Wednesday, October 10, 2012

Business Math 101

How about a quick lesson in business economics?

First; you have a business, selling the always popular widgets.

In order to make your widget you need 3 things: A place, materials and labor.

The place is first a capital cost, like your house. You have to either pay cash and tie up a lot of capital (Money); purchase with a loan and make a monthly payment, or rent. A mortgage or rent is a monthly cost that needs to be factored into the cost of your widget. If you tie up cash in the place then you are costing yourself the interest that money could make somewhere else, like the stock market. This is, for our example, COST A. We’ll say its $.25 a widget.

Then you need materials. Unless you are making your widget out of thin air, or a commodity that someone else is ready to give away to get rid of, materials will cost. And those costs will vary depending on a multitude of things, including the cost of the fuel to ship the materials to you. With a contract for delivery you can sometimes regulate the cost so it will be consistent over a year, but that is usually the best you can do. If fuel costs double in the course of 4 years, then your raw material cost may go up 5%-25%, depending on how fuel dependant the process is. And fuel is just one factor.

You also need to figure in equipment as a capital cost, unless your workers can walk in with bare hands and produce quality widgets. As well as other overhead costs like accountants, advertising, attorneys, support staff in the office that does not make widgets, but designs widgets, purchases materials for widgets and maintains the equipment that makes widgets.

This is COST B. We’ll say its $.25 a widget as well.

Then you need folks to make your raw materials into your widgets. Each employee will have a compensation package, consisting of hourly wage and benefits; plus the cost of taxation. For our argument our employee will make $1.00 an hour. So his hour of labor will cost you a buck, right?

Wrong. Social Security makes his hour cost you $1.07. And then you have the benefits. Two weeks vacation? $85.60, plus you need someone to replace the work while he is out. Call it another 5 cents an hour, spread out over the rest of the year.

Health insurance? And here we enter a whole new world of costs well beyond your control. This year the coverage per individual is $208 a year; about $.10 an hour (I love doing math when I can make up my own numbers), but what new regulation will the state or federal governments add that will raise costs? Assuming a 10% increase means the per hour cost of the policy goes to $.10 an hour. It doesn’t sound like much, but multiply that by 2080 hours a year (a 52 week, 40 hour work week) and then multiply by 100 employees. That penny an hour is now $2080.00 extra cost a year.

Let’s assume it takes a man an hour to make a widget. Labor is now $1.22 a widget. This is COST C.

So far we have $.25 plus $.25 plus $1.23; a total of $1.72 per widget.

Now we get to sell our widget.

We can sell our widget for $1.72, but that does not earn a profit. After all, as owner of the company you have capital tied up in the building and the equipment, plus you have to pay taxes. $1.75 is the least we can charge for a widget and make a profit.

Now we go see Martwall to sell them widgets. Our evil competitor is in another country, and even including the shipping costs from the other country, they can price their widgets at $1.77. We sell them at $1.76, undercut the competition and make a $.04 profit on each widget.

Until another new regulation hits, like say, OBAMACARE. Instead of insurance costing $.10 a widget, it now costs $.14 a widget. Not a problem; raise the cost of a widget by $.04. Except now we are more expensive than that foreign widget. If we do that, we can no longer sell widgets to Martwall. We have to hold the line at $1.76. We need to cut costs in order to still make a profit.

We can’t change buildings because of the capital tied up in the building and the cost of a move. We can’t cut material costs, in fact our suppliers are faced with a cost increase as well- same Obamacare- and are talking about raising prices to cover the hit to them.

Looks like labor will take the hit. But we won’t cut wages; we will just increase the cost of the insurance to the employee. Our costs will stay at $.10 for insurance an employee, but the employee, instead of taking home $1.00 for an hour’s work, now takes home $.96. And resents it.

He finds another widget maker, or a maker of getwids that will still pay the $1.00 and changes jobs.

This example is so simplistic I am almost ashamed of myself. But it does illustrate the vise employers are in. The value of what they sell, based on what the market will pay, pushes from one side, and the costs associated with making the product are pushing from the other side. And what’s left is what you, as the owner get to take home.

At what point do you take your capital, invest it in something else that will make easier money, with less work, and stop making widgets?