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Rules of Thumb in Pricing and Profitability

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by Eugene Schwartz, President, Consortium House

Eugene G. Schwartz

Eugene Schwartz

When I first started my career in the printing business in New York City (after abandoning my civil engineering and public administration goals), I started selling for a $35-a-week draw against commissions. We did our own estimating, and my boss, Ozzie Schroeder, who could practically make ready a letterpress form with his eyes closed, told me the basic rule is three times labor (which was our product) and 25% markup on cost of purchased materials. Add 12% to cover the 10% commission, and that was the price.

The 3 x Labor Rule

It sounds simple but if labor was $6-7/hour (yes, it was once!) you still needed to know how much work could be accomplished in that hour. To solve that problem, we had the Franklin Blue Book with charts laying out the standard time it took to do all kinds of operations-makeups, lockups, makereadies, washups, impressions-data we modified, of course, using our own experience.

I’ve always remembered that three times formula. Like the 80/20 rule (20% of your customers yield 80% of your sales), it seems to work in all kinds of circumstances as a handy yardstick for business planning.

Recently the subject of financial rules of thumb (also referred to as back-of-the-envelope, formulas, and multipliers) have engaged the attention of the PMA listserv as budding publishers try to make sense of pricing in a consignment market with discounts varying all over the lot.

This is not an issue for newcomers only, however. While riding the bus at the ABA, I had a conversation with a quite successful publisher with fast growing mid-western independent-niche business. We were discussing the challenge of maintaining and monitoring profitability in a fast-growing company with a varied product mix.

The Average Sales Per Employee Rule

I didn’t know how much business her company was doing so when it was appropriate I asked how many employees they had. About 25 she said. “You must have about $2.5-3.5 million in sales,” I guessed (using my handy rule of thumb that a going concern should be averaging $100-$150,000 per employee, at least). “Actually, it’s somewhat over $3 million,” she responded.

If you stop to think for a moment that the average cost of maintaining an employee with salary, benefits, overhead, payroll taxes, etc., can run $30,000 to $50,000, then the Three times Formula shows up behind the scenes. You can also say (and nowadays you have to take into account contract and free-lance employees who are not capitalized in cost of product) that if you are not bringing in at least three times the average cost of running your business (less out-of-pocket cost of product), you may be heading for trouble.

The Rule of Thirds

There’s also the Rule of Thirds, which I brought up in the foregoing conversation. I learned about it during my basic training with a few successful direct marketers, but it applies across the board as a recipe for publishing profitability:

  • 1/3 to cost of product
  • 1/3 to marketing
  • 1/3 to overhead and profit

Starting with this guideline, if you add to one of the thirds, you have to subtract from another. The bottom third (overhead and profit) requires that you stay within 13% overhead to get to 20% profit. This is almost impossible to do when you’re in your first full year of sales. The upper third (cost of product) means that if manufacturing is 20% of net income, and you are attempting to recapture pre-pub costs at the rate of 5% of projected sales, you can only afford an 8% royalty (33% – 20% – 5% = 8% ). So, if you are paying 10%, you’ll have to find 2% elsewhere.

The middle third (marketing) says that if you’re paying a distributor 33%, that’s it. Bringing it down to 27% leaves you 6% for advertising and sales support, clearly not enough for an aggressive marketing effort in the initial years. But as backlist becomes more significant (say 50% of sales, with no special promotion outside of catalogs, etc.), your 6% becomes 12% for the frontlist.

Book Clubs and Direct Mail Marketers used to start out assuming they can spend up to 33% for the cost of sale and 33% for the cost of product (including 5 to 10% for your royalty [plus pp&b {printing, paper, and binding}]). With cost of sales going up (postage, etc.), they need to drive down the 33% cost of product. Remember also that they are buying nonreturnable product from you or their printer, so they have to add the cost of unsold or remaindered books (as do you).

Multipliers of Product Cost Rules

The Three times Formula also shows up hidden in pricing formulas. I always counsel that your core sales have to net you at least 3 x cost of product. See how this works using the standard manufacturing multiples of say 6 x mfg in the college market (25% discount), and 8 x mfg in the trade market (45% discount). Your $2 pp&b college reader priced at $12 returns $9.00, or about 4.5 x. Your $2 trade pp&b trade paperback priced at $16 returns $8.80. 3 x pp&b is $6, so you have $3 (or $2.80) to spare. Now add in the cost of shipping, royalties, and recovery of prepub costs, and that $2.80 to $3 goes rapidly. Now we’re back to 3 x to cover marketing and distribution, overhead, and profit.

The question often comes up about how to price premium and bulk sales. If these are incremental to your core market, you can use 2.5 – 3 x pp&b only, and everything less the author’s share drops down to the bottom line bypassing any other distribution or overhead expense.

Using the standard multiples of manufacturing cost as a yardstick to profitability assumes that your marketing costs and discounts are “average.” The 8 x multiplier works in trade if your marketing ratio is 33%. If you are paying 30% to a master distributor for all of your sales, you add another 10% for sales support and advertising. If you have a royalty of more than 10% of net, you need to be using the 10 x multiplier.

The 25% of List Price Rule

Another rule of thumb that comes up from time to time appears in packaging or co-publishing deals. The standard formula here is the publisher marketing the book (in the trade) wants to limit cost of product, delivered, to 25% of list. This enables them to assume an average 50% discount (taking into account wholesalers, promotion allowances, etc.) and leaves 25% of list (or 50% of net) for marketing, distribution, overhead, and profit. They can do all of that on 50% under circumstances such as: (1) They expect to do 25,000 or more copies in sales on the first printing, so that there is a good allowance for absolute promotion dollars ($20 list, $10 net, 20% ad and sales commissions = $50,000), or (2) It’s a $50 coffee table book and will have a 10,000 or more copy sale in the discount after market.

Your 25% has to cover development, royalty, manufacturing, and profit. That’s why these deals almost always specify a minimum first printing purchase.

The 3-Year and 50% of Sales Rule

Lastly there is the often asked question, “How much money do I need to run my business?” You all know your own special circumstance so you can modify any proforma accordingly. But absent any reasons to the contrary, a good rule is the Three-Year Formula:

  • Year 1 – Start-up and little or no sales
  • Year 2 – Market entry and rollout
  • Year 3 – List and sales expansion

Year 3 is the year you expect to break even. Of course, if you are a one- or two-book publisher operating your business on a cash basis out of the house or garage, you may be showing profits at the end of the first year. But your cash flow and collection problems will be the same-in proportion.

The answer to how much money you need to start your business is at least 50% of estimated third year sales. If you expect to be doing $300,000 in net sales the third year, you should be prepared to lay your hands on at least $150,000 along the way. Why? If collections average 90 days, there’s 25% (or one-quarter of your income). If you’re maintaining a cost of product of 33% (including royalties) and need a six-month inventory, there’s 16% of your budget-and then there’s other out-of-pocket pre-pub costs. Since you are likely to be waiting longer than 90 days for cash, and your cost of product may exceed 33%, 50% of third year sales may not be enough working capital in your pipeline.

The Weather Forecast Rule

By now your thumb is probably worn out. I know mine is. Moisten it and hold it against the wind. That’s opposite the direction you should sail in.

Gene Schwartz, President of Consortium House, is a publishing consultant in business and product development. Schwartz has held sales, production, and management positions, and has operated his own businesses in the printing and publishing industries for over 40 years. He is a former board member and treasurer of PMA. Schwartz is currently active in multimedia and Internet business development. He can be reached at eugenegs@aol.com.

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