makes sense as different production processes have different ways of recording information.
Normal costing is widely used by most companies to improve the accuracy of the standard costing 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 expected overhead costs and quantity to be sold – instead of relying only on what happened in the past. Because it is about expectations you can incorporate known information such as an electricity rate rise scheduled for this quarter, or a price rise in eggs as winter approaches.
Back to the cake example above, you think the electricity bill for next quarter will be about $350 due to the price rise and you intend to bake 150 Cakes, and you decide that you this will be slightly more electricity for cake baking say 7%. Then you will attribute $24.50 of your forecast electricity bill to the 150 cakes you plan to bake – ie add 16.5c to each cake cost to include the electricity costs for all the cakes you will sell in the next quarter.
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 so additional cost for use of the machine need to be recognized proportionally. 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.
Activity Based Costing looks at through-put and so tries to identify cause and effect relationships between inputs and outputs to objectively assign costs. This method enables apportionment according to process and product differences.
Firstly list all of your outputs, products or services you will sell – can you price for ‘cake production’ because you only produce sponge cupcakes, or do you need to price for cake type by size because you have an entire range of cakes from ‘chocolate mini-bites’ to ‘wedding fruitcakes’?
Once you have sorted your list of outputs for each one work out your 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 – you can do this by fine tuning the formula for Normal Costing, and instead of using a blanket ‘Budgeted Overhead Cost’ narrow it down to ‘Budgeted Time Cost’, ‘Budgeted Materials Cost’ ‘Budgeted Equipment Cost’ etc. and add them all together to get your total Indirect Costs.
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.
No matter how you decide to work out your indirect costs, to complete this step add them to your direct costs to get your Total Costs. If you set your price at this amount you will make zero profit, but can still pay all your bills. Any amount you charge above this point will lead you to make a profit – so the question becomes to how much profit do you want to make?
Step 3: Consider your Sales Strengths
When making this final pricing decision also keep in mind that your selling price is a function of your ability to sell – this may seem oversimplified, until you consider this:
“What’s the difference between an $8,000 Rolex and a $40 Seiko watch?
The Seiko is a better time piece, it’s far more accurate.
The price difference is related to each brand’s capacity to sell watches.”
If you are extremely capable at closing sales and bring in the money, then you are able to price higher than someone with weaker sales skills. This isn’t about your personal sales strengths; does the business have a good sales person, a premium brand, a hot product?
Once you understand your markets and costs, now you can set your final prices.
Step 4: Add your Mark-up
Mark-up is the amount added on top of Direct and Indirect Costs to create your selling price, this will tie directly back to how much profit you plan to make. This is where the Dark Art of price setting really comes into its own. But remember nothing is locked in stone, you can change your prices as often as you like or need (especially if you are decreasing them), but price increases are also relatively easy to orchestrate if you know how – see last week’s post Charge More
e.g. If you are a start-up it may serve you well to begin lower, establish your brand then follow through with several rapid price rises.