How to make profit by pricing your products and services correctly
Using the cost-plus-profit calculation for pricing products
It is essential to know that your pricing allows a real profit. This is done through a cost-plus-profit calculation.
As marketing consultant Annemarie Hanlon observes: “I’ve found over the years that many people think they are adopting cost-plus pricing but often there is an additional factor which means they are actually making a loss on sales.
“While it’s important to make sure the cost-plus pricing is there, added to that is market pricing so that it is appropriate and feels right for that market.”
What do your costs include?
Depending on the nature of the product or service, and the method of producing or buying it in, your costs will include any or all of the following:
- Cost of stock or materials
- Employed labour
- General overheads
- Rent and council tax
- Repairs and renovations
- Storage, handling and packaging
- Transport and distribution
- Depreciation of capital equipment
- Insurance and interest charges
- Outsourced services (for example accounting and legal costs)
- Utilities (electricity, gas, water)
- Franchise fees or patent royalties
- Promotional and sales costs
- What else should you consider?
If you are selling into the retail trade, you need to find out what mark-up is added by the distributor/wholesaler and retailer in order to see what the price to the ultimate consumer will be.
For businesses that are on a basic level, such as working from home with no other staff and requiring little equipment and materials, this initial calculation is relatively straightforward. The more complex and large your business is, the more you will benefit from an accountant’s professional advice to ensure your budget is accurate.
Many factors influence sales. If you knew that you would be selling, say, a thousand widgets a week you could arrive at an exact cost per unit, to which you would add a profit margin. Sadly, it doesn’t work like that.
Sales will fluctuate according to market demand, the effectiveness of your promotional activities, seasonal variations and what the competition is doing. This means unit costs will vary, since your fixed costs will remain substantially the same no matter how many or how few sales are made.
In the extreme, if you sold only one widget in a week you would be placing your total costs on its price, which of course would be ridiculous.
Setting a price
So you can’t take cost-plus-profit in isolation in setting your prices. Also, in a start-up situation you will probably have to accept that there will be a development period during which the business will be operating at a loss.
You have to make a judgment decision on how much you can realistically charge, bearing in mind that in most cases it’s going to be more profitable to sell a lot at what is deemed to be a fair price than just a few at an exorbitant one.
You want to grow your business. To achieve that, the people who buy from you must be left with a feeling that they have received value for money and talk to others about it. The most valuable form of advertising for a new business is word-of-mouth from satisfied customers.
What’s known as marginal pricing is sometimes employed. This is where products are sold (or ‘dumped’) at a price below the full cost. It can make sense in some circumstances because, as long the price is greater than direct production costs, a contribution is made towards overheads.
You have to make a judgment decision on how much you can realistically charge.