My client has operated a successful business for over 11 years, but has struggled to grow it. She decided to review the pricing structure of her highest volume products to see if her margins were still adequate. It was a relatively simple exercise and raw material costs, while higher, were still low enough to support strong gross margins before conversion costs.
The owner performed most of the work converting raw materials into finished product and so we valued conversion costs at the hourly rate she felt she was due. This wasn’t a problem for most of her products as margins after conversion costs were still strong. But for one of her highest volume products, gross margins after conversion costs was just 43%, well below her targeted level of at least 65%. This product took much more time to make, but was also one of her strongest selling items. And to get targeted margins, she would have to raise the price on the item by more than 15%, an amount that might hurt demand.
The owner was kind of upset thinking how she’d lost so much money selling the product over the past few years and was set on dealing with the problem. She starting thinking out loud, questioning whether she should just raise the price, and hope demand was inelastic, or just stop selling the product and try to replace lost sales with those of a higher margin item.
I suggested we look at it differently. I ask her how much she would have to pay someone to do the tasks involved in the conversion process on that product. She replied in the current environment she could likely pay someone $10/hour. To that, I suggested we use that rate to calculate conversion costs and see whether it makes a difference. And it did. Using an hourly rate of $10/hour lowered conversion costs substantially and increased margins after conversion costs to 63%, just below her desired standard. So with that, I suggested she use the hourly wage rate she’d have to pay an employee in her costs calculations, instead of the rate at which she values her time. Doing this would give her a more accurate estimate of what her true margins are and a better picture of her true competitive position in the marketplace. Using her hourly costs could have led to her discontinuing a product or raising its price, with both actions having an adverse impact on sales.
Of course, her business will only generate those margins if she actually hires the employee. Until then, her active role in the conversion process will reduce her overall return on investment and overall profitability. And, unless she’s careful, she can fall into the “small business owner who could do better flipping burgers” trap. We’ll discuss that later.
