In order to survive, companies need to create and retain customers while dealing with competition in the marketplace. Advertising, customer service, product strategy are all important elements, but perhaps the most critical factor in a company’s ability to succeed is its pricing strategy. How do we determine the right price for our product or service? Businesses that do this poorly are quickly drained of resources or get left behind by better-prepared competition.
Presented here, are some pricing secrets, which are simple yet powerful.
The first question we ask is “How do you make sure that each project or product ‘pulls its weight’ toward the goals set out by the investors and management in the original business plan and on what do you base the price?” The only things you know for sure are the costs (if you don’t, you had better get them). From those, you can derive a price, given a business plan and some simple algebra.
The odd lucky business may find a market that is willing to pay many times what it costs to provide the product, and so it is of little interest what that cost really is. Unfortunately (for that lucky business) the competitive market will soon drive prices down to a more favorable point for the even luckier consumer. If it is not now important to understand the arithmetic of cost-based pricing, it soon will be in order to stay in business over the longer term.
It should go without saying (but it doesn’t) that a cost-based pricing formula will result in a cost-based price. The result of this exercise may well not result in the price presented to the market, but instead be used as a floor when setting a market-based price if you happen to be one of those “lucky” companies. In the case where a product is under intense competition, it may also be used to calculate how much a “strategic partnership” with a customer will cost, and how much will be needed from future projects to recoup the cost.
Let’s begin by stating that profit is the objective. It is clear that revenue must exceed cost by the desired profit amount. So:
Profit = Revenue – Cost
P = R – C
Easy…. So a business plan can be written, making some assumptions about revenue and costs, and we can start making money. Let’s say we plan to sell a million dollars worth of product this year, so R = $1000k. We will have to buy some material and pay for some labor to put the product together so direct costs can be broken down into two parts, labor and material.
We also have some overheads, so we can say that:
Profit = Revenue – Direct Cost – Overheads
The overhead costs can be broken down into things like rent, utilities, an engineering department, an accountant and a shipping/receiving clerk. We also have a sales department and, of course a general manager’s salary (probably yourself). We will have to borrow some money to buy inventory, so there will be interest costs as well. Now our overhead cost formula looks like this:
Cost = Rent + Utilities + Engineering + Sales/Marketing + Purchasing/Shipping/Receiving + General/Administrative + Interest
You may be wondering “why all the categories?” Remember, we are developing a costing formula for our products, and want each one to pull its weight toward the profit goals. These categories will come in handy as we try to come up with a fair price for each product. If a product has no labor content, then it would not be fair to burden it with the cost of the assemblers’ benefits for instance. The formula we develop will take this into account and allow us to make decisions about whether to accept a given project at a given price, whether to make or buy component parts, and whether or not we will be able to stay in business.
We started by describing our business as follows:
Profit = Revenue – Cost
And our objective was to come up with a pricing formula, so we can say that each product’s revenue must cover its costs and contribute its share of the profit:
Revenue = Cost + Profit
Where Revenue is now the price at which the product must be sold to satisfy the conditions of the original Business Plan. There is an important change of perspective here. The first formula applies to the overall company objective of profit in terms of revenue and costs. The second applies to the particular product or project being priced. The assumption is that each product or project conforms to the ratios of revenue, cost and profit established in the business plan.
So far this is all very simple. The rest is really just basic algebra, and making some decisions about what cost is associated with what activity. For instance, it might be evident that if we are to build a product with 1000 tiny parts there would be more assembly labor than if we were just stuffing a finished product in a box and re-selling it. So the labor cost is a variable according to the requirements of each product. On the other hand, the accounting job is not much different if there are 1000 parts at $1.00 or one part at $1000, so the accounting costs are relatively fixed as a proportion of revenue. It makes sense then, in our costing formula to base the price on an estimate of the actual labor cost per unit, while we might base the cost of accounting on some percentage of the overall revenue.
I find it easier to work with real numbers, so I will propose a simple business plan as follows:
Revenue (R) (target) = $1000k
Profit (P) (target) = $150k (.15R)
Sales & Marketing (S&M) = $140k (.14R)
Engineering (ENG) = $130k (.13R)
General and Admin (G&A) = $120k (.12R)
R = P + S&M + ENG + G&A + Manufacturing Costs
Sometimes the first four terms are grouped together and called Gross Margin (GM).
R = GM + Manufacturing Costs (MC)
In any case, the numbers work out like this now:
R = .15R + .14R + .13R + .12R + MC
R = .54R + MC (The Gross Margin target is 54% of Revenue)
R – .54R = MC
(1-.54)*R = MC
R = MC/(1-.54) = MC/.46
Remember that .54 is the Gross Margin, so the desired price for a product (R) is the Manufacturing Cost divided by one minus the Gross Margin. I can’t tell you how many business managers I have come across who cannot understand why this is so.
Now we can try to figure out the actual Manufacturing Cost.
You might think that the Manufacturing Cost would be simply the cost of material plus the cost of labor, but there is more. It costs something to get the material here, to handle it, to store it, to borrow the money to pay for it and so on. Some of the material will be defective, some will get damaged in process, some will get stolen, and this is called “shrinkage”. Labor is also burdened with factors like employee benefits, sick time, and something I call “slippage”. Slippage is simply the ratio of productive labor time to non-productive. People will go to the bathroom, get a drink, chat, be late, leave early, and the result is that you might expect 25% of their time to be non-productive. This factor must be taken into account when pricing a job that might take 1 hour of labor to perform. Over the longer haul, it will take an average of 1.2 or 1.3 hours. On the other hand, the more times a job is repeated, the less time it takes due to the “learning curve”. These factors must be derived for each situation, but they are generally about 78% for efficiency (1/slippage) and 5% per doubling for a learning curve. (It will take 95% of the time to do the second hundred as the first hundred, the second thousand as the first thousand, and so on)
All of these additional factors are called burdens and after the direct labor and material costs are factored with their burdens, they are called burdened labor and material.
Some guideline factors will be given here, but it is best to be collecting data for a particular facility to determine the real factors applicable. These are also metrics to which one might manage, setting goals and incentives against target performance.
Labor Overhead (LOH): This is relatively easy to gather for each facility, but benefit rates of 35% are not uncommon. As mentioned earlier, efficiency might be 78%. The cost of utilities and rent allocated for the manufacturing area is usually added to the labor burden, in the view that it may be managed (up or down) as demand dictates. This may not be strictly true for other than large excursions of demand.
My experience has been that an appropriate burden rate as a portion of direct cost of labor might range between 85% and 160% depending on the character of the business and the assumptions made about variable vs. fixed costs. 120% might be a good place to start for the purposes of this exercise. So:
Burdened Labor = 1.2 x Direct Labor + Direct Labor = 2.2 x Direct Labor
Material Overhead (MOH): Similarly, any cost category that relates to the buying and holding of inventory is factored here. Interest costs, taxes and duties, landing and freight costs as well as rent and utilities attributable to warehousing are generally included. Purchasing, shipping and receiving are often not factored here, as purchasing and receiving costs tend to be relatively fixed. Shipping costs in the term “Purchasing, Shipping and Receiving (PS&R)” are generally outgoing shipping costs. They are difficult to account for directly and are generally dealt with as general overhead, although if a product has a size or weight that is far from the norm, one may wish to make an adjustment in the costing formula. I will talk more about adjustments later.
Once these rates have been established, they may look like this as a portion of Material Cost (M):
Interest: .05M ($100k of inventory at 6% APR)
Warehousing: .05 M (you have $100k of inventory in 600sf at $10/sf gross)
Landing (taxes, duties, incoming freight): .01M (you pay 10% duty on 10% of your material)
So from this, material burden as a percentage of material cost, is 5%+5% + 1% = 11%, so:
Burdened Material = 0.11 x Direct Material + Direct Material = 1.11 x Direct Material
So going back to Material Cost (MC), we can say that
Material Cost = Labor + Labor Overhead + Material + Material Overhead
= Burdened Labor + Burdened Overhead
= 2.2 Labor + 1.11 Material
Now the pricing formula becomes:
R = (2.2 Labor + 1.11 Material)/.46
This covers all direct and Manufacturing costs and will result in a 54% Gross Margin. If everybody holds to their respective budgets, and you do indeed generate $1M in revenue, you will end up with $150K profit, which is where this all started.
Inevitably, the minute you get this pricing process established, there will be a great opportunity that requires a “special case”. Do not fear. The main reason for establishing rules is to be able to break them. This methodology provides a guideline for pricing the average project and provides a path back to the original business plan to allow for tweaking. For example if a potential opportunity to do $2M in business presented itself, you would know that your burden rates are all out the window and you would have to go back and re-plan, derive new rates and price accordingly. That is why it is important to understand the relationship between the pricing strategy and the business plan, as rigid adherence to either one will surely lead to disaster.