When your company produces and sells a product, the price you charge will have a direct effect on the success of your business. Though pricing strategy and computations can be complex, the basic rules of pricing are straightforward.
1. Prices must cover all costs. See SCORE Brief 4.05, Profit and Loss (P&L) Statement
2. The most effective way to retain or improve the profit margin is to reduce fixed and variable costs, and adjust price as necessary.
3. Prices may need to be increased or decreased to assure that they reflect changes of costs, market demand, and competition.
4. Competitive prices must be established to assure sales. Benchmark pricing against your competitors, but price to sell. Pricing of some products may be lower than cost (known as a loss leader) to create demand for products that can be priced at the desired profit margin.
5. Product utility, longevity, maintenance, and end use must be judged continually, and target prices adjusted accordingly
6. Prices must be set to preserve order in the marketplace. If you raise your prices because you want a higher profit or a bigger marketing budget, but the competition doesn’t follow suit, your price will not be consistent with the market.
THE RELATIONSHIP BETWEEN PRICES AND COST
Before you can set a price for your product you have to determine the costs of running your business. Revenue from the sale of your products and services must cover all of your expenses, no matter how or why they are incurred. If the prices you set for your products and services do not cover all your costs, you will have a negative cash flow and have to infuse cash into the business until your resources are depleted and your business fails. See SCORE Brief 4.09, Cash Flow Projections.
How much does it cost to run your business? You must add fixed costs (such as property/equipment leases, loan repayments, management cost, and depreciation) to the variable costs of raw material, inventory, utilities, and labor. See Score Brief 4.07, Balance Sheet.
You must also take into account other costs such as damaged goods and handling of returns, and desired profits to arrive at an initial price for your products and services. However, the most important aspect of cost versus price is that ultimately the market determines the price you may charge. Bottom line, successful pricing must be between your cost/breakeven point and the maximum price the market will allow. See SCORE Brief 4.13, Breakeven Sales.
COST PLUS PRICING DEMAND PRICING
COMPETITIVE PRICING MARKUP PRICING
Many manufactures use cost-plus pricing. The key to employing cost-plus pricing effectively is ensuring that the “plus” figure not only covers all overhead, but generates the desired percentage of profit as well. The following sample calculation should help you grasp the concept of cost plus pricing.
Formula for cost plus
Cost of materials $ 50.00
Cost of labor $ 30.00
Overhead (allocated/unit) $ 40.00
Total costs $ 120.00
Desired profit (20% on sales) * $ 30.00
Required sales price $ 150.00
To calculate the desired 20% profit on sales, simply divide total the costs by the difference between the desired profit (20%) and 1. (1-. 2=. 8) $120 /. 8= $150, the selling price.
Pricing a product
To price products, you need to be familiar with pricing structures, especially the difference between margin, markup and break-even. As mentioned already, every product should be priced to cover its production costs, packaging, freight charges, a proportionate share of overhead ( fixed and variable operating expenses), and a reasonable profit. Such factors as unpredictable insurance expense, theft, shifts in wholesale or raw material costs, freight expenses, and sales or discounts will all affect final pricing.
Margin, also referred to as gross margin, is the difference between your total sales and the cost of sales. It can be expressed as a percentage or a dollar amount. As a percentage, the GP margin is always stated as a percentage of net sales. It represents a percentage of the seller’s price.
(Total sales-Cost of sales) / Net sales = Gross profit margin %.
$5,000-$3,000 = $2,000 = .4 = 40 percent
Markup represents a percentage of the sellers’ costs. It is expressed as follows:
(Total sales – Cost of sales) / Cost of sales = Markup %.
$5,000 - $3,000 = $2,000 = .66 = 66 percent market.
Breakeven analysis is a method that indicates when revenues equal total cost. Your break-even point represents the point at which you neither make nor lose money in producing your product. It is expressed as follows:
Breakeven sales = (Fixed cost x Unit selling price)
(Unit selling price- Unit variable cost)
It is highly recommend that you get advice from your SCORE counselor or go to the library or search the internet (Google “Pricing”) to get as much information as possible on pricing. Pricing is not easy and can be very confusing if you are not familiar with pricing concepts and structure. Just remember, with any business that you start, the key to pricing is to find the price that (1) Customers are willing to pay, (2) is competitive in the marketplace, and (3) will produce the desired profit for your business.
Do not forget a very important rule: “Cash is King”.
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