In most situations, the cost of your products will determine the lower limit of your prices. To accept a price that is lower than the cost of producing or sourcing the product will mean that you are operating at a loss.
To define the lower limit of your prices, the first step is to calculate your product costs. I strongly recommend that you look into using a cost accounting method to cost your products. This exercise is important, and not just if you have decided to use a Cost-plus method of pricing your goods and services.
Calculating your product costs will also enable you to:
On the previous pages, you have read about the difference between variable costs and fixed costs.
Basing Your Pricing Decisions on Your Product Costs - How Cost-Plus Pricing Works...
Before you can use Cost-Plus pricing you need to have a good idea of the cost to your business for your goods and services.
If you are a retailer or a drop shipper, calculating your product level costs will be very easy. Basically you just add together the purchase price with any costs you have incurred to purchase the product.
For example if you buy a particular product at a price of $5.95 per unit in lots of 10, the freight costs $25.00 per order, and there are no other costs related to the purchase or sale of the product, your product level cost will be $8.45 (see calculation below).
Purchase price of product
Cost per Unit
$ 2.50 ($25 for 10 units)
What if You are a Service Provider or a Manufacturer?
Depending on the complexity of your product, you can just about guarantee that your costing model will be much more complicated.
Click here to take a look at some examples of product cost calculations. These are product cost calculations for real products, produced by a local company that I did some costing work for in 2006.
Feel free to have a look. I have included three examples in the file, one for a product with low levels of complexity (a set of bed slats), one with a moderate level of complexity (a bookcase), and one with a high level of complexity (a hall stand).
Identifying Your Direct Variable Costs
To calculate your product level costs you will need to identify all of your inputs plus any costs that you incur to convert those inputs into a viable product.
- Raw materials,
- The cost of inward freight,
- Labor costs,
- Machine running costs, and
- Machine set-up costs.
Don't forget to include the costs of any of the production work that you have outsourced to other firms (like the cost of polishing the timber furniture in the examples provided above).
For an online business you also need to take your method of supply into consideration. You have a choice, you can build the cost of shipping or delivery into the product cost or you can calculate a separate delivery cost to be charged for each order placed by your customers.
Identifying Your Indirect (Overhead) and Fixed Costs
Your Indirect Costs will be overhead items that cannot be directly allocated to a particular product or service and might include items like your phone system, the cost of maintaining your website or your autoresponder email system. Fixed costs are costs that do not charge with fluctuations in sales volumes and usually relate to large items like the lease for your premises or the costs of fixed assets (machinery etc).
Basically to recover the total cost of production you need to spread your overheads and your fixed costs across all of your products or services. The simplest allocation form is to divide total fixed costs by the number of products you intend to produce or sell and apply that amount to each unit.
For example, if your total fixed costs amount to $20,000 per annum and you plan on selling 50,000 in the first year, you would allocate $0.40 to the variable or product level cost of each unit.
There are more accurate methods of allocation (job costing or activity based costing methods) but these are outside the scope of this discussion for now.
Now for the Cost-Plus Bit...
Once you have calculated the full cost of your products or services you add a predetermined margin - your required profit - to the cost of your products to arrive at your sales price, (costs plus profit margin = cost-plus pricing).
For example if you had calculated your product cost at $ 8.45 (see above) and your desired profit margin or return on investment is 15% you would multiply the cost by 1.15. This gives you a result of $ 9.71, which I would round up or down to either $ 9.70 or $ 9.75. But that is a personal choice...
Once you have a cost-plus price it is always a good idea to test the market to see if your price is within an acceptable range for your target customers.
If your competitors prices are higher, maybe you can put your prices up a bit, if their prices too much higher than yours you may find yourself being targeted by their marketing efforts to eliminate the threat you pose to their position in the market.
If your price is higher than your competitors, you may need to revisit your cost calculations, production methods, suppliers or your business model. If you need to cut your profit margin to bare bones to sell your products, you may end up losing the money you have invested in your business.
And let's face it, your competition is either able to demand lower prices from their suppliers, they have a serious competitive advantage in their operational processes or they are selling at a loss. Either way price matching without seriously looking at every aspect of your business is a sure way to go broke!
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