The basic premise for going into business, is to make some money for whatever cause it is that drives you – whether it’s self-preservation or some desire to contribute to a cause. Very few businesses set out to lose money, yet if one is not careful, that is exactly what will happen.
Goods vs Services Pricing
Many businesses look at what their competition charge for Goods or Services and use this to determine their pricing. Whilst you cannot ignore this, when you supply some form of product to customers, to formulate a price, you need to look at ALL the costs to produce/buy the goods you supply – this might include (but is not limited to):
- The number and cost of ALL materials (including the cost of offcuts that are thrown out) required to manufacture one unit of your product – it’s easy to overlook small, inexpensive items – like nails/rivets/tacks etc. – but many such items cost a lot of money;
- The number and cost of any finished goods that you use in your product or sell directly;
- All delivery and sundry costs of goods and materials acquired for production/sale (e.g. shipping, goods in transit insurance, storage, inspection etc.);
- Any taxes or other government charges incurred – e.g. customs and excise duties incurred on imports;
- All costs directly associated with producing a product (e.g. a share of your rental for space occupied by the production line and storage, a share of the electricity and water bills – if you have a reasonable basis upon which you can allocate this, all staff costs for staff employed directly to produce the product, etc.); and
- All labelling, packaging and storage costs incurred for a particular product.
To be sure that you have covered ALL product costs, look at all costs that your business incurs per your bank statement and analyse what it is that you are getting. IF it is a product or service – assess whether it is an input cost to your own production process. If it is, make sure that you include these costs in your cost of production – otherwise your unit cost will be incomplete and the resulting selling price will be too low.
If for example, you produce ‘Widgets’ that require the following inputs to produce 100 units:
- 1 ton of Material A – bought in the USA for USD500/ton (we actually pay AUD649.35 as the exchange rate was USD0.77:AUD1 when we paid);
- We pay shipping and insurance of AUD35/ton and upon arrival in Australia, a further AUD15.65 for inspection, customs and excise duty;
- Finally, we pay AUD25 to have Material A delivered to our site
- 1 ton of local Material B that costs AUD350/ton, delivered;
- Each unit should take 1,5 hours to produce by Staff Member 1;
- Staff Member 1 costs the company AUD5,000 per month (including Super, Medicare and all allowances) and the company’s Standard Month is 22-working days, working 7-hours per day;
- Each Widget requires 2 units of Input 1 that cost AUD20 each;
- The factory costs AUD5,000 per month in rent and the production line for the widgets takes up 50% of the floor space; and
- The labels and box for each Widget cost AUD1 and AUD0.75 respectively.
So the COST of each widget is calculated by costing the entire production run:
|Material A (Cost AUD649.35 + Shipping AUD35 + Duties AUD15.65 + Delivery AUD25)||
|Material B – delivered||350.00|
|Labour – 100 units x 1.5 hours x [AUD5,000/(22 days x 7)]||4,870.13|
|Input 1 – 100 units requiring 2 items @ AUD20||4,000.00|
|Factory Rent – [AUD5,000/(22 days x 7)] x 50% x 100 units x 1,5 hours||
|Packaging – 100 units x (AUD1 + AUD0.75)||175.00|
|Total Cost of Production Run (100 units)||12,555.20|
|Cost per Unit||125.55|
Costing Services can be a little tricky too as you don’t necessarily have an invoiced cost that you can use as a basis. When costing a service, you need to:
- Understand your hourly time cost (this is relatively straight forward as it is the gross cost to the company of the staff member doing the work – including Super, Leave Pay and other benefits, divided by the number of hours available in a standard month) – refer to the example above;
Note: Once you have this figure for each staff member, either bill per staff member or create separate categories of staff and use the average cost.
- If you invoice time spent then this is straight forward BUT where you charge a flat call out/other fee, you need to understand what the average time requirement is to perform the task as this ‘standard’ time, multiplied by the staff member’s cost per hour, will give you the ‘standard cost’ of that service – including travel time etc.;
- Include ALL sundry costs incurred to complete the service (e.g. a garden service must include fuel for the equipment, consumables like whipper-snipper cable, dump costs etc.)
Note: If you finance your equipment, these costs could also be included here
Example, you run a garden service (assume labour cost is as above) and you have a standard cost for lawn mowing (based on an assumed 1.5 hours required):
|Labour (Travel) – 0.25 hours x [AUD5,000/(22 days x 7)]||8.12|
|Wear & Tear and Fuel (Travel) – assume 10Km @ $0.66||6.60|
|Labour (Garden) – 1.25 hours x [AUD5,000/(22 days x 7)]||40.58|
|Materials (1 Lt fuel + Cable)||1.32|
|Total Cost of Service||56.62|
Why is costing so important?
Using the above examples, you should calculate the ‘selling/service price’ you need, by adding your desired ‘mark-up’ to these costs and THEN compare these prices to your competition. The difference between your Selling/Service Price and the Cost Price is your ‘Gross Profit’, the amount of money that you have available to pay all the other costs incurred by your business. If you therefore get the Product/Service costs that form the basis for your selling price wrong by, for example not including the costs of YOUR time (as you don’t draw a set salary and therefore don’t COST the business anything), then your resulting Selling Price will be wrong and you will potentially not be covering all of your costs – which will ultimately result in your business failing.
Finally, when evaluating your company performance, you MUST look at your actual costs vs the standards used in reaching your cost base and therefore your selling price. Using the examples above – you assumed it takes 1,5 hours to produce a widget, or completing a basic lawn service takes 1,5 hours but when looking at timesheets, if total time booked (including rework) takes 2 hours each on average, then you are under-recovering (in the above examples) AUD16.23 on EVERY item, so in that production run of Widgets, that would be AUD1,623 or if you attend to 3 gardens per day, for 22-days, that’s AUD1,071.18 per month – a small error that would potentially be catastrophic for any small business..
Disclaimer: The advice provided on this blog is general advice only. It has been prepared without taking into account your objectives, financial situation or needs. Before acting on this advice you should consult your accountant or professional advisor.