Any and all pricing process, you must have a costing. But it is not every business that almost entirely bases its pricing on its costs, this is much more common in industrial activities, since the products developed usually have little differential between competitors. Thus, the cost ends up being the decider of the purchase decision of the customers.
See also: All About Pricing
What is Pricing?
The activity of pricing or pricing involves defining mathematical and also strategically, viable pricing and the method of charging for your products or services. In general, the issues involving pricing are fixed costs, variable costs, definition of contribution margin e point of equilibrium, competition analysis and positioning.
Continue reading about What is pricing?.
How to Price Based on Costs
This type of pricing is rather mathematical and focuses on being able to understand deeply and separate them in a conceptually correct way to get the most reliable results possible. Before going deeper into important examples and concepts, let's remember that any pricing has 5 steps:
- Cost Raising
- Point of Equilibrium Analysis
- Business Model Definition
- Competition Analysis
- Positioning and Strategy
By focusing on costs, you will likely deepen your 1 point a lot and also use the 2 point. However, the 3, 4, and 5 points should also be used as support to make final adjustments.
Fixed, Variable, Direct and Indirect Costs
We have a complete and thorough post on cost accounting, so here we will only quickly exemplify each concept.
Fixed Costs: Those that matter regardless of their production and sale. Typically, including rent and salary.
Variable costs: Those that charge according to their production and sale. We usually have raw materials, taxes, commission.
Direct Costs: Those that affect only one production line.
Indirect costs: Those that affect more than one production line and need to be correctly prorated.
Cost-Based Pricing Example
Now let's take a classic example to put theory into practice. Imagine that you have a small industry producing rewinds and screws.
Fixed Costs: In your industry, you have the rent of the shed in the amount of R $ 10.000,00 and salaries that total R $ 20.000,00
Variable costs: For each rebinboca, you spend R $ 0,30 on raw material and for each screw, R $ 1,00.
Direct Costs: The rebinboca is made in a machine that costs R $ 2.00 and the screw costs R $ 5,00 in its machine.
Indirect costs: However, both products go through the same machine to do their finishing. This machine can work 100 hours a month, costing R $ 1.000,00. That is, it costs R $ 10 / hour. For simplicity, let's say the bolt needs double the time to finish. So for each screw, let's say the cost is $ 10, that is, 1 machine time and for every rebinboca, only $ 5.00 (30min usage).
Thus, we arrive at the unit production cost of each piece:
- Rebinbocas: R $ 0,30 + R $ 2.00 + R $ 5.00 = R $ 7,30 per unit.
- Screw: R $ 1.00 + R $ 5.00 + R $ 10.00 = R $ 16,00 per unit.
Now, to finalize the sale price, you should do a break even analysis to see if you can pay fixed costs, profit and be competitive in your market!
Problems in Cost-Based Costing
In the example above, I have quite simplified some calculations and challenges to fit within the post and to focus on the main concept of cost pricing. However, in the real life of a business she has some problems that you will probably face:
- Costing and Inventory Management: In real life, the cost of raw materials is not stable and simple. You are always buying and conditions change. To ensure the correct cost, you must have good inventory management and use the correct costing method for your business.
- Complex Production Lines: Apportioning overhead costs is often very complicated. Sometimes many products use the same machine, you have to take into consideration that the machine itself varies its cost over the months due to maintenance problems, among other factors. This is the true art of the great industries.
- Overall Efficiency of Processes: This is another factor that will affect its cost, but it is invisible in a simple mathematical formula. Are your suppliers delivering on time? Is your storage generating losses? Do you have more stock than you need?
- Cost is not Value: It is tempting to get too addicted to cost numbers and forget that you have to generate value also to compete and innovate. From time to time, one should forget the number and understand and get to know their customers to think about new products and businesses.
Cost-based pricing is an essential part and a science apart in industries. It has a number of consolidated methods and must be done with determination for companies to remain competitive. However, it is neither easy nor simple, depending on the complexity of the business. In case you want to use our excel spreadsheets for this challenge, do not forget to meet them in our website!