Maybe you saw my recent blog about the cafe customer who thought £2 was too much to pay in a cafe for a cup of hot water and a thin slice of lemon? The point was that the actual cost of the service in providing the product was much more than the direct cost of the product itself.
I’d like to just explore a little more the mechanics of how you price your product or service. Are you really getting it right?
First of all, there’s direct costs. Depending upon what your product is, this may be the easiest part. If the components of making it are X, then the direct costs will be X plus the cost of the time of the person who makes or processes it, plus the costs of packaging and delivery. In fact, it’s anything that you can point to and say that it was directly attributable to the expense of creating that item. This will usually be shown in your accounts under the headings ‘Sales’ and ‘Costs of Sales’. So far, so good – although of course it’s much more difficult to quantify if what you’re selling is essentially a service.
So, where do you go from there? Well for a start, I used the expression the ‘cost of time’ of the personnel involved. This can be a tricky one and for that reason you often see salaries and wages shown as an overhead instead of a direct cost. Why? because unless you can say that a worker’s time is related solely to the volume produced, it’s very difficult to assign what proportion of the time relates to which part of productive activity. It works if you’re operating an assembly line style of production, or if you have workers who are paid on a commission basis. However, even so, if you want to attribute workers’ time as a direct cost, then you have to consider what is the true cost of that time, because it’s more than what you pay them!
There are various ways in which your costs and expenses can be shown in your accounts and particularly in your management accounts and much depends on the level of detail you want to have and what information is useful in your business.
Returning to how you get from the direct cost of the product to what you sell it for, we come onto overheads. These are, in essence, items which you have to pay for, but which can’t be assigned specifically to individual products or to volume of production. For example, salaries (where these are not a direct cost, as explained above), national insurance and workplace pensions (and any other employee benefits) rent, rates, maintenance, light, heat, insurance, training and recruitment, marketing, stationery, equipment, professional services – the list goes on and on! The significant point is that whereas direct costs should rise and fall in line with turnover, overheads will, to a large extent, remain constant irrespective of turnover. In fact, that is really what defines a direct cost.
So, with this information, how do you arrive at the appropriate sale price? In my previous blog, the cost of £2 for a cup of hot water and a slice of lemon was explained by the fact that the customer was buying, not just the water and lemon, but the attendant’s services. So one way of looking at pricing based on cost is to work out exactly what it costs you to be in business, stay in business and make a profit. You then have to allocate a proportion of that to every item you sell – easier said than done! In many sectors, there is a recognised mark-up and in some sectors this can be as high as 400% of direct costs. Again in order to operate this you need to know what your direct costs are! Easy if you’re buying in wholesale and selling retail – not quite so easy in other sectors.
Even using a specific mark-up, you’ll still need to make sure that your overheads (and your profit element) sit within the parameters of the mark-up. In my experience, failing to keep a strict check on overheads is one of the quickest ways to business disaster, so do make sure you monitor these on a month-by-month basis.
And finally do, please, make sure that you’re not selling too cheaply! It simply isn’t worth it.
Do let me know how you manage your pricing/costing strategy.