Product pricing is a critical business skill to develop. You must be able to strike a balance among a number of factors including direct costs, staff costs, overheads, profitability and market influences. In this article, we will make a fast survey of these elements so you will have a working knowledge of the framework for pricing based on costs, then look more closely at these issues in Pricing Part II – Measuring Market Influence.
Direct costs, also known as variable costs, are those costs that are directly attributable to making or buying a product. In general, the direct cost varies in direct proportion to the product produced or purchased. Although we understand that you probably do not produce the products that you sell, we'll walk through one production example then, for the rest of this article, assume that you are purchasing goods for resale, rather than manufacturing goods for wholesale or retail sale.
If you sell bookshelves that you make, the direct costs associated with making wooden bookshelves might be:
- Nails, glue, other fastening materials
- Finishing materials
- Packaging if required
Each time you make a bookshelf, you need a unit of each of these materials, i.e., the cost varies directly with the number of units produced.
If you are purchasing bookshelves and storing them for resale, the direct cost will be the price of the bookshelf purchased from the wholesaler or manufacturer plus the cost of shipping.
If you are purchasing bookshelves from a drop shipper, the shipping cost will be a pass-through, i.e., passed through to the customer so your cost will be the cost of the product plus any per piece transaction fee.
If you are selling on eBay, you will have a cost per sales transaction that should be considered a direct cost.
If you are importing the product from another country, you may pay a duty per piece, such as a 10% duty and some additional tax such as VAT. These importation costs are direct costs.
The term indirect cost essentially refers to anything that's not a direct cost. Indirect costs can also be referred to as semi-variable, fixed or overhead costs.
Indirect costs represent the expenses of doing business that are not readily identified with a particular product but are necessary for the general operation of the business.
Fixed costs are those costs that will exist regardless of the volume of products you purchase and sell. For example, the cost of maintaining your website is generally a fixed cost. Other fixed costs could include ISP fees, business insurance and accounting fees.
Another way to look at fixed costs is to think about the costs that a business incurs even if it is not buying and selling any products. Even if you sell nothing on your website, you will continue to have the cost of maintaining that site.
The term 'overhead cost' is often used interchangeably with the term 'fixed cost' although there is a distinction to be made. Fixed costs tend to remain whether or not you are selling, such as the website costs mentioned above. Overhead costs can sometimes be modified. For example, online traders' overhead costs include ISP costs, merchant account fees, paid advertising and so on, generally fixed costs. On the other hand, office supplies, education and travel are also considered overhead costs but those costs can be reduced if your site is not selling much merchandise. For our purposes, we will make no distinction between fixed and overhead costs; they will be treated in the same way (You will sometimes see these costs referred to as G&A – general and administrative costs).
Semi-variable costs are those costs that vary with your business needs but not in a directly proportional way. For example, if you have a clerical person who helps you with website maintenance, customer service and other administrative duties, that person is basically a fixed cost although there may be some variability associated with that cost. If sales plummet, you may ask that person to take some unpaid time off, essentially varying the cost of the assistant with the revenue generation of the business. On the other hand, if order filling demand continues to increase, you may have to add hours to your employee's work schedule. This cost is semi-variable because you can vary the cost of additional workers somewhat but in order to keep reliable helpers, you need to provide a somewhat steady or fixed schedule. Personnel costs are generally considered semi-variable. (There are times when worker costs are variable as in when you pay someone by the piece.)
You may be saying, ''Wait, how does my compensation fit in?'' You as the owner can be paid in one of several ways. One of the most common is for you to be paid a 'draw', that is, your compensation is drawn from the profits, meaning that your compensation rises and falls with the health of the business. Alternatively, you may provide yourself a salary (usually when you are setup as a limited liability company), in which case your salary will be considered an overhead cost. For the purposes of pricing, even if your compensation is a draw from the business, you should estimate what you would like that draw in order to establish product pricing.
Of course, you are interested in realising a profit when you sell your products. The profit is the amount of money left over after all expenses are paid. Profit expectation is extremely variable and has a lot to do with the typical profit available within your sector of the marketplace, your personal profit plans, your ability to minimize costs, etc.
The Pricing Formula
In general, the pricing formula for a product looks like this:
Direct cost + % overhead costs + profitability % desired = Price
Very simply, if you are an online trader selling CDs and DVDs using a drop shipper, your pricing formula may look like this:
$2/CD or DVD plus 5% transaction fee (eBay, credit card) on price
Merchant account monthly fee, website host, online advertising, high speed connection, telephone, ofc supplies, prof svs = $400/month
You sell 1000 disks/month. Therefore, the overhead cost/disk = $400/1000 = $.40/disk.
You plan to pay yourself a salary of $3,500/month or hope to draw $3,500 per month from the business or $3.50/disk
You are hoping for approximately 50% profitability. (We will discuss issues related to profitability in much greater detail in Part III – Profitability in Pricing.)
Cost category Cost
CD cost $2.00
Total Cost $6.90
50% profitability $3.45
5% Transaction fees $0.52
Final price $10.87
Your selling price for a disk should be around $10.87. Now you need to figure out if you can actually sell your disks at that price. Move on to Pricing Part II – Market Influences in Pricing.