Pricing for Profit. Part 2
by on May 12th, 2011
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In this post, the second in the “Pricing for Profit” series, we look at the difference between pricing and costing.
The importance of Pricing vs. Costing
One of the jobs that I had early on in my career was that of “Industrial Accountant” in a sewage pump factory. One of my duties was to cost out new products in conjunction with the design engineers in advance of a new product being manufactured.
Reflecting on the position afterwards, I realised, as a matter of fact, (as opposed to a lack of professional confidence), that my position was one of the least critical to that team. This was because, by the time the product concept was given to the R & D teams, a customer need had been identified and a sales price had been set. It was up to the R &D staff to find a way to manufacture a product so that the company could make a profit. On occasion, this even necessitated a whole new manufacturing process or a new assembly line being developed. Cue the R & D engineers of assorted flavours. I merely checked the sums. I was costing, the engineers were designing. The critical job of pricing however, was the responsibility of the group marketing team.
Business theories, developed over the last 200 years, are responsible for the mistaken view that many entrepreneurs hold, that the more labour and / or cost that is put into a product, the more valuable the product becomes.
As noted in Part 1, your customers don’t care about your costs. They only care about the value that they get. However, one thing is certain, if you sell below cost you will make a loss and there is no business future in that.
Definitions
- Costing involves working out the cost of what you sell to your customer. It is simply a numeric calculation. The main function of product costs in business is to value stock for accounting purposes and to keep an eye on product line profitability. Costing is really a historic function. Product costs shouldn’t be used solely as a basis for setting sales prices. However, you should know your product costs when setting your sales price, because, presumably, you don’t unwittingly want to sell below cost.
- Pricing is a process that is more art than science, and although product costs have a part to play in that process, there are a whole range of other factors that should affect your eventual pricing decision. We’ll look at those factors in Part 3.
Unit Costing
Unit costs include all fixed costs and variable costs involved in bringing a product or service to the point of sale. Costs can broadly be split into two types, variable costs and fixed costs.
- Variable costs are those that vary with your level of activity, i.e. the more you sell, the more variable costs you will incur. Some typical examples of variable cost would be raw materials, temporary staff or sales commission.
- Fixed Costs stay the same regardless of the level of activity or volume of sales. Fixed costs remained unchanged over a given period. Some typical examples of fixed cost would be rent, interest on debt, insurance, business licenses and the salary of permanent full-time workers.
Contribution
All sales prices should ideally be set higher than your variable cost, and should make a contribution to covering your fixed costs and, of course, your profit. While selling above cost is a basic concept that everybody understands, it is a concept that is sometimes forgotten in a rush to simply make sales.
Pricing
if pricing were easy, no business would ever make a loss on a product line. However, the fact that pricing isn’t easy is no excuse for overlooking the basics. Calculate your costs and make sure you don’t price below cost. If your costs are too high, either reduce your costs or don’t sell the product.
Next time, in “Pricing for Profit”
Over the next two posts, I’ll outline the first steps you need to take in order to price your product for profit. I’ll also review special factors that affect pricing professional services.
In your opinion, how important is product cost in setting your prices?
Karol K. (@carlosinho) is a freelance blogger and writer. He's passionate about turning blogging into a business, and…
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