Pricing a product (Part II)
Technical note on pricing a product (Part II), with a focus on diagnosis, prevention and criteria applicable to professional pest management.
As mentioned, each product must be priced to cover production or wholesale costs, shipping charges, a proportionate share of overhead expenses, fixed and variable operating expenses, and a reasonable profit. Factors such as high overhead costs, particularly when renting in a major shopping center or other retail location, unpredictable insurance costs, shrinkage, theft, theft by employees or others, shipper errors, seasonality, changes in wholesale or raw materials, increases in production and shipping costs, and sales or discounts will all affect the final price.
General expenses
Overhead expenses refer to all non-labor expenses required to operate your business. These expenses are either fixed or variable.
Fixed expenses
Regardless of sales volume, these costs must be covered each month. Fixed expenses include rent or mortgage payments, depreciation on fixed assets such as cars and office equipment, salaries and associated payroll costs, liability and other insurance, utilities, membership and subscription payments, which may be affected by sales volumes, and legal and accounting costs. These expenses do not change, regardless of whether a company's income goes up or down.
Variable expenses
Most so-called variable expenses are actually semi-variable expenses that fluctuate from month to month in relation to sales and other factors, such as promotional efforts, changing seasons, and variations in the prices of supplies and services. In this category are expenses for telephone, office supplies, printing, packaging, mailing, advertising and promotion. When estimating variable expenses, use an average amount based on an estimate of the annual total.
Cost of goods sold
Cost of goods sold, also known as cost of sales, refers to your cost of purchasing products for resale or your cost of manufacturing such products. Transportation and delivery charges are included in this amount. Accountants segregate the costs of goods on an operating balance sheet because it provides a measure of the gross profit margin compared to sales, an important parameter for measuring business profit. Expressed as a percentage of total sales, the cost of goods varies from one type of business to another.
Normally, the cost of goods sold is closely related to sales. This will fluctuate, however, if increases in the prices paid for the merchandise cannot be offset by increases in sales prices, or if special price purchases increase profit margins. These situations rarely make a large percentage change in the relationship between cost of goods sold and sales, making cost of goods sold a semi-variable expense.
Determine the margin
The margin, or gross margin, is the difference between total sales and the cost of those sales. For example, if total sales equal $1,000 and cost of sales equals $300, then the margin equals $700. Gross profit margin can be expressed in dollars or as a percentage. As a percentage, gross profit margin is always expressed as a percentage of net sales.
The equation is: (Total sales – Cost of sales) / Net sales = Gross profit margin. Using the example above, the margin would be 70 percent.
When all operating expenses, rent, salaries, utilities, insurance, advertising, and so on, and other expenses are deducted from the gross profit margin, the remainder is net income before taxes. If the gross profit margin is not large enough, there will be little or no net profit from sales. If operating expenses are comparatively low, then a lower gross profit margin can still yield the owners an acceptable profit.
Some businesses require a higher gross profit margin than others to be profitable because the costs of operating different types of businesses vary greatly.
Trade margin and gross profit margin on a single product, or group of products, are often confused. The reason for this is that when expressed as a percentage, margin is always calculated as a percentage of the sales price, while trade margin is traditionally calculated as a percentage of the seller's cost.
The equation is: (Total sales – Cost of sales) / Cost of sales = Commercial margin. Using the numbers from the previous example, if you purchase goods for $300 and set a sales price of $1,000, your markup is $700. As a percentage, this commercial margin reaches 233 percent. In other words, if your business requires a 70 percent margin to show profit, your average trading margin will have to be 233 percent.
Although the trade margin may be the same in dollars, 700, they represent two different concepts as percentages, 233 percent versus 70 percent. More than a few new businesses have failed to make their expected profits because the owner assumed that if his trading margin is X percent, then his margin will also be X percent. This is not the case.
Price of a service
Definition: establish a sales price for a service. How should you set quotas or prices for your service business? Procedures depend on the business, but the same three elements must be considered for every service business: labor and material costs, overhead, and profit. These factors must be considered not only during startup but also during growth.
Labor and materials
Labor costs are wages and benefits paid to employees and/or subcontractors who perform, supervise or manage your service business. If you as the owner are involved in a job, then include the cost of your labor in the total labor charge. The cost of your labor will be quite significant during the start of the business, when most new owners put a lot of time and energy into their businesses.
Labor costs are generally expressed in an hourly rate. Check your library for official publications that list state and national salary ranges for different occupations. Editors of trade publications may also contain similar information. Current rates are often found in newspapers or available at your local chamber of commerce.
Labor can also be subcontracted, such as workers who are not on the payroll as employees. When labor is purchased for each job on a contract basis, the total cost is agreed upon in advance, which helps keep your costs fixed. The key is to carefully estimate the labor time it will take to complete each job you bid on.
Utility
Profit is the amount of income earned after covering all costs of providing the service. When calculating the price of a service, the profit is applied in the same number as the commercial margin on the cost of a product. For example, if the labor costs for a job are $210 and you plan for 21 percent net before taxes on your gross sales, you will need to apply a profit factor of about 25 percent to your labor and overhead expenses to achieve your goal. For example, let's say you have an operating cost subtotal of $324 and you want to have a profit of 81, so you quote the price to the customer at 405.
If you compare the price of 405 with the already estimated labor cost, 210, you will notice that one amount is more than double the other. Some contractors use this ratio as a basis for determining price: they estimate their labor costs and double the quantity to arrive at the bid price.
Setting a price can be time-consuming, especially if you are not good at it. Some contractors seem to have a sixth sense when it comes to pricing and estimate or guess what they need to quote to make a job profitable for them. If you're just starting out, you obviously won't have the skill of an already experienced professional.
If your quote is too low, you will either rob yourself of your profits or be forced to lower the quality of your work to meet the price. If the estimate is too high, you may lose a contract, especially if you are in a competitive bidding situation. Make it vital for you to learn how to estimate labor time accurately and how to calculate your overhead properly so that when you quote a price you can be competitive, profitable and successful.