From the May 2002 issue of Startups

At the recent YoungBiz Summit on Financial Literacy, Mark Victor Hansen, co-creator of the Chicken Soup for the Soul series, asked a crowd of young entrepreneurs to give their No. 1 reason for being in business. To be independent? To help their communities? How about to make a profit?

While there are lots of great reasons to be in business, Hansen emphasizes that if you want to stay in business, making a profit has got to be No. 1. That's all fine and well, you say. But how do you set prices so that your business makes a good profit?

We thought that might be your next question. Here are five steps for figuring out how to make money on the goods that are the cornerstone of your business:

Step 1: Determine Your Cost of Goods
First up, you've got to figure out how much it costs to purchase or produce the products you sell. Kenneth Allen, 18, owner of KS Candies in Gary, Indiana, says the secret to making a profit is to pay the lowest wholesale price for your merchandise. "It's like a golden rule for me," Allen says. "I don't spend more than 25 cents per unit if I don't have to."

For Allen, figuring his cost of goods is simply a matter of dividing the price of a box of candy by the number of bars per box. But if you sell something handmade, like jewelry or food items, determining the cost of goods is a little more complicated.

Fifteen-year-old Emily Manassero, from Oceanside, California, loves to bake homemade bread. When she opened The Bread Barn two years ago, Manassero had to determine the cost of each loaf of bread she baked. To do this, she made a list of all the ingredients--then estimated the cost of each ingredient. When it was all added up, her average cost of goods per loaf of bread was 50 cents.

Step 2: Estimate Your Operating Expenses
Running a business costs money, even on the days when you don't bring a single customer through the door. Known as operating expenses, these costs include everything from electricity and office supplies to phone, rent, advertising and Internet service. Add these costs up for a month, and you've got your monthly operating expenses.

Most young entrepreneurs keep operating expenses to a minimum by running their businesses from home, using borrowed equipment and relying on word-of-mouth advertising. However, even a small amount of operating expenses (or overhead) is important to take into consideration when setting the price for your merchandise or services.

Step 3: Estimate Your Monthly Sales
Now that you've figured your cost of goods and your operating expenses, it's time to do some market research. Can you sell enough merchandise every month to cover your cost of goods as well as operating expenses--plus make an adequate profit?

Here's how to find out. First, write down the lowest average number of sales you expect to make each month. Then divide your estimated monthly operating expenses by the number of sales or units of your product that you expect to sell. The resulting number is the amount of operating expenses you must pay out of each sale in order to cover your costs. If you make more sales than expected, you can pat yourself on the back--you've made it to an even higher profit zone.

Step 4: Determine Your Profit Zone
After you have figured the cost of goods for each unit of sale and the operating expense for each unit of sale, you are ready to look at one more factor in pricing: the amount of profit you need to make to cover your time and labor.

For business owners like 15-year-old Asha Santee in Houston, being paid for your time is very important. While Allen and Manassero invest quite a bit of cash in the inventories for their businesses, Santee has no inventory and very few operating expenses. But she does invest a lot of time in her business, Drum Lessons by Asha. "Once you have your basic equipment, almost everything is profit in this business," she explains. "You just have to figure out what your time and knowledge are worth."

To do this, estimate the amount you need to earn on the business each month to cover the value of your work. Then divide this monthly amount by the number of sales you expect to make. The resulting number is the lowest amount of profit you need to make on each sale.

Step 5: Set the Price of Your Product
The last step in setting the right price for your merchandise is to add up your cost of goods, operating expenses and target profit on each unit of sale. This will tell you the lowest amount you can charge for your product and still make a decent profit. You will need to test this price to see how it compares to your competitors as well as how your customers react.

Some 'treps use a formula for setting prices that is known as "keystoning." Keystoning is the practice of simply doubling the cost of goods (or wholesale cost) to determine the retail price. "I buy my goods through a wholesaler," Allen says, "then resell them with a 100 percent markup." He finds that his 100 percent mark-up covers his expenses and leaves him with a reasonable profit to pay for his time and labor.

No matter what your primary goal is for starting your own business--whether to be your own boss or to offer a much-needed service to customers--if you want to stay in business, you've got to make a profit. Follow the five steps we've outlined above to set the right prices for your products, and you'll be headed down the road toward long-term success.

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