ask you to fill out a form then they do a simple plus-and-minus operation
and give you a balance statement – this
is not true profit! Beware!
The following equations
are adaptable to the unique production economics
of your business, and give you the TRUE estimate of your profits.
11a. Business Algorithm for Profit after Tax (per head tax method)
Profit after Tax
(per
head) = Throughput x [(1 ± tax %) x (1 + markup
%) – 1] x [∑ (Material Cost Per
Unit Quantity (MCQ) x Material Quantity per Unit Product (MCP)) + ∑ (Wage
Rate (WR) x Staff
Strength (N)) + [PRODUCTION
TIME (T) x (machine operating rate (Rmo) + machine rental rate (Rmr) + machine maintenance rate (Rmm))] ] – TNPC
11b. Business Algorithm for Profit after Tax (sales income tax method)
Profit after Tax (per sales income)
= (1 ± tax %) x [Throughput X [∑ (Material Cost Per Unit Quantity (MCQ) x Material
Quantity per Unit Product (MCP)) + ∑ (Wage Rate (WR)
x Staff Strength (N))
+ [PRODUCTION
TIME (T) x (machine operating rate (Rmo) + machine rental rate (Rmr) + machine maintenance rate (Rmm))]] x [(1 + markup %) - 1] – TNPC]
Too much for you to calculate
by hand?
Fortunately, we have a FREE software
solution for you.
Our Optimize
1.5 Business Profit Simulator uses the algorithms described above
to accurately and correctly estimate business profits based on solid production
economics.
Get it from our website – www.montydimkpa.com/business+software
or DOWNLOAD Direct from RapidShare - http://rapidshare.com/files/2994621377/optimize_1_5_stable_final_public_demo.rar
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