PRICING YOUR PRODUCT OR SERVICE
One of the most difficult and most important decisions for managers to make is how to price the product or service they sell.
One popular approach is to take the direct costs, then add a factor like 15 percent for overhead and 10 percent for profit. Another system for developing pricing is to base the price on what competitors are charging, adjusting for quality differences. Still another is to use last years price, adjusted for inflation. Often, the price ends up being whatever the salesperson is able to negotiate.
One of the most powerful ways to determine pricing is by understanding your fixed and variable costs, and having an awareness of the market sensitivity to your sales price. This method is variously called 'Cost-Volume-Profit (CVP) Relationship', 'Operating Leverage','Contribution Margin',and 'Break-even' analysis. For purposes of this article, We will refer to the process as CVP analysis.
In order to work with CVP, you must obtain several numbers:
FIXED COST is the monthly cost of operating your business that doesn't vary with sales. Common examples of fixed costs are rent, office salaries, supervisor salaries, property tax, and depreciation. Note that fixed cost is only fixed over a relevant range of sales. For instance, if sales skyrocket, you would probably need bigger facilities, and you would have a new fixed cost structure.
VARIABLE COST is the direct cost of producing the product or service that you sell. These are the costs that vary with sales volume, like materials, supplies, shop labor, payroll tax and workers compensation insurance related to shop labor, salesperson commissions, and business license fees. Variable cost is expressed as a percentage of sales. For instance variable cost might be 60 percent of sales.
Use your income statement to determine these costs. Be sure to allocate each cost on your income statement to either fixed or variable. Some costs might seem to be partially fixed and partially variable. In this case allocate the cost to whatever is closest. Later on, you will be able to test your allocations against the actual results in order to see if your assumptions are correct. Also, keep in mind that CVP is only an approximation. In order to be more accurate, calculus would be needed.
Fortunately, a simple allocation between fixed and variable cost is usually sufficient to manage a business.
CONTRIBUTION MARGIN is the amount of each sale available to cover fixed expenses and provide a profit. Mathematically, contribution margin is equal to one minus the variable cost percentage. For instance, if the variable cost is 60 percent, the contribution margin is 40 percent.
OPERATING INCOME is equal to sales less costs (both fixed and variable).
After you have computed your fixed costs, your variable costs, and your contribution margin, you can start analyzing your company's profit structure in order to make decisions. Some of the calculations you can make are break-even point, sales required to reach a targeted operating income, and sensitivity analysis.
BREAK-EVEN POINT is the condition where sales are equal to costs (both fixed and variable), so that there is no profit or loss. Break-even can be calculated by dividing your fixed cost by the contribution margin. For instance, if the fixed costs are $30,000 per month, and the contribution margin is 40 percent, the break-even sales figure is $75,000 per month. ( $30,000 / .4 ).
SALES REQUIRED to reach a targeted operating income can be calculated by dividing the total of fixed costs plus targeted operating income by the contribution margin. For example, lets say that management feels $10,000 per month is an acceptable profit. If the fixed costs are $30,000 per month, and the contribution margin is 40 percent, the sales required would be $100,000. (($30,000 + $10,000) / .4).
EMPIRICAL TESTING means comparing the model of fixed and variable costs to the actual company financial statements. By doing this, you can develop reliance on your calculations.
SENSITIVITY analysis is the activity of changing the assumptions and reviewing the results. An example of this is exploring the consequences of lowering or raising the sales price per unit. In order to demonstrate this, assume that the product you make for variable costs of $6.00 normally sells for $10.00. This yields a variable cost expressed as a percentage of 60 percent.
What would happen if the sales price was increased to $12.00, and profit of $10,000 was still required? Instead of having to sell $100,000 per month, the company would only have to sell $80,000 per month; The new contribution margin is 50 percent. (($12.00 - $6.00)/ $12.00). The sales required is equal to (($30,000 + $10,000) / .5).
Similar calculations can be made to calculate sales required for other prices. For example, any of the following sales and price levels would yield a net income of $10,000;
80,000 units@$12.00/unit; 100,000units@$10.00/unit;
160,000 units@$8.00/unit; or 280,000 units@$7.00/unit
By making calculations similar to the above, and combining the results with your knowledge of the market's sensitivity to price, you can make an informed decision as to the best way to price your product or service.
Other uses for CVP are the decision to rent or buy, to enter a new market, start a new product, hire a new supervisor, or any other decision where fixed cost, variable cost, or sales volume might change. By understanding your fixed and variable costs, and having an awareness of market sensitivity to your sales price, you can maximize your company profit. In addition, you can reduce exposure to losses, and increase the long term staying-power of your company.