Running a Small Business

Lesson 1: Setting Prices

Overhead

Overhead is a dirty word. That's because it increases the cost to your customer without actually giving him anything specific of value. In many large companies, it is also very vague and poorly defined. Most people who have worked in management for large companies have received memos instructing them to, "... reduce overhead by 30% ...". Typically the manager re-assigns George, down at the end of the department, to Research and Development, reduces hours budgeted for training by half and transfers the costs of two part-timers to a project. Nothing has actually changed (nobody ever goes on training anyway) and overhead is way down.

If you've properly and consistently assigned all variable costs to production, there shouldn't be all that much left in overhead. Typical unavoidable costs here are office expenses including paper etc., car expenses, telephone, Internet, office equipment like computers and licensing and permit fees. All these will stay at exactly the same level whether you get any orders or not. Note that if an order involves substantial additional costs in one of these areas, like long distance telephone costs for example, those costs should be tracked and assigned to the order if they're at all substantial.

There are three other major overhead items which have to be looked at separately. The first is administration and management. If you've just started your business, you're probably doing a lot or all of this yourself. It is very important to track these hours, assign an hourly rate to them and assign the cost to overhead. That's because this work is not productive in the sense that it generates direct income.

You started this business to do something you enjoy doing and do well. For most people administration is not it. If you track these hours and assign a normal hourly rate to them, a rate that you would have to pay to get someone to do this work and probably less than you are charging for your main activity, then you are tracking this as a cost. This means that, once you have enough business to work 100% on your main activity, you can hire someone to do this work without affecting your overhead or cost structure. If you don't track your costs in this way, you'll have a hard time hiring the administrator you need because it will put your costs way up. At the same time you'll be stuck doing low-value admin work when you could be earning more with your principal activity. Try doing a couple budgets to see how this works if you need to.

The second item is the rental and associated costs of your place of business. If you're renting an office and paying insurance, heat, electricity etc. then these costs are clear. If you're working from a home office, then they're not. To get at the true overhead costs of your business you should evaluate these home office costs and add them to your overhead. They would include rent you pay to yourself, part of your heating, electricity and insurance and part of your home maintenance. Although you're paying this to yourself, the exercise clarifies the true costs of running your business

The third overhead cost that has to be looked at separately is promotion and advertising. This has to be a separate item because this cost has to result in performance and has to be tracked separately. Run an extra ad somewhere and track the extra costs - have your sales gone up? Drop a promotion item and its costs - have sales decreased? If not why were you running it? This item can easily get out of hand and that's why I always suggest tracking it separately and monitoring performance.

Now you're ready to add up your overhead and apply it to your business. You may be surprised at how high it is and we'll look at strategies to deal with high overhead later in the course. What you have achieved is to add up the true cost of running your business and what you can now get, by adding in your cost of production, is the true cost of what you're selling. That's the starting point for setting your prices.

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