Two major influences help determine the price charged for an item or service. The price competitors are charging is one. Customers may accept a small price differential between businesses if one has a better reputation for quality, honesty, or service, but getting the most for their money is always the first consumer concern. The other major influence is how much return on equity the business owner wants or needs to have to maintain a profitable business. Equity is the dollar amount of assets owned by the business that is not offset by indebtedness.
Equity = Total assets ^ Total liabilities
The rate of return on equity is the percentage of the owner’s equity that is returned as net profit during the business year. Every owner needs to know if the money invested in the business is making enough money to equal or surpass the interest it would earn if it had been deposited into an ordinary savings account or invested in bonds, money market certificates, or even a different business. The rate of return on equity provides the information needed to make that comparison. To calculate it requires two figures: the net profit for the past year and the net worth or equity of the business for the past year. The sample profit – and-loss statement in Table 25-2 illustrates how to determine net profit. The sample balance sheet in Table 25-3 illustrates how to determine net worth or equity.
From the sample financial statements, the net profit of Garland’s Nursery and Greenhouses is seen to be $80,880, and the total equity at year’s end is $317,820. The rate of return on equity can be calculated using the following formula:
Percent rate of return on equity =—————–
Percent rate of return on equity =———- = 25%
In the example, 25 percent of the owner’s cash investment has been repaid in net profits for the year past. Should this highly successful rate of return on equity continue, the owner’s entire cash investment will be recovered in four years. While a 25 percent rate of return is high compared with what many owners recover, it must be higher than the rate of return that other uses of the money could provide or the owner will have suffered a loss on the money invested, not to mention the time and hard work spent on the business during that period.
Using the percent rate of return and the past year’s price figures as guides, pricing for the current year can be developed. If the percent rate of return was too low, prices for the next year would need to be raised, particularly if increasing the volume of business did not seem like a realistic solution. If matching the prices charged by competitors does not permit the owner to make a profit, problems will need to be recognized. Overhead costs may have to be reduced; the staff may have to be
reduced or productivity increased; salaries may be too high; or the desired profit margin may be unrealistic. It is also possible that not all components of the cost of an item or service justify the same profit margin. The profit markup on material costs may differ from the profit markup on direct labor or overhead costs.