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Costing and Pricing

Objective:

 

  • Understand the terminology of costs, pricing and profit
  • How to calculate costs for a production-based business
  • How to calculate costs for a service-based business
  • What to consider when deciding pricing
  • Different pricing strategy
  • Useful tips for pricing

Overview:

The activity is designed to assist the entrepreneur/ small business owner in understanding how to work out costing for both production-based and service-based businesses. It covers things to consider when deciding how much to charge and different pricing strategies that an entrepreneur can use.

Activity:

 

Introduce the terminology – Costs, Pricing and Profit

1)      Cost

  • Direct costs. The direct cost of a product or service is the cost incurred in producing and supplying the product or service. These costs are also known as variable costs, because they vary in direct proportion to the number of units produced. Direct costs include, for example, the cost of raw materials, bought-in components or goods and direct wages (that is the wages of staff employed specifically to produce the product or service).
  • Fixed costs. All businesses have costs that are incurred regardless of whether any products are produced or sold. These fixed costs are also known as overhead costs and include items such as your salary or drawings, administration and sales employee costs, rent, rates, insurance and depreciation of the value of fixed assets such as machinery and equipment.

2)      Pricing

  • Cost plus pricing. This is a traditional method of calculating the price to charge and is often used in pricing products rather than services. It is based on applying a percentage mark-up on top of the direct costs of a product in order to cover the fixed costs and make a profit.
  • Value-based pricing. This is based on what the market will bear. The impact of factors such as fashion, convenience and market share affect the price level that can be achieved.

3)      Profit

  • Gross profit. Gross profit is the selling price less the direct costs involved in making a product or delivering a service.
  • Operating profit. A business' operating profit is the gross profit minus the fixed costs.
  • Contribution. As long as a business sells a product for a higher price than the direct cost, the income received from the sale of the product will make a contribution to the fixed costs of the business and then to the operating profit. If you sell a range of products, you should look at the gross profit generated by each to compare their contribution and therefore their importance to the business. The product that has the highest volume of sales may not contribute the greatest gross profit, but could be useful in marketing terms to attract and retain customers.
  • Breakeven point. The breakeven point is the point at which income from sales exactly equals all the costs incurred by a business. A higher level of sales will result in a profit; fewer sales will result in a loss.

Explain how to calculate costs for a production-based business with an example:

  • Cost per item
  • Direct/Variable Cost
  • Fixed Cost/ Overheads

Explain how to calculate costs for a service-based business with an example:

  • Labour cost
  • Overheads/ Fixed Cost

A photographer has an overheads of the year are £30,000, which includes salary, office and vehicle running cost. She estimates her working day during the year will be 200 days. She expects to have 5 chargeable hours per day and this equates to 1000 productive hours per year. Therefore her daily cost is £150 and her hourly cost is £30.

How to decide how much to charge?

  • Determine the costs of producing and delivering a product or service – covered in 4 & 5
  • Market Value:

Entrepreneurs will need to research their market carefully to determine the price range that they will be able to charge. This is difficult for start-up businesses, since they may have little information on which to base their pricing decision. They can only refer to the prices charged by their competitors and compare these with the market research they have carried out with potential customers.

Once they are in business, pricing becomes easier since they can adjust their prices up and down and review the effect this has on demand.

The price can always be changed, but there will be customer resistance if an increase is too great or if it is changed too frequently. Ultimately, the price that is charged depends on what the market will stand - that is, on how much the customer is prepared to pay. By understanding costs they are able to make a decision as to whether it is cost effective for them to sell their goods or services at that price.

Explain different pricing strategies

Strategy 1 - Pricing low to penetrate the market and gain customers

Objective: you are just entering the market with a new product and want to gain as many customers as possible.

When to use: you may have a consumable product that people will buy repeatedly so you want to gain customers, get them hooked and then slowly raise the price.

Strategy 2 - Pricing high to gain maximum profits (price skimming)

Objective: you want to gain the maximum profit per unit in the shortest amount of time.

When to use: when a product is unique and new, with no competition, and you have a short window to obtain the maximum profits before copycat products start flooding the market.

Strategy 3 - Pricing to make a 'normal' profit

Objective: to set a price that is seen by the customer as honest and reasonable.

When to use: if you want to develop long-term relationships with your customers. In this case, you might use a cost-plus pricing strategy.

Strategy 4 - Pricing to be competitive in the market

Objective: you want to be competitive and considered for any tenders, proposals, auctions or other competitive pricing situations.

When to use: when your product is very similar to the competition, and you are limited in the methods you can use to differentiate it.

Strategy 5 - Pricing for maximum profit and maximum sales

Objective: you want to get the maximum amount of profit possible, but not at the expense of losing customers.

When to use: after the initial introduction when you have the ability to differentiate your product.

Tips for an entrepreneur

 

  • Pricing is a key factor in marketing and selling a product or service. Whatever price entrepreneurs choose, make sure they have an end objective in mind and that their pricing strategy supports this.
  • Price is primarily a perception of value. By building value, they can charge higher prices. Make sure that their test price points for their   products or they might miss out on a lot of additional profit. They could do this by carrying out market research to establish their customers' perception of possible price points, both before They start trading and once their business is established in the marketplace.
  • The greatest danger when setting a price for the first time is to pitch it too low. Raising a price is always more difficult than lowering one, yet there are temptations to undercut the competition.
  • Price is important, but it is often not the most important issue for a customer. Even if you have a product that is regarded as a commodity, there may be ways to differentiate it so that you can charge a higher price for it than other similar products.

Review the aims and objectives of the session and what was covered in this session.

Skill Development:

  • Reflection
  • Financial analysis and budgeting
  • Rationalising
  • Decision Making

Resources:

References:

Cobweb BIF 054 Business Information Fact-sheet

 

Author / Attribution

This guide was produced by Yan Miao (Business Adviser - The Women’s Organisation).