Two tasks for any new business are estimating the potential sales volume, the amount you think you can sell in the first year, and estimating the sales price. These can be difficult tasks. New business owners are often surprised to learn that formulas exist that can be of help in both of these areas. However, formulas are much the same as computers, “garbage in, garbage out.” That is, the answers are only as good as the assumptions and information used.
Why are these two issues so often difficult in the new business venture? For one thing, the new business owner often lacks good information about the cost of the new product if it is one that will be manufactured in his/her business rather than purchased. The new business does not have information about the market place that is normally brought in by actually selling a product in the market. The new business also can lack any market clout – it must be a follower and not a leader in pricing.
A firm that is offering a product at a lower margin may do so because of capacity issues or because the product is complimentary to another product the firm is selling. The product you are selling may have a rival product that is well established in the market place with many recognized features and benefits. To set the price of your product the same as that one may not work, because your product is new and is not recognized by consumers as having the same or superior features and benefits. The goal in setting prices should be to maximize profit as well as gain a share of the market place. As a small manufacturer, you should not compete on the basis of price alone unless you are the low cost producer. That, for a new business, is difficult to know.
Basic Rules of Pricing
Pricing of products is a part of marketing strategy. You may want to set a lower-thanmarket place price to gain market share and to introduce your product. Your goal may be to maximize profits. The three factors of profits are cost, selling and the unit sales volume, in the proper proportions.
Pricing should be considered as part of the marketing mix of product performance, quality, delivery time, features and benefits unique to your product, and other advantages you believe you have over your competitors.
Good pricing requires an understanding of influence in market factors, the economy, technology, competition and resources, and the internal cost of your business. Internal costs include (but are not limited to) labor, material, overhead and interest. As any of these conditions change, prices may also change. The point is this: There is more to pricing than just internal costs. The market sets a price ceiling. The ceiling is, in effect, the maximum price you can set for your product and still compete in the market place against similar products.
Two factors are important in determining pricing. One, the market most likely will determine the pricing at which your product will sell. Two, your internal costs and profit goal can be used to establish a price floor. This is the lowest price that you can set and still make a profit.
The difference between the price ceiling, established by the market, and the price floor, established by internal costs and profits, is the “relevant price range.” Your challenge is to provide a competitive product priced within that range.
How to Compute Price Based on Cost – Setting the Price Floor
Several methods of cost based pricing will be discussed with examples. Before that, however, you must understand the difference between margin and markup. You will hear both terms. The manufacturer often talks about margins, and the retailer or wholesale talks about markups.
Margin and Markup
Many a business fails to make an expected profit because its owner figures his percentage of margin on the cost of goods. He assumes that the percentages of margin and markup on cost are the same. This confusion is not strange, because both margin and markup in dollars are identical. The percentages, however, are different. Both represent the difference between cost of merchandise and selling price.
Selling price covers the cost of merchandise plus all expenses of operation and net profit. The selling price is always 100 percent because it is the total amount of money a business is going to get from the sale.
Margin is always figured on the selling price. It is a percentage of sales.
Example
Suppose we buy an article for $1.20 and sell it for $1.60. The margin is 40 cents, which is one-fourth or 25 percent of the selling price. Therefore, our margin on this article would be 25 percent.
Markup can be computed as either a percentage of cost or of selling price. Although many consider markup a percentage of the selling price, retailing authorities point out that figuring markup on the cost price is easier and less confusing in everyday pricing. The important thing to keep in mind is that when markup is figured on the selling price, a different markup percentage must be used than when figuring the markup on the cost price. Otherwise, the anticipated margin will not be attained.
Example
Suppose we buy an article for $1.20 and wish to sell it on a markup of 25 percent. What must the selling price be? The markup of 25 percent times the cost of $1.20 equals 30 cents. Add the 30 cents to the cost price of $1.20, and we have a selling price of $1.50 with a margin of 30 cents, or 20 percent. However, if we want to mark up the article so that we have a 25 percent margin, we must first determine the percentage that will yield the desired margin when applied to the cost price. Looking at the Markup Table which follows, we see that a 25 percent margin is equivalent to a 33 1/3 percent markup on cost. Multiplying 33 1/3 percent times the cost, $1.20, equals 40 cents. Adding 40 cents to the cost prices gives us a selling price of $1.60.
However – A markup on cost of 25 percent gives a selling price of $1.50.
Therefore, we must have a margin of 25 percent to cover the cost of operation and net profit. We would be losing money by pricing merchandise on the basis of a 25 percent markup on cost! To realize a 25 percent margin, we would have to use a markup of 33 1/3 percent on the cost price.
The following table shows what the markup on the cost must be to give the desired margin in a number of more common cases. To use this table, find your margin or gross profit percentage in the left-hand column. Multiply the cost of the article by the corresponding percentage in the right hand column. The result added to the cost gives the correct selling price.
|
Margin Percent of Selling Price |
Markup
Percent of Cost |
Margin Percent of Selling Price |
Markup Percent of Cost |
Margin Percent of Selling Price |
Markup Percent of Cost |
|
4.8 |
5.0 |
17.5 |
21.2 |
30.0 |
42.9 |
|
5.0 |
5.3 |
18.0 |
22.0 |
31.0 |
44.9 |
|
6.0 |
6.4 |
18.5 |
22.7 |
32.0 |
47.1 |
|
7.0 |
7.5 |
19.0 |
23.5 |
33.0 |
49.3 |
|
8.0 |
8.7 |
20.0 |
25.0 |
34.0 |
51.5 |
|
9.0 |
9.9 |
21.0 |
26.6 |
35.0 |
53.8 |
|
10.0 |
11.1 |
22.0 |
28.2 |
36.0 |
56.3 |
|
10.7 |
12.0 |
22.5 |
29.0 |
37.0 |
58.7 |
|
11.0 |
12.4 |
23.0 |
29.9 |
37.5 |
60.0 |
|
11.1 |
12.5 |
23.1 |
30.0 |
38.0 |
61.3 |
|
12.0 |
13.6 |
24.0 |
31.6 |
39.0 |
639 |
|
13.0 |
14.9 |
25.0 |
33.3 |
39.5 |
65.3 |
|
14.0 |
16.3 |
26.0 |
35.1 |
40.0 |
66.7 |
|
15.0 |
17.6 |
27.0 |
37.0 |
41.0 |
69.5 |
|
16.0 |
19.0 |
28.0 |
38.9 |
42.0 |
72.4 |
|
17.0 |
20.5 |
29.0 |
40.8 |
43.0 |
75.4 |
Formulas
Which formula to use depends on what information you have to determine the price. If
you are talking to the retailer, who says he or she wants to have a 30 percent margin on
sales, use formula A. If you know what contribution margin you want but need to know if
the margin will give you a sales price within the relevant range and an acceptable
markup to the retailer, use the formula B.
Formula B: Percentage Margin on Selling Price
Percent Margin = 100% Markup on Cost/(100% + % Markup on Cost)
Note: markup on the selling price is equal to the contribution or gross profit margin per
product
Use this formula when you know the total cost of your product with profit and you know
the contribution or gross profit margin you want to attain.
For example, in the above example, we bought an item for $1.20. We wanted to have a 25 percent contribution margin based on sales price left from the sale after paying expenses. What should the price be? There are two ways to work the problem. One, look up the markup percent in the table above. The second way is to use our formula B.
Percent Markup on Cost = 25/(100-25) *100 = 33.3%.
Price = 1.20+(1.20*.333) = $1.60.
Does this give you the desired contribution margin of 25 percent?
Sales = $1.60
Less: Cost = 1.20
Contribution = .30
Contribution Margin = .30/1.60 *100 = 25%
So a markup on cost of goods of 33.3 percent provides us with a gross margin based on
sales of 25 percent.
Formula A: Percentage Markup on Cost
Percent Markup = % Markup on Selling Price/(100%-%Markup on Selling Price)
In this case, if the retailer says he/she wants a 33.3 percent markup on the sales price, how can you compute a sales price? Again assume you know the cost of goods, which is $1.20.
Percent Markup on Cost = 33.3/(100-33.3) = 33.3/67.3 = 50%.
The price is then $1.20 +(1.20*.50) = $1.80.
Does that price put you in the relevant range?
Price Ceiling
Two basic methods to determine the price ceiling are trial and error in the market place or market research. The trial and error approach requires that the product be introduced to the market place to see what the customer will pay for it. A mistake you do not want to make is to put the product on the market at a low price, which squeezes your margins. You often will find it easier to lower your price at a later date than to raise it. Consider putting the product on the market with higher margins. Then if the market will accept the product at that price, you will make extra money. If not, you can lower the price to try to determine where the product will sell. This practice is simply more favorable in consumers’ eyes.
Market research, however, may prove to be more costly and time consuming. Will it be less expensive and easier to actually make a small amount of product and do test pricing in the market place than to use market research techniques? Most small firms find it more reasonable to try the market introduction approach. Even then, you will find market research is necessary to see how competitive products are priced and what is happening as a result. That information should be discovered during your competitor
analysis.
What alternatives do you have if the market will not take your product at the price you have set? There are several basic options to explore. One is to lower the price. Will that price still cover costs and allow for an acceptable margin? If not, then you have the option to not make the product. Another option is to reduce your costs so the price does cover costs. This may require changes in packaging, delivery, portion size, etc.
Another option is to accept the lower margin, even though you do not make a profit. You may choose to accept the lower cost if the price will cover cost of goods and still contribute to paying overhead costs. The assumption here, of course, is that you have other acceptable products and that this particular product is needed or required in your
product line.
Another option, if the market place will not accept your price, is to somehow differentiate your product from your competitors. You are trying to make customers recognize your product as one they will pay a higher price to have. Price sensitivity comes into play with differentiation or trying to raise price. That is, the less sensitive the buyers are to prices when purchasing your product, the more likely they are to buy at a higher price. For example, if a substitute product is readily available, a customer may choose the lower priced competitor’s product. But if there is no close substitute, then the customer may be willing to pay a higher price. Also, if the purchase is not a major budget item, there is less price sensitivity. Finally, if the buyer buys your product on an infrequent basis, then price may be less of an issue.
Keep in mind that products are bought on the basis of perceived value in the minds of the buyers and not on the basis of what it costs you to produce the products. Your challenge, then, is to produce a product at a price equal to or below the buyers’ perceived value for your product.
Pricing Examples
These examples are approached from the aspect of four elements of pricing: direct costs, manufacturing overhead, non-manufacturing overhead and profit. With these costs, the assumption is made that the contribution margin can be determined. Often, however, the new venture has difficulty determining all costs to determine the contribution margin required. In that case, a way to approach the issue is to use the gross margin from one of two sources: Robert Morris Annual Statement Studies, a compilation of financial ratios for retail, wholesale and manufacturing industries, compiled from company financial statements; or the IRS Corporate Financial Ratios, by Schonfield and Associates. Most banks and libraries will have a copy of the Robert Morris book.
Cost Based Approaches to Pricing Using Contribution Margin
The price can be set using several approaches based on which cost input has higher or
equal value, labor, raw material or contribution per pound.
Example 1
You determine your desired contribution margin (gross profit margin) is 30 percent. The
cost of material is $10 per pound and direct labor cost is $10 per hour. If you want a 30
percent contribution margin, the price would then be $10 +$10/60%. Direct labor and
material is 60 percent of the selling price. So the price is $33.33. Proof is this way:
$33.33- 20.00 = 13.33. Contribution margin of $13.33 divided by sales price of $33.33 equals the desired 40 percent.
Example 2
If the value of the material is high or material is the limiting factor, a contribution margin
can be established for material. If the labor is the limiting factor or if labor can not be
fully utilized at all times, then a fixed contribution margin per labor hour may be desired.
Here is an example based on pounds.
Determine a mark-up on percentage based on price per pound. If the material cost is $5
per pound, and a contribution of $2 per pound is required. Then contribution as a
percentage of pounds is 2.00/5.00 = 40%. The mark-up on factor to use for pounds is 40
percent.
Material cost = $5.00
Labor cost = $3.00
Total = $8.00
Plus Contribution = $2.00
Total price = $10.00
Market conditions will affect pricing decisions, but pricing based on costs will help you maximize your profits.