Costing and Pricing
Although accountants define costs in several different ways, there are, effectively, just two types of cost. The first cost is that which is directly attributable to the product or service. Direct costs include raw materials and sub-contract work. If you make desks, for example, the cost of wood will be a direct cost. Within reason, the cost will be the same for each desk, no matter how many desks you make. When you make a sale the income first has to cover the direct costs relating to that sale. Whatever is left is called gross profit or contribution.
All other costs are overheads, eg staff salaries, marketing, rent, rates and insurance. They also include depreciation; that is, an allowance for wear and tear on capital equipment. Overheads are often called fixed costs because, generally, they are fixed for the business. Interest is often regarded as a deduction from net profit rather than an overhead cost. You need to include it as an overhead in your costing calculations, even though it varies with the size of your overdraft or loan. If you are self-employed, you will take drawings from the business. Whilst, strictly speaking, drawings are an advance against profit, include them (and an allowance for income tax) as an overhead when calculating total costs.
The contribution is so-called because it contributes towards covering the overhead costs. Each sale generates a contribution. When enough contributions have been made, and all the overhead costs are covered, they start to contribute to net profit.
The price at which you sell your product or service clearly needs to exceed the total costs of providing it. But the price should also reflect what the market can stand. If you are selling a differentiated product or have adopted a strategy of market focus then you may also be able to charge a premium price. If you are pursuing a cost leadership strategy you will need to be ruthless in keeping your costs down and under control.
In calculating your price you will need to follow a number of steps:
- estimate your likely sales for a period, say, one year;
- calculate the total direct costs and divide by the sales volume to give direct costs per unit (say per product or per hour of service);
- calculate your total overhead costs and divide by the sales volume to give overhead costs per unit;
- add direct costs per unit and overhead costs per unit to give total cost per unit; and,
- add a further profit margin (to allow for re-investment, etc). If necessary, add VAT as well.
You now have a first stab price. How does that compare with your competitors? Will customers buy at that price? Do you need to reduce costs? Can you achieve a higher profit margin?
What happens if you fail to achieve sales at the determined price? Remember that the overhead costs are fixed, so if sales fall the overheads will be spread over fewer items and the unit cost effectively increases. The converse is also true. Increasing the volume of sales means that the overheads are spread over more units, so the unit cost falls. This means that you can, if you choose, reduce the price. And reducing the price might increase your level of sales. It’s a fine balancing act.