Financial Management: How To Make a Go Of Your Business 6

VI. Pricing Policy

Identifying the actual cost of doing business requires careful and accurate analysis. No one is expected to calculate the cost of doing business with complete accuracy. However, failure to calculate all actual costs properly to ensure an adequate profit margin is a frequent and often overlooked cause of business failure.

Establishing Selling Prices

The costs of raw materials, labor, indirect overhead, and research and development must be carefully studied before setting the selling price of items offered by your business. These factors must be regularly re-evaluated, as costs fluctuate. Regardless of the strategies employed to maximize profitability, the method of costing products offered for resale is basic. It involves four major categories:

• Direct Material Costs
• Direct Labor Costs
• Overhead Expenses
• Profit Desired

Combining these factors allows you to calculate an item's minimum sales price, which is described below:

1. Calculate your Direct Material Costs. Direct material costs are the total cost of all raw materials used to produce the item for sale. Divide this total cost by the number of items produced from these raw materials to derive the Total Direct Materials Cost Per Item.
2. Calculate your Direct Labor Costs. Direct labor costs are the wages paid to employees to produce the item. Divide this total direct labor cost by the total number of items produced to get the Total Direct Labor Cost Per Item.
3. Calculate your Total Overhead Expenses. Overhead expenses include rent, gas and electricity, telephone, packing and shipping, delivery and freight charges, cleaning expenses, insurance, office supplies, postage, repairs and maintenance, and the manager's salary. In other words, all operating expenses incurred during the same time period that you used for calculating the costs above (one year, one quarter, or one month).
   Divide the Total Overhead Expense by the number of items produced for sale during that same time period to get the Total Overhead Expense Per Item.
4. Calculate Total Cost Per Item. Add the Total Direct Material Cost Per Item, the Total Direct Labor Cost Per Item, and the Total Overhead Expense Per Item to derive the Total Cost Per Item.
5. Calculate the Profit Per Item. Now, calculate the profit you determine appropriate for each category of item offered for sale based on the sales and profit strategy you have set for your business.
6. Calculate the Total Price Per Item. Add the Profit Figure Per Item to the Total Cost Per Item.

A Pricing Example

You produce skirts that take 1 1/2 yards of fabric per skirt, and you can manufacture three skirts per day. The fabric costs $2.00 per yard. The normal work week is five days. If you complete three skirts per day, your week's production is 15 skirts.

1. Calculate Direct Materials Cost

Materials Cost
Fabric for 1 week's production:
15 skirts x 1 1/2 yds. each = 22 1/2 yds. x $2 per yd. $45.00
Linings, interfacings, etc.:
$.50 per skirt x 15 skirts                               7.50
Zippers, buttons, snaps:
$.50 per skirt x 15 skirts                               7.50
Belts, ornaments, etc.:
$.75 per skirt x 15 skirts                              11.25
Notions, seam binding, etc.:
1 week's supply                                          5.00
                                                       ------
Total Direct Materials Cost:                           $76.25 per week
Total Direct Materials Cost per week =                  $5.08 Direct Materials
                                      ------------------------------------

Cost per skirt                                    15 skirts per week

2. Calculate Direct Labor Costs

Wages paid to employees =                                    $100.00 per week
Total Direct Labor Cost per week =                             $6.67
Direct Labor Cost -------------------------------- per skirt 15 skirts

3. Calculate Overhead Expenses Per Month

Overhead Expenses Monthly Expenses
Owner's Salary                    $400.00
Rent                               100.00
Electricity                         24.00
Telephone                           12.00
Insurance                           15.00
Cleaning                            20.00
Packing Materials and Supplies      15.00
Delivery and Freight                20.00
Office Supplies, Postage            10.00
Repairs and Maintenance             15.00
Payroll Taxes                        5.00
                                  -------
Total Monthly Overhead Expenses:  $636.00
15 skirts per week x 4 weeks in one month = 60 skirts per month.
Total Monthly Overhead Expenses =  $10.60 Overhead Cost
          ------------------------------- per skirt
                                          60 skirts per month

4. Calculate the Total Cost per Skirt by adding the total individual costs per skirt calculated in the three preceding steps.

Total Direct Material Cost per Skirt $ 5.08
Total Direct Labor Cost per Skirt      6.67
Total Overhead Expense per Skirt      10.60
                                     ------
TOTAL COST PER SKIRT                 $22.35

5. Assume you want to make a profit of $5.00 per skirt.

6. Calculate the Total Price Per Item:

Total Cost per Skirt          $22.35
Total Profit per Skirt          5.00
                              ------
Total Selling Price Per Skirt $27.35

The Retailer's Mark-Up

A word of caution is in order regarding the popular but misunderstood pricing method known as retailers mark-up. Retail mark-up means the amount added to the price of an item to arrive at the retail sales price, either in dollars or as a percentage of the cost.

For example, if a single item costing $8.00 is sold for $12.00 it carries a mark-up of $4.00 or 50 percent. If a group of items costing $6,000 is offered for $10,000, the mark-up is $4,000 or 66 2/3 percent. While in these illustrations the mark-up percentage appears generally to equal the gross margin percentages, the mark-up is not the same as the gross margin. Adding mark-up to the price merely to simplify pricing will almost always adversely affect profitability.

To demonstrate, assume a manager determines from past records that the business's operating expenses average 29 percent of sales. She decides that she is entitled to a profit of 3 percent. So she prices her goods at a 32 percent gross margin, in order to earn a 3 percent profit after all operating expenses are paid.

What she fails to realize, however, is that once the goods are displayed, some may be lost through pilferage. Others may have to be marked down later in order to sell them, or employees may purchase some of them at a discount. Therefore, the total reductions (mark-downs, shortages, discounts) in the sales price realized from selling all the inventory actually add up to an annual average of six percent of total sales. To correctly calculate the necessary mark-up required to yield a 32 percent gross margin, these reductions to inventory must be anticipated and added into its selling price. Using the formula:

                  Desired Gross Margin + Retail Reductions
Initial Mark-up = ----------------------------------------
                      100 Percent + Retail Reductions

                             38 percent            35.85 percent
32 percent + 6 percent = ----------------------- = -------------
                         100 percent + 6 percent   106 percent

To obtain the desired gross margin of 32 percent, therefore, the retailer must initially mark up his inventory by nearly 36 percent. Pricing Policies and Profitability Goals Break-Even Analysis, discussed in Chapter IV, and Return on Investment, described in Chapter III, should be reviewed at this time. Remember, all costs (direct and indirect), the break-even point, desired profit, and the methods of calculating sales price from these factors must be thoroughly studied when you establish pricing policies and profitability goals. They should be understood before you offer items for sale because an omission or error in these calculations could make the difference between success and failure.

Selling Strategy

Proper product pricing is only one facet of overall planning for profitability. A second major factor to be determined once costs, break-even point, and profitability goals have been analyzed, is the selling strategy. Three sales planning approaches are used (often concurrently) by businesses to develop final pricing policies, as they strive to compete successfully.

In the first, employed as a short-term strategy in the earliest stages of a business, the owner/manager sells products at such low prices that the business only breaks even (no profit), while trying to attract future steady customers. As volume grows, the owner/manager gradually builds in the profit margin necessary to achieve the targeted Return on Investment."Loss leaders" are a second strategy practiced in both developing and mature business. While a few items are sold at a loss, most goods are priced for healthy profits. The hope is that while customers are in the store to purchase the low-price items, they will also buy enough other goods to make the seller's overall profitability higher than if he had not used "come-ons." The seller wants to maximize total profit and can sacrifice profit on a few items to achieve that goal. The third strategy recognizes that maximum profit does not result only from selling goods at relatively high profit margins. The relationship of volume, price, cost of merchandise, and operational expenses determines profitability. Price increases may result in fewer sales and decreased profits. Reductions in prices, if sales volume is substantially increased, may produce satisfactory profits.

There is no arbitrary rule about this. It is perfectly possible for two stores, with different pricing structures to exist side by side and both be successful. It is the owner/manager's responsibility to identify and understand the market factors that affect his or her unique business circumstances. The level of service (delivery, availability of credit, store hours, product advice, and the like) may permit a business to charge higher prices in order to cover the costs of such services. Location, too, often permits a business to charge more, since customers are often willing to pay a premium for convenience.

The point is that many considerations go into setting selling prices. Some small businesses do not seek to compete on price at all, finding an un- or under-occupied market niche, which can be a more certain path to success. What is important is that all factors that affect pricing must be recognized and analyzed for their costs as well as their benefits.