Pricing products and services for profit

What is Variable Costing?

Every business owner, sooner or later has to consider what to charge for products and services.

There are many great marketing works on pricing strategies and tactics – which are interesting, but ultimately prices settle at what the customer is willing to pay dependent upon the value they perceive the product has to them.

Marketing is about building your customer’s perception of value, but what’s important to you is that you can deliver the product or service at the price the customer wants and you can afford.

In a nutshell, if you don’t know what it costs to produce your products, how do you know that you are not selling it at a loss? (The sales price does not exceed what it costs you to make).

This is where variable costing comes in. Your desire to make a decision about prices means that you need to verify information about costs.

Pricing products

Variable Costing – Key Concepts

Thinking about costs quickly raises some issues that need to be addressed in any costing system. Some costs can be directly attributed to activities. Some cannot.

Direct Costs

Direct costs are costs that can be directly attributed to an activity on a product or service.

For example, the time I spend assembling a chair can be measured, and attributed to that particular product. If it takes me 30 minutes for each chair, and I get paid $15 an hour, then you can deduct the assembly (labour) cost to be $7.50 – half an hour’s worth of $15.

A classic example of direct costs is raw materials. If the wood required to build the chair costs $10 per chair, then cost of materials for constructing the chair is a direct cost of $10.

From these examples we can now at least attribute $7.50 labour cost and $10 materials cost to the chair = $17.50.

Indirect Costs

Indirect costs are costs which are not directly attributable to a specific product.

For example, if you rent a warehouse for the storage of your finished goods, then the cost of that warehouse is attributable to all products.

If you lease a car for your production supervisor, then the cost is borne by the business, but not by any specific products.

The Variable and Fixed nature of costs

Some costs are naturally direct and variable to the production activity being undertaken. Like labour and materials.

Other costs do not move directly in relation to production, but are fixed in nature such as the cost of production machinery, or buildings rent. When the indirect fixed costs of production, are incorporated into the product costing, this is known as absorption costing

It is important to recognise that even fixed costs have a semi fixed nature in the fact that at some time if your business wants to produce more, it will have to acquire a new machine, or a new factory.

Profit Contribution

Making a profit contribution is one of the fundamental ideas behind variable costing. If you are in business, then at the very least, every product that is sold should contribute to the fixed overheads of the business

Profit Contribution = Sales Value – Direct Costs

If contribution is not greater than zero, then the business is not even covering it’s directly variable overheads. This is a very unhealthy place to be. It is the core objective of any variable costing that each sale be in a profit contributing position

Monitoring Gross Profit Margin at an invoice or customer level is an effective way to keep tabs on this key measure

Cost Plus Pricing

Cost plus pricing is a widely used method of computing prices. This is because of the guarantee that the computed selling price will be greater than the costs of the product.

Typically, a business will compute the cost and add a mark-up. This approach also guarantees a profit contribution to fixed overheads that cannot be directly attributed to the product.

For example:

Direct Materials$15.00
Direct Labour$22.00
Machine Overhead$11.00
Manufacturing Cost$48.00
Mark up (35% * $48)$16.80
Selling Price$64.80

There are a couple of well known limitations to this method of computing prices. The first is that there is no guarantee that your cost plus pricing will be competitive in the market place.

Secondly, cost plus pricing doesn’t take market demand into account.

This is best demonstrated by refering to the situation when Sony or Microsoft release their very latest games consoles, and can’t produce them fast enough to satisfy demand. At this time in the product pricing cycle, demand is high, and we all know from experience that the first couple of thousand people to buy the latest thing are going to pay more than the rest of us.

For Microsoft or Sony though, it’s highly likely their production cost + normal profit margin would not come out anywhere near these early prices

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