Critical connection: How costs impact pricing
October 5, 2017
As we head toward year end, your company may be reviewing its business strategy for 2017 or devising plans for 2018. As you do so, be sure to give some attention to the prices you’re asking for your existing products and services, as well as those you plan to launch in the near future.
The cost of production is a logical starting point. After all, if your prices don’t exceed costs over the long run, your business will fail. This critical connection demands regular re-evaluation.
One simple way to assess costs is to apply a desired “markup” percentage to your expected costs. For example, if it costs $1 to produce a widget and you want to achieve a 10% return, your selling price should be $1.10.
Of course, you’ve got to factor more than just direct materials and labor into the equation. You should consider all of the costs of producing, marketing and distributing your products, including overhead expenses. Some indirect costs, such as sales commissions and shipping, vary based on the number of units you sell. But most are fixed in the current accounting period, including rent, research and development, depreciation, insurance, and selling and administrative salaries.
“Product costing” refers to the process of spreading these variable and fixed costs over the units you expect to sell. The trick to getting this allocation right is to accurately predict demand.
Deliberate over demand
Changing demand is an important factor to consider. Incurring higher costs in the short term may be worth it if you reasonably believe that rising customer demand will eventually enable you to cover expenses and turn a profit. In other words, rising demand can reduce per-unit costs and increase margin.
Determining the number of units people will buy is generally easier when you’re:
- Re-evaluating the prices of existing products that have a predictable sales history, or
- Setting the price for a new product that’s similar to your existing products.
Forecasting demand for a new product that’s a lot different from your current product line can be extremely challenging — especially if there’s nothing like it in the marketplace. But if you don’t factor customer and market considerations into your pricing decisions, you could be missing out on money-making opportunities.
Check your wiring
Like an electrical outlet and plug, the connection between costs and pricing can grow loose over time and sometimes short out completely. Don’t risk operating in the dark. Our firm can help you make pricing decisions that balance ambitiousness and reason.