Understanding Cost & Pricing for Profit
Pricing your product or service is one of the most important business decisions you'll make. You must offer your products for a price your target market is willing to pay–and one that produces a profit for your company–or you won't be in business for long! There are many approaches to pricing, some scientific, some not. This article provides a framework for making pricing decisions that takes into account your costs, the effects of competition and the customer's perception of value.
A quick note about how the terms "cost" and "price" are used in this article:
o Cost is the total of the fixed and variable expenses (costs to you) to manufacturer or offer your product or service.
o Price is the selling price per unit customers pay for your product or service.
So, when customers ask, "How much does it cost," your answer is your price.
The Fundamentals: Price Floors and Ceilings
Think of cost as the floor–you must set prices above the floor to cover costs or you will quickly go out of business. (If you decide to set prices at or below cost it should be for a temporary, specific purpose such as to gain market entrance.)
Think of customer "perceived value" as the ceiling–this is the maximum price customers will pay based upon what the product is worth to them. This is sometimes described as "what the market will bear." Perceived value is created by an established reputation, marketing messages, packaging, sales environments, etc. An obvious and important component of perceived value is the comparison customers and prospects make between you and your competition.
Somewhere between the floor and the ceiling is probably the right price for your product or service; a price that enables you to make a fair profit and seems fair to your customers. Consequently, once you understand your cost floor and your value price ceiling, you can make an informed decision about how to price your product or service.
In summary, while you must be mindful of costs in setting your prices, don't limit your thinking only to cost-based pricing. Value-based pricing makes you think about your business from the customer's perspective. If the customer doesn't perceive value worth paying for at a price that offers you a fair profit, you need to re-think your game-plan!
The Starting Point: Calculating Break-Even
Before you can decide upon a fair price for your product, you need to know how much it's costing you! You'll need to know this no matter which pricing method you use.
Once you've identified costs, you can determine your break-even point. This is the point at which you neither make nor lose money in producing a product or delivering a service. For example, you would be at the break-even point if it cost you $100 to produce a product that you sell for $100.
A break-even analysis is the process you use to uncover those break-even numbers. To begin your break-even analysis, add up all fixed costs and determine what your variable costs are at different production volumes.
o Fixed costs, sometimes referred to as overhead, are expenses that don't vary according to production amounts–such as rent for office space (and storage space if you store inventory), office equipment (telephones, faxes, computers, etc.), insurance, utilities, etc.
o Variable costs are expenses that do vary with the amount of service provided or goods produced. They include costs such as hourly pay for a contractor on a specific project, raw materials, etc. Some variable costs don't depend specifically on the number of products produced but are still variable, such as advertising or promotion expenses.
You must know the cost of your overhead (fixed costs) as well as the incremental cost-per-unit (variable costs) before you can determine your break-even points.
Next, substitute your figures into the following break-even formulas.
To calculate break-even dollars–the amount of revenue needed to cover both fixed and variable costs so your business neither makes nor loses money–use the following formula:
Fixed Costs 1 - (Variable cost per unit/Selling Price per unit) = Revenue to Break-even
Example: Calculating Break-Even Revenue
As an example, let's try to determine an appropriate hourly rate (revenue) to charge for a consultant or service business.
Using the break-even revenue formula, plug in total fixed costs of $30,000, variable cost-per-unit of $15 (hourly pay to consultant), and unit selling price of $30 (per hour of consulting). The formula yields a break-even annual revenue of $60,000.
$30,000 1 - ($15/$30) = $60,000
So, this company needs revenues of $60,000 just to cover costs. If it doesn't have enough business at these rates, it loses money by being in business. If it makes more than $60,000 in revenue, it's making money.
To determine how many units must be produced and sold to break-even, use the following formula:
Fixed Costs Unit Contribution Margin* = Number of units needed to break-even
Selling Price per Unit - Variable cost per unit
Example: Calculating Break-Even Number of Units
The "unit" produced in this example is one hour of consulting. In our example, the number of hours required just to cover costs is 2,000.
$30,000 $30 - $15 = 2,000 units (hours per year)
If you assume consulting hours are spread out evenly over a 50-week work year, 40 hours must be billed and collected each week just to break-even.
2,000 hours per year50 weeks = 40 hours per week
With 40 hours of consulting per week by one person, the business only breaks even. Unless that person can consult additional hours to make a profit while marketing the service and managing the requisite paperwork, this business cannot turn a profit. Since this is highly unlikely (unless the consultant is an insomniac) this doesn't appear to be a realistic pricing model.
Let's play around to see what the company's options might be. If we raise the hourly rate from $30 to $35 per hour, we find that the break-even revenue figure drops from $60,000 to approximately $52,500.
$30,000 1 - ($15/$35) = $52,500
Also, the number of hours per week required to cover costs drops from 40 to 30 per week.
$30,000 $35 - $15 = 1,500 hours per year
1,500 hours per year50 weeks = 30 hours per week
It still might be a challenge for one consultant to work 30 hours a week because she needs time for researching, learning, administrative duties, breaks, etc. Also, it might be difficult to sell 30 hours of consulting consistently every week. Even if these challenges are overcome, the business is still only breaking even. A profit needs to be made!
At a rate of $50 per hour, the number of hours required per week to cover costs drops to an attractive 17, which is a more realistically achievable number in terms of sales and staffing.
$30,000 $50 - $15 = 857 hours per year
857 hours per year50 weeks = 17 hours per week
Also, the revenue needed to break-even drops to $42,857.
$30,000 1 - ($15/$50) = $42,857
So the price floor range for this business is $35-$50 per hour just to cover costs. (The range is dependent on how many hours can actually be offered and sold. It's up to the entrepreneur to judge how realistic profit expectations are and to price accordingly.)
Pricing for Profit: Cost-Based Pricing
After you've determined your break-even points which establish "floors" for your price, there are strategies for establishing pricing based upon additional financial objectives, such as:
o Establishing a high price to make high profits initially. This strategy is used to recover high research and development costs or to maximize profits before competitors enter the market. (Pharmaceutical companies often use this strategy when introducing new drugs.)
o Setting a low price on one or more products to make quick sales to support another product in development. (Some companies also employ this strategy when they need to increase cash flow.)
o Setting prices to meet a desired profit goal. For example, if the desired profit per unit is 20 percent and unit costs are $10 (taking into account your fixed and variable costs), set your price at $12.
You may also determine how many units you'll need to sell to meet a profit goal by using the following formula.
Break-Even Unit Volume = Fixed Costs Unit Contribution Margin*
* Again, remember Unit Contribution Margin =
Selling Price per Unit - Variable cost per unit.
Pricing for Profit: Value-Based Pricing
How high can a price be before the product or service is priced out of the market?
To understand the customer's perception of the value of your product or service, look at more subjective criteria such as customer preferences, product benefits, convenience, product quality, company image and alternative products offered by the competition.
o How do your customers describe what they get for their money?
o Do they save a great deal of money or time by purchasing your product or service?
o Do they gain a competitive advantage from using your service?
o Is it more convenient to use your service rather than try to do it themselves?
o What does the competition charge?
With this information, you can begin to understand the maximum price the customer will pay for the benefit received. Often, a customer may think it's worth paying $75 per hour for the convenience and security of dealing with a local business, rather than a paying an impersonal chain $30 per hour. If the customer, however, is only willing to pay $30 per hour, you have to ask yourself whether you can make any money in this business.
A few value-based pricing strategies are listed below that take into account the break-even point, but are heavily weighted with subjective judgments–not just the numbers.
o Price the same as competitors. This strategy is used when offering a commodity product, when prices are relatively well established (such as with professional services) or when you have no other means to set prices. Your challenge then becomes to determine how to lower your costs so you can produce a higher profit than your competitors.
o Establish a low price (compared to the competition) on a product in order to capture a large number of customers in that market. This strategy may also be used to achieve non-financial objectives such as product awareness, meeting the competition or establishing an image of being low-cost. It works if you are able to maintain profitability at the low price, or if you're able to maintain an acceptable level of sales should you later raise prices.
o If your product has a mystique and uniqueness that is valuable to customers, you might have the ability to charge a very high price relative to your cost. Also, if your target market is affluent and you are positioning your product as a "prestige" product, an especially high price could be in order. (For example, do Rolex watches cost that much more to make than other brands? The high cost, however, brings a "status" benefit to Rolex's affluent market.) This strategy of charging "what customers are willing to pay"–even though it's high–requires alertness and a willingness to change on your part because customers (and competitors) might decide that you're making too much of a profit!
Your pricing strategy might include discounts to customers who offer you a business benefit.
o You may offer cash discounts to customers who pay promptly. This rewards those who help your company maintain a steady, positive cash flow and reduce credit-collection costs.
o Offering quantity discounts for large orders often makes economic sense when the cost-per-unit to sell or deliver a product declines as the quantity increases. For example, a caterer might fill an order for 12 dozen cupcakes for one customer at 10ў each, while cupcakes sitting in the bakery display rack might be sold to several customers throughout the day for 20ў each. This is because the possibility that some of the cupcakes won't sell has to be taken into account, there are costs associated with having the store open for random customers' convenience, etc.
o Seasonal discounts given to buyers who purchase during a product's slow season reward customers who essentially assist a company in balancing its cash flow and in meeting production demands.
o Trade-in allowances for returned old products that you may either re-use or re-sell for a profit may benefit both a company and customers.
o Promotional allowances often make economic sense. For example, if your product is sold by a retail chain which includes your product in its ads or in promotional activities, those activities leverage your marketing efforts. If so, you might choose to discount your price to this retail chain.
Sample Revenue Planning Worksheet for ConsultantsUse the following worksheet to calculate your annual expenses, annual profit goal and hourly rate necessary to achieve the profit goal. Example Your Worksheet
Labor: My Salary Staff Salary Total Labor $60,000 25,000$85,000 __________ __________ __________
Benefits (30%) $25,500 __________
Telephone 1,200 __________
Meetings & dues 360 __________
Office Supplies 600 __________
Total Expenses $37,400 __________
Total Operating Expenses $122,400 __________
Profit Goal (10%) 12,240 __________
Hourly Billing Rate $130/hr __________
* Most consultants estimate that they are doing well if they are billable 50 percent of the time. If there are 2080 hours in a year to work (excluding weekends and holidays), that means that your billable target is 1040 hours.