Guaranteed Profits for Screen Printing or Embroidery - Part 2

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Part 2 - Making Cents of it All: How Manufacturers Arrive at the Prices They Charge

The whole idea behind the costing process is to arrive at an annual profit figure that the company can be happy with. They try to look at the big picture. Instead of looking at the cost of building a car, they look at the cost of building all the cars of a particular model for the year. It's difficult to determine how much of the annual cost of executive salaries or insurance should be allocated to each car, but it's easy to determine what the total cost of these items will be for the year! And it's hard to determine how productive an employee will be on a given day, but the company has records that show how productive the employees are for an average year. Looking at the big picture not only makes costing easier, but it also makes it more accurate.

Nearly all manufacturing pricing theories are derived from a centuries-old practice called "Standard Cost Accounting." Let's say that you run a factory that produces rubber ducks. In looking at your last year's income statement, you discover that it cost you $100,000 to run your factory last year. That number included the costs of plastic, (they're not really rubber, you know) labor, utilities, insurance - everything. You anticipate that number to be similar this year. You also know that your factory produces 100,000 units per year - you have the production records to prove it.

When we talked about the objectives of a pricing system, we talked about forecastability. I told you that manufacturers could forecast profits in their pricing system. Let's do that now. Let's say that you've decided you want to make $60,000 this year running your rubber duck factory. The math is very straight-forward.

The math works in both directions. You can work forward to develop a price, or you can prove that price by working backwards, like this:

It's a very simple idea, and it is relatively reliable. There are only a few minor stumbling blocks that you need to overcome with some elementary analysis. For example, you need to sell all the ducks to make this work. Any shortfall will come out of your profits. Also, any variance between budgeted costs and actual costs will deduct from profits as well, but risk and uncertainty are a part of any business. That gives you something to manage over the year.

Standard Cost Accounting is a fast, easy way for manufacturers to create a guideline price for products that accounts for even the most remote costs associated with making a product. It helps ensure that adequate, forecastable profits will be made as well. Incidentally, the larger the period of time we use, the greater it's accuracy. That's why I prefer to use a year as my timeframe as opposed to individual months. Unfortunately, this industry and many others are saddled with one big problem in using standard cost accounting: We don't make the same product every day. Fortunately, a derivation from a concept called throughput accounting (an offspring of standard cost accounting) handles the job beautifully.

Adapting Standard Cost Accounting to the Garment Decoration Industry

The whole idea behind standard cost accounting is to define all costs of the manufacturing process over a large period of time, and assign a meaningful portion of that figure to the individual unit produced. "Unit" is the key word in that sentence. Even though one traditionally thinks of a unit as a single production piece - such as one rubber duck - a "unit" can be defined in many other ways. A "unit" can be any quantifiable sample of the total production that represents a homogeneous or uniform portion of the whole being measured. For example, if our rubber duck production numbers had been expressed in dozens of ducks produced instead of individual ducks, we would still have a valid unit, our final price would have been $19.20 per dozen - which is still $1.60 per duck.

For use in our industry, we just need to find a production unit that remains similar from order to order for our needs. Nearly thirty years ago, I chose "hours of production" as the unit for costing screen printing and embroidery in my shop. This meant that I was able to establish a dollar-per-hour rate and use it for pricing the orders my shop produced. I did this because every order requires time to be produced, and most expenses are incurred over time. Labor is paid per hour, insurance is paid per year, even thread flows through an embroidery machine at a similar rate per hour of sewing. There might be other acceptable units of production for some shops, but this is the best one I've found, and I've discovered that most experts who derived prices for other service and finishing industries have used time as their unit of measure as well.

So let's make a very slight change to our rubber duck factory example, and express our costing in the new unit - hours of production. Let's suppose that this factory works one thousand hours over the course of a year, producing one hundred ducks per hour. Doing the math, that still equals one-hundred thousand ducks per year, but we'll express it like this:

Before we can adapt this to our industry, we also need to accommodate the fact that the type of garment we embellish will change with every order. In the rubber duck factory, roughly the same amount of plastic went into every duck, so the cost of the raw material (plastic) remained relatively constant. But in our industry, different garments have different costs. You might have a garment that costs a dollar, or you could be decorating a fifty-dollar jacket. If we want to determine a selling price for an hour of production in a screen printing or embroidery shop, we will need to omit the cost of our blank garments from the computation of our annual costs, then add the cost of the garment to the final selling price at the end. Of course, a one-dollar Tee shirt does not cost you a dollar. You will definitely need to accommodate shipping costs, and you might need to address warehousing costs, costs of keeping inventory, etc. With just shipping accounted for, a one-dollar T-shirt probably costs you at least $1.15 to $1.20. Whatever the blank garment really costs must be passed on in the price of the order.

Figuring Your Costs per Year

If you have been in business for any length of time, you certainly have one or more income statements from your accountant or accounting software. (also called a profit/loss statement) Even if you have only been in business for a month, you can still generate one of these for the period. Of course, the larger the period the statement covers - up to one year - the more accurately it will tend to portray your real fiscal history. Your income statement cannot provide actual numbers for your costing exercise. Instead it acts as your "crystal ball" for forecasting what your expenses will look like for the coming year.

Using your income statement as your guide, you want to create a worksheet for costing your shop's production. A traditional income statement is divided into sections. The top section usually contains the sales and cost of goods sold information, resulting in gross profit. The lower section contains the expenses that took away from gross profit. That is the section we want to concern ourselves with. For every expense that shows up on your income statement, you want to create a row on your costing worksheet representing the same expense. You will likely have expenses for rent, insurance, office supplies, printing or embroidery supplies, and if you have employees - labor will show up too. The only expenditures that should not show up on your costing worksheet are garment costs and the cost of inbound shipping for the same. (those should have been listed in the "Cost of Goods Sold" section)

Rent is an easy expense to estimate. You probably have a lease that states the amount you will pay this year, so you can compute the annual figure for the coming year and place it on your worksheet. Insurance is easy too. Your agent gave you an annual quote. Other costs are not quite as easy, but your income statement provides a guide for each one. Let's look at labor as an example. Let's suppose you paid $20,000 for one part-time employee last year. Do you intend to keep that part-time helper this year? Based upon your sales growth, might you need to add another person? You want to look at each expense on your income statement, ask yourself what factors affect that cost, and consider how those factors might play out to arrive at an estimate - and "budget" figure - for the coming year. While you are at it, now is a great time to examine each expense, and try to figure out if you are really comfortable with that figure. You can formulate plans for cutting unnecessary expenses too. Can you change insurance providers and pay less? Could you negotiate a better rent or telephone rate? Even though it won't show up in your costing, consider whether you could negotiate better prices with your garment suppliers too. Every discount helps you charge a fair price for your services and make more money.

Once you have accounted for every expense category on your income statement, it is time to create one more expense to be considered in costing: Profit. I often think of profit as an "expense" of the business that is due and payable to you as the provider of your business investment. Just like any other expense, if it does not get paid, the business will fail. As you forecast your profit, what amount would you deem appropriate? If you own a one-person shop, and decide to enter a million dollars - our final formula will compute prices that will earn that amount. Unfortunately, the odds are that you won't be able to sell the goods at those prices. On the other hand, many people fail to demand a profit that they can be happy with. You probably have a mortgage, growing kids who need shoes now and will need an education later, and plans for an eventual retirement. If your business is your career, then profits will need to cover all those things, plus the substantial taxes you will need to pay on your earnings.

Compiling all the expenses of your business isn't rocket science. Even though it might have seemed like a daunting task before you read how to do it, you hopefully feel confident that you can perform this task adequately and correctly now. You just needed somebody to show you that you had the "tools" to do the job. Congratulations! - no part of correctly pricing your product requires any more complicated math skills than those we've just used. With your expenses tallied up, you're ready to create an hourly rate for work performed in your shop.

Before we do that, take a moment to relax and think about everything you've jsut read. If you move too fast on all of this, your head will surely explode. Perhaps you'd like to get a cup of coffee first, but you're heading into the final stretch of understanding a correct process for pricing your product. When you are ready, click th elink below to go to:

Guaranteed Profits for Screen Printing or Embroidery - Part 3