Determining the price for your products is often a challenging one. As an entrepreneur, you continuously ask yourself and others who care to listen; “how much should I charge?” Making pricing decisions worse are the intrigues of rising prices (inflation), unstable and largely unpredictable foreign exchange (FOREX) fluctuations. Without the aforementioned complexities, price fixing is a little bit dicey and puzzling, hence this article is to guide you in product/service pricing.
The article explores what goes into determining the selling price of a product or service and how to manage the many questions that might bother the mind regarding determining an appropriate price, a suitable price, a sustainable price, and an unbeatable price as the case may be.
What should be considered in determining the price for your products? I highlight some few points to consider below:
- The first item I highlight is the cost of producing the product or rendering the service. No entrepreneur should be made to fix a price lower than their product/service cost. However, it does happen where sometimes, entrepreneurs are required to set a temporary distress price.
- As funny as this sounds, entrepreneurs are encouraged to include the cost of “I will be here tomorrow and better when and if you need me” in their product/service costs. You may like to call it profit loading. This value covers the need for constant research to keep your product/service relevant and evolve. Additionally, you need to keep the best of human resource to keep your business running. A fraction of these costs should be included in the product/service pricing decisions.
- Understanding the demography of buyers and users. Many times, entrepreneurs forget to consider that there is a difference between buyers and users. For example, children clothing is largely paid for by parents but used by children. Given that sales is a fulcrum for business survival, understanding how buyers and users relate and the influences between them matters significantly. Some parents keep buying items they have no pleasure in and at prices they consider inconsiderate, yet, they keep doing so, because their (teenage) children require them.
- Understanding buyers’ sociological and psychological satisfaction helps entrepreneurs arrive at a price that is justifiable as well. Normally, it is said that the lower the price, the higher the demand and vice-versa. However, we also understand that some persons given their status have peculiar triggers for satisfaction. For example, Sir Alex Ferguson spent gum during his last match as coach was auctioned for millions – what drove that purchase decision?
Asides cost, there are varying schools of thought on the extent of things to include as well as their considerations. Some hold that you use an industry average, others go with intuition, while for some, it is pre-determined. For example, some persons hold the view that their profit loading on cost should be the barest minimum while others will charge the maximum. This is not the focus of this article, as I dwell majorly on cost determination.
Pidgin English attributes “cost” to being expensive. However, for the purpose of this article, a layman’s definition of cost is the amount used to produce a product or amount incurred in rendering a service. In accounting, it is conventionally believed that the cost of producing or rendering a service is significant in determining its selling price regardless of other compelling qualitative considerations as highlighted earlier.
Categories of Products/Services
Broadly, in professional accounting view, there are four categories of products/services.
- A single set of specific product/service, that is custom-made (bespoke): Examples include custom-made shoe, or personalised training. Job costing methodology is applied in determining the cost of the product/service.
- Products/services that go through more than one identifiable process: Process costing methodology is used to determine these types of products/services. Examples of these products/services are off-the-shelve confectioneries with identifiable processes e.g., mixing, baking, icing processes or laundry services (e.g., washing and rinsing, drying and ironing processes).
- Products/services that have unique characteristics and are produced in multiples (lots and batches). These types of products/services are produced or rendered in batches. These products/services will sometimes also go through different processes. Batch costing is used in determining the cost of these types of products or services. Generalised educational services or targeted financial services fit this category while off-the-shelve bottled water or packaged biscuits are examples of such products.
- Specific product/service, that is custom-made but will be produced/rendered for a long period e.g., more than a year. Contract costing method is used to determine the cost of the product/service. Construction work or a long-term consulting service offering are popular examples.
Identifying your type of product/service is only a first step. Applying the principles of the four costing methods requires more than intermediate knowledge of accounting. However, since this article is written for general knowledge purposes, I will try to simplify some key principles. However, I must note that the need for a Management Accountant for pricing decision cannot be ruled out especially for growing businesses with varieties of products/services.
Elements of Product or Service Cost
In determining cost, entrepreneurs are encouraged to consider that there are three (3) elements of costs (materials, labour, and expenses/overheads). Simply, a quick formula to use to determine your product/service cost is:
Product/service cost = Production cost (Direct cost + Indirect cost) + A fraction of Administrative cost + Selling and distribution cost + Profit loading.
It is quite easy to determine direct cost, because they are directly attributable to the product/service e.g., wood for furniture. Indirect cost is harder to identify sometimes, because they are not directly attributable to the product or service. Any cost that goes into producing a product or rendering a service but cannot be directly identified with the product/service is indirect. Examples include factory electricity, factory supervisor’s salary, compliance fees, etc. For emphasis, electricity bill may be paid monthly, so it is difficult to say that product A or service X gulped Y% of electricity. To resolve this challenge, we apply apportionment of cost using both scientific and non-scientific methodologies. The same apportionment goes for administrative cost and selling and distribution costs except where directly identifiable.
For profit loading, some argue that a % of total cost should be used, while some use an arbitrary or market-based %. (Please note that these broad-based calculations and assumptions apply largely to unregulated products and services.)
Given these considerations, it should be easy to determine your selling price knowing that identifying and computing product/service cost is a significant step. The best way to compute product/service cost is to document all forms of cost incurred either considered relevant or not. Many entrepreneurs will for example not include the cost of their own service rendered in the production process assuming that profit will cover for them. But you should note that if you hire someone to do what you do, they get paid, so include your own cost if and when you contribute to the production process.
Conclusively, what is an appropriate price, a suitable price, a sustainable price, and an unbeatable price?
Appropriateness in this context means that your selling price covers all your cost including a profit load. However, as earlier mentioned, that may not be suitable for particular markets or jurisdictions. In this case, a suitable price may have to be determined, considering the market dynamics. A sustainable price as the name conveys is a price that is appropriate and includes social and environmental considerations. Finally, an unbeatable price relates to a market-based price that is generally accepted as minimum. Please note that in other contexts, this classification may differ.