Pricing = Understanding Costs = Maximising Profits
Costs can be slippery but capturing them all will enable you to make better pricing decisions
AND better pricing decisions enable you to make more PROFIT
Pricing products and services has two components – one component is a calculated fact and the other requires some sleight of hand.
1. The Cost – everything you sell will have associated costs and there are many ways of increasing how accurately you allocate all of your costs to each item you sell
2. The Mark-up – it is how much ON TOP OF your costs you add to arrive at the selling price
Quick Definition – Costs and expenses are basically the same term; the difference is the term expenses is time bound – it includes ALL of the costs for running your business that are included in ANY REPORT FOR A SPECIFIC PERIOD. Costs on the other hand are the things sacrificed to achieve a specific objective, such as manufacturing a particular product, or providing a client a particular service and may include expenses from multiple reporting periods spanning up to several years.
The Timeframe when the money is spent is not important to the pricing process, what is important is capturing and allocating all the cost incurred to make sales.
Anything sold has two sorts of costs, (the same way as there are two sorts of expenses):
Direct – costs that have a direct correlation with the number of products/services sold eg each piece of stock has an attributable purchase cost; every sale has a set amount of Commission; every item sold has a package/box
Indirect – costs that have no direct correlation to the number of sales eg rent, electricity, stationery
For each item of product or service direct expenses are easy to understand – it is like cooking for every cake you make you need 2 eggs, 1 cup of flour, ½ cup of sugar etc. You can easily work out the price of each ingredient as you know the cost of one packet of eggs, one packet of flour and one packet of sugar you can apportion a part of that cost to what you have used in the cake.
Indirect expenses are harder to asses on an item-by-item basis as they cannot be attributed in any kind of direct proportion to the finished product. In the cake example above – How long did the cake take to make – do you include only the time you were measuring and mixing, or your time whilst it was cooking in the oven as well? – How do you include an amount for the wear-and-tear on the equipment you used? These are harder to cost as they are not used and paid for in any kind of proportion to the number of items sold.
There are many many methods and systems for costing these indirect expenses (often also know as Overheads) – but to start here are just a few. The method you will need to use in your business tends to vary according to the type of goods/service being sold – which makes sense as different production processes have different ways of recording information.
A. Standard Costing
The simplest and easiest, and therefore generally the least accurate method. This involves calculating a standard rate ($ value) of overheads added on top of the direct cost of each unit sold.
Overhead Rate for next period =
Overhead Cost from last period
Total Units sold from last period
So in the cake example above, if the electricity bill for the quarter came in at $300, you baked 100 Cakes, and you decide that you use your electricity about 5% for cake baking. Using this method you will attribute $15 of your electricity bill to the 100 cakes and so add 15c per cake to include the electricity costs for all the cakes you will sell in the next quarter.
B. Normal Costing
Normal costing is widely used by most companies to improve the accuracy of the above method.
Overhead Rate for next period =
Budgeted Overhead Cost for next period
Budgeted Units to be sold for next period
This method calculates and applies their overhead rate using budgeted overhead costs and the budgeted quantity of the allocation base – instead of actual overhead costs and the actual quantity of the allocation base. By assessing how cost behaved in the past, and adding in information and plans about what is intended for the coming period, generally a more accurate cost allocation, and therefore price, is calculated. This method enables the incorporation of known information such as an electricity rate rise scheduled for this quarter, or a price rise in eggs as winter approaches which are overlooked by the Standard Costing Method.
Back to the cake example above, you think the electricity bill for next quarter will be about $350 and you intend to bake 150 Cakes, and you decide that you always use your electricity about 5% for cake baking. Then you will attribute $17.50 of your forecast electricity bill to the 150 cakes you plan to bake – ie add 12c to each cake cost to include the electricity costs for all the cakes you will sell in the next quarter.
It is important to remember not to mix and match – use either budgeted numbers in both the numerator and the denominator of the overhead rate, or actual numbers in both the numerator and the denominator of the overhead rate. Companies never use budgeted overhead divided by the actual quantity of the allocation base, or actual overhead divided by the budgeted quantity of the allocation base.
Both of the above methods add a standard averaged overhead rate on top of the direct costs. However indirect costs do not necessarily arise equally for all products. For example, one product might take more time in one expensive machine than another product to produce, but if the number of outputs are the same, additional cost for use of the machine is not being recognized when the overhead rate is added to all products equally. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another with the prices will be set incorrectly.
There is an alternative.
Instead of using broad brush ‘one-size-fits-all’ cost percentage to allocate costs, through-put accounting methods seek to identify cause and effect relationships between inputs and outputs to objectively assign costs. So thinking again about cakes, if we are making 50 carrot cakes and 50 sponges, the carrot cakes take longer to cook and therefore have a greater proportion of electricity in their actual production cost. This method enables apportionment according to process and product differences.
There are many versions of this approach, but for ease we will only look at one in this article.
C. Activity Based Costing
The first step is to identify and measure all of the costs incurred in carrying out specific activities. Firstly determine all of your outputs, do you want to simply account for ‘cake production’ because you only produce sponge cupcakes with vary little variation, or do you need to account for cake type by size because you have an entire range of cakes from mini-bites to wedding cakes?
Then understand all of your cake inputs:
- who carries out the work and how much time they devote to it
- what materials are required for the activity
- what equipment is used in the activity
Then the per unit cost for each of these inputs needs to be calculated and assigned to each activity so that the total cost of the activity can be determined.
Activity Based Costing, and other similar allocation methods are significantly more complicated to calculate – in Micro and Small SMEs with very little product differentiation not always necessary. However as a business grows in size and complexity improvements in costing accuracy that drive price adjustments will always deliver improvements in profit.
It is also important to understand the difference between your mark-up and your margin – click here – for clarification.