12.03 – Accounting for Pricing
Setting a selling price for your products is one of the most important and frequent business decisions you need to make. It might seem straightforward at first glance: add up all the costs, add a healthy profit margin, and you’re set as long as customers are buying. However, this process can be more complicated than it appears.
Understanding Costs
Complications arise when you consider the characteristics of different costs. Not all costs behave the same way. For example, the rent on a shop, office, or workshop is a fixed cost, payable monthly or quarterly. Your landlord doesn’t usually expect more rent if you get more customers, nor is he especially generous during lean periods. Business rates on any premises and the cost of an advertisement in the local paper are also fixed costs. These costs don’t vary directly with the volume of sales but are regular expenses.
In contrast, the cost of the products you plan to sell is a variable cost. Assume you’re selling a bottle of wine that costs £3 to buy. The more you sell, the more your stock costs. Variable costs change with the volume of sales, making them easier to adjust in your pricing strategy.
Breakeven Analysis
The main tool that helps with pricing decisions is breakeven analysis. This tool helps you set the best price for single or multiple products, see how much you have to sell to hit your profit goals, and handle price changes.
Breaking Even
Let’s simplify: imagine your business sells only one product, wine, and you have one fixed cost, the rent. Figure 13-8 provides a graphical picture of how your costs stack up. The vertical axis shows the value of sales and costs in thousands, and the horizontal axis shows the number of units sold. The rent is £10,000 per year, represented by a straight line labeled ‘fixed costs’. The angled line from the top of the fixed costs line shows the variable costs. Every bottle you buy adds £3 of variable costs to the total costs.
To find the breakeven point, calculate when you’ve made enough money from sales to cover the rent. If you sell wine at £5 a bottle, the breakeven point arises when you’ve sold 5,000 bottles.
Breakeven Formula: Breakeven Point=Fixed Costs / (Selling Price – Unit Variable Cost)
Pricing for Profit
Breaking even is necessary to stay in business, but it’s not sufficient. You need to make a profit above the breakeven point. Profit should be a specific, quantified goal that you set in advance.
Continuing with the wine example: you invest £10,000 in rent and need at least £5,000 worth of stock, totaling £15,000. If your profit goal is £4,000, you must sell enough to cover both your costs and this profit.
The formula to calculate this is:
Breakeven Profit Point (BEPP)=(Fixed Costs+Profit Goal) / (Selling Price−Unit Variable Costs)
From this, you now know that to reach your profit goal, you have to sell 7,000 bottles of wine. You can adjust the elements of this formula to experiment and find the optimal result. For example, if market research suggests selling 7,000 bottles is unlikely, but you can sell 6,000, calculate the new selling price required to meet your profit goal.
Using the BEPP equation:
New Selling Price = (Fixed Costs + Profit Goal) / Units Sold + Unit Variable Cost
Handling Price Changes
Pricing is a sensitive and frequently revisited area of business strategy. You can analyze the impact of a pricing policy on profitability using breakeven analysis. Lowering prices typically aims to increase sales, but it requires careful calculation. For instance, decreasing prices by 5% often means you need to increase sales by three times that percentage to maintain the same profit level. Conversely, raising prices by 5% allows you to lose around a seventh of your business before profits drop.
Several tools can help with these calculations, such as software from BizPep or free resources from Harvard Business School. These tools provide breakeven charts for different pricing scenarios and make complex calculations easier to manage.
In summary, effective pricing strategies involve understanding your costs, calculating breakeven points, setting profit goals, and adjusting prices based on market conditions and business needs.
