Contents of the free course 
Have you also considered these aspects of the course?
- Why price is important
- How do you set the price?
- How to present the price so customers say "yes"
- Price discounting
- Costing a Product
- Traditional Costing Methods
- Standard Costing
- Pricing a Service
- Break-Even Analysis
- Fixed and variable costs
- Break-even charts
- Break-even examples
- Contribution Theory
- Absorption Costing
- Model Answers
- Glossary
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Introduction
Three factors affect business profitability ;these are price, volumes and cost. Unfortunately, each affects the other; price affects volume, volume affects cost, and cost affects price. Getting all three right is a delicate balancing act. In this course, we will look at various methods of setting prices, calculating costs, and estimating sales volumes. Price is hard to determine because finding the ‘ideal’ price is so difficult. Customers don’t just buy on price. They are influenced by all sorts of intangibles like advertising, promotion, image, fashion, ‘hype’ perceived quality etc. This is why it is almost impossible to determine the ‘ideal’ price. How high can you go? Cynics say that there are only three areas where there is no price ceiling - fast horses, fast cars and fast women!
Costing is fascinating - this course introduces four methods. We need to understand costs in order to control them. Effective cost control can mean the difference between profit and loss for many businesses.
Many businessmen have difficulty pricing their product or service so they effectively allow their competitors to dictate price. In doing this, they may be missing out on a great opportunity to generate additional profits from an understanding of what makes the business really tick.
Pricing a Product
It is important to set the right price. Here’s an example of how a small change in price can produce a big change in profitability.
Example 1
Suppose a greengrocer normally sells £10,000 of apples. What would happen to the profit if:
. He raised apple prices by 1 % and still sold the same weight of apples, or
. He lowered apple prices by 1% and still sold the same weight of apples.
Let’s work out the effect on profits resulting from these price changes.
Value of Sales
Total Costs
Profit ()
% Change in Profit
These figures show that a 2% change in price can produce a 1 0% change in profits.
Before |
After 1%
price rise |
After 1 %
price cut |
10000
8000
2000
- |
10100
8000
2100
+5% |
9900
8000
1900
-5% |
Note: To keep the arithmetic simple. we have priced the apples in the cartoon at 99p per kilo and £ 1 .0 1 per kilo. In practice, of course, some people will buy apples at 99p per kilo whereas they may not buy at £ 1 .0 1 per kilo. This is because the price crosses the psychological barrier of a pound per kilo. However, don’t let the desire to keep the arithmetic simple confuse the message which is ‘small changes in price can produce big changes in profit’.
Exercise 1
Using the same figures as the example above, work out what would be the effect of a 5% change in price assuming that there was no change in the weight of apples sold.
Setting prices can be more of an art than a science. The ‘right’ price has to satisfy both buyer and seller. On the one hand, the price can’t be so low that the seller makes no profit. On the other hand, the price can’t be so high that it frightens customers away. Between these two extremes, there is a whole range of possible prices.
In theory, the higher the price, the less the customer buys. This is because, at higher prices, increasing numbers of customers decide that the product fails to satisfy their sense of value.
In practice, pricing a product can be complicated. Many factors affect the customer’s decision to buy. Some customers buy on impulse without even giving price a thought! Ideally, we would like to experiment with different prices so that we can check customers’ reactions at different price levels. However, it is hard to experiment with price because you upset customers who hear of others paying a lower price.
Pricing
Many businesses set their price by adding a profit margin to cost. Despite the widespread use of this method, ‘cost plus profit' pricing is unlikely to give the best price for the seller (or for the buyer), except by chance. For a start, most customers don’t know how much the product cost to make, nor do they know how much profit PRICE margin has been added, so they are in no position to judge whether the price is ‘fair’ or ‘reasonable’ .
Customers make their decisions on more varied grounds such as:
- Is this product cheaper or dearer than competitive products?
- Is the product better or worse than competitors’ products?
- Is the product better value than competitors products?
- Does this product meet their needs?
- Does it offer value for money?
- How good is it - the perceived quality?
- Will it ‘do the job’?
- How much they can afford (either now when the bill has to be paid, or on monthly credit)
- Advertising, branding, image
- Convenience
- How much do they trust the supplier
- Availability
- How much they need it
- How much they want it.
An acceptable price will depend more on the customer’s perception of worth rather than product cost.
We have said that the price must be right for the customer but it is also important that the price is right for the seller. Businesses have different targets at different times. For example, the business may be looking to:
- Maximize short term profit
- Maximize long term profit
- Increase market penetration
- Have a high rate of growth.
Price will have an important influence on whether the business can reach these targets. For example, a business looking for rapid growth may choose to offer low prices on the basis that low price encourages more people to buy. However, this argument can be a double-edged sword. Sometimes, businesses ask low prices because they fear they may not attract enough customers. This is dangerous especially if prices are set so low that they generate insufficient profits. The resulting strain on finance may be more than the firm can bear. If successful, low prices could attract sufficient customers to overstretch finances to breaking point. This is called overtrading. In extreme cases, it can lead to bankruptcy.
Of course, everyone wants a lot of customers at high profit margins; however, this rarely happens.
Practical Price Setting. Techniques
If high prices really do discourage customers from buying, and low prices encourage them to buy, then the price should be decided by customer reaction. From a pricing standpoint we can identify three situations. We need to pitch for the middle one.
. The price is too high (you lose both custom and profit).
. The price is ‘right’ (the customer is prepared to pay that price but no more).
. The price is too low (you sell a lot of product for little profit).
Here are some steps which you can take to check whether the price is ‘right’.
. Ask customers what they think of your prices. Either do it yourself or pay someone else to do it on your behalf.
. Watch customers reactions when they pick up your product and see the price (or read your price list, or read the price on your estimate etc).
. Study their reactions when you tell them the price.
Was their pained expression genuine or fake?
. Find out why customers buy your product/service.
. Find out why they choose a particular supplier.
Price is only one of the factors customers consider when making a buying decision. Is it the most important factor for your customers?
. Analyse the strengths and weaknesses of your competitors’ product. Analyse your own product. Work out what yours is worth to the customer.
. Get competitors’ prices/quotes. Find out if they will negotiate on price, credit or discounts.
. Get competitors brochures, prices lists, exhibition catalogues. adverts etc.
. Enlist the help of all your staff who come into contact with customers. Don’t take hearsay at face value. Record your findings and make use of them.
. Find out how customers rate your products/ services against your competitors’.
. Quote different prices to different people but beware of upsetting them. Also beware of drawing conclusions from different groups of people. Their opinions may not be comparable.
. If in doubt, start with a high price and steadily reduce it if necessary.
 How to Present your Price so Customers say ‘Yes’
We have seen that modest increases in price can lead to significant increases in profit. This means that it is important to justify your price to your customers. Here are 30 tried and tested ways of getting a higher price.
. Sell to the easier parts of the market, where they:
- buy from habit
- have greater desire
- can afford it
- don’t know other prices.
. Develop a ‘USP’ (Unique Selling Proposition)
Be better - then you don’t have so many close competitors.
Special benefits merit higher prices.
. Sell to your existing customers.
- sell more of the same
- sell related items
- sell them an up-market version
- ask them what other things they would like to buy.
. Sell to the rich.
Boost the quality. Sell them the best.
. Sell to the ‘MAN’ (The people with the Money, Authority, Need) Where the ‘MAN’ is three different people, start with the one who needs it badly, but doesn’t have to pay.
. Add value and better services.
. Build desire before you tell them the price.
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. Compare yourself with higher priced competitors. Not lower priced ones.
. Tell them it’s their last chance.
For example, before you sell out. Or before the price goes up.
. Condition them to think it will be high.
Surround it with opulence.
. Sell them on the idea of ‘value for money’ instead of price. Focus on the value rather than the money.
. Give something free with it.
. Present the price in a quietly confident way.
Professional buyers are paid to give sellers a hard time on price. Some buyers bully sellers who seem nervous or unsure.
. Give a concession.
Make them think they’ve won.
. Explain what they get for their money.
Concentrate on those benefits that match their needs.
. Make buying a comfortable and pleasant experience.
. Make buying exciting.
. Put it into perspective.
How can they argue over the price of a 5Op pair of shoelaces when they’ve just spent £50 on the pair of shoes?
. ‘Fly a kite’.
Ask for more to begin with; then the true price is a pleasant surprise.
. Take away the risk.
Many buyers pay more for peace of mind. Find out what worries them. Prove to them that you have the solution. Charge them more. And never, ever let them down.
. Show them it’s a bargain.
. Break down the price.
If it’s £50 more than a competitor charges, that’s less than £1 a week for a year. £10 more per meter is only 1 Op more per centimeter. or ip more per millimeter.
. Tell them how good a track record you’ve got.
Tell them about your famous customers. Or quote testimonials.
. Sell to people who have fewer alternative suppliers to choose from.
. Become their sole supplier.
. Sell to ‘trendsetters’.
They’ll pay more to be first.
. Get the endorsement of a famous name.
For example, designer label products.
. Offer credit.
Make it easy to pay. Make it affordable.
. Produce a ‘flagship’.
Offer a product/service which is superb and desirable but very highly priced. It doesn’t matter too much if you don’t sell many because, relative to that, your other prices will seem reasonable. Value is relative.
. Get them to like you and trust you.
We prefer to buy from people we like and trust. And will pay a little more for the privilege.
. And here’s 10% more. Free! ...
. Improve the product/service as you raise the price.
Now. : .new improved Zippo, with added vat!
. Don’t focus on price in your adverts and brochures (etc).
Tell them about quality instead. Then you’re likely to attract buyers for whom quality is more important than price.
. Put your adverts in quality magazines rather than ‘freebies’.
People judge you by the company that you keep, and expect to pay accordingly.
A Word About Price Discounting
It can be very tempting to discount prices on the assumption that reduced prices will mean increased sales which will, in turn, lead to increased profitability. This is a dangerous practice because discounting can have profound effects on profitability.
Standard Costing
Standard costing is a method of working out how much products ought to cost. Once a standard cost has been calculated, a business will normally compare the actual cost of production with the standard cost. Detailed comparison will reveal the reason for the cost divergence. Studying the reasons for cost divergence is called ‘variance analysis’.
Standard costing is particularly valuable for a repetitive manufacturing process. Standard cost estimates can be prepared which determine the amount of time, material and expense which should be expended on the product.
Variance analysis has advantages in terms of management control. Only significant positive or negative variances are reported. This avoids management having to sift through a mass of cost detail. Once the variances are highlighted by type, eg labour variance, material variance etc, an exercise can be undertaken to establish:
. What went wrong?
. Whose responsibility was it?
. What steps is he/she taking to ensure that future costs will be contained?
Sometimes, of course, the responsibility for a cost increase does not lie within the organisation, eg a fuel price rise. Once alternative fuels have been investigated and discarded, there will be no alternative but to incorporate the increased cost into the standard cost.
Pricing a Service
Increasingly, people in Britain earn a living by performing a service instead of producing a product. People who provide a service are usually selling their time and skills to satisfy their customers’ wants.
Many professionals like dentists, engineers and consultants use their time, skill and knowledge to earn a living. This also applies to tradesmen such as carpenters, plumbers and electricians. Even those who produce products without the help of machines (such as wedding cakes, craft furniture, bespoke tailoring) are really performing a specialist service for customers rather than manufacturing goods in the traditional sense.
People who repair things also produce a service. Let’s take the garage repair bill shown below as an example of pricing/costing a service. The bill may seem to be largely made up of the cost of the spare parts. However, the real cost of providing the service is contained in the labour cost. Here is an example.
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The reasoning behind this approach to charging is very simple. Ultimately, the charge made to the customer must take account of not only the direct costs of running the business but the overheads and profit as well. There is a limit to the amount that can be added to the bought-in cost of materials. The most you can charge a customer is the price he expects to pay for the parts at recommended retail price. This means that the labour element must make the major contribution to overhead recovery and profit.
Here is another example.
Example 2
Let’s take the case of a self employed graphics designer operating from a small office whose work involves traveling about 200 miles a week for 40 weeks of the year.
The direct costs of this business will be low compared to manufacturing industry. For example, materials could comprise paper, pencils, paint, computer supplies etc. Even when these items are charged out to a customer’s job, there is little scope for profit since the customer will expect to see the costs of these items shown on his bill at normal retail price.
Overhead costs for this business might comprise: 
£
Rent/rates 2500
Advertising 1000
Telephone 300
Insurance 200
Stationery and Postage 100
Sundries 300
Motoring (200 miles x 40 weeks @ 2O per mile) 1600
Total 6000
Calculating the Labour Charges
What standard of living should our designer aim for? £15,000, £20,000 or £40,000 per annum? Remember, the drawings must not only cover what he has to live on but also tax, national insurance, private medical insurance, pension provision etc. To keep the example going, let’s say the designer requires drawings 2O,000 per annum.
How Much Time is Saleable?
Nobody can work for 52 weeks a year. There must be time off for holidays and sickness etc. There will also be productive time lost for other reasons, including:
Marketing - Time needs to be spent marketing the business. This will vary greatly from one business to another.
Traveling - This is not only a cost, it also reduces effective working time.
Purchasing - Time has to spent searching for products from suppliers, wholesalers etc
Researching - This will include a range of activities such as attending exhibitions, conferences, trade shows, libraries etc in order to keep up-to-date with development in materials, equipment, techniques etc.
Leisure - Nobody can work 100 hours a week. Time has to be allowed for holidays, otherwise family life will suffer.
So what percentage of time can our designer sell? Let’s assume he attends work for 40 hours a week. For the purpose of argument, we will take three cases. Let’s assume that our designer can sell:
(i) 77% of his time
(ii) 58% of his time
(iii) 48% of his time.
Productive hours would, therefore, be:
(i) 77% x 52 weeks 40 weeks x 40 hours = 1 600 productive hours
(ii) 58% x 52 weeks 30 weeks x 40 hours = 1200 productive hours
(iii) 48% x 52 weeks = 25 weeks x 40 hours 1000 productive hours What will his rates be?
He is budgeting to earn £26,000 pa (C20,000 ‘drawings’ + £6,000 ‘overheads’)
If he sells 77% of his time, he must earn £650 per week (or £16.25 per hour)
If he sells 5 8% of his time, he must earn £867 per week (or £2 1 .67 per hour)
If he sells 48% of his time, he must earn £1040 per week (or £26.00 per hour) Plus VAT. if applicable.
Checking the Market Rates
The above example shows a ‘charge out’ rate based on reasonable assumptions. The next step is to look at the market place. What are the going rates for this trade or profession? This doesn’t mean the wages or salaries paid to the individual but the rates charged out to a third party.
For example, we may find that:
- The garage mechanic is charged at about £30 per hour
- Your private physiotherapist will charge about £40 per hour
- Your accountant will charge about £80 per hour
- Your consultant surgeon will charge upwards
A number of factors are involved:
- The rarity value of the skill or service
- The quality of the performance
- The extent to which work can be farmed out to less expensive labour
- The number of ancillary services, receptionists, secretaries, technicians etc supported by the charging service.
If the rate calculated by our designer is less than the market rate, he has two courses of action available. Firstly, he can ‘up’ his rate to the market rate on the basis that too low a rate could deter as many customers as it encourages. Alternatively, the designer could charge out at the lower rate, at least in the short term, on the basis that he could devote more time to each client and, hopefully, build a client portfolio who could be charged slightly more each year so that, eventually, the designer would develop a large and profitable business.
If the rates calculated for our designer are higher than market rate then there are some serious decisions to make. Can overheads be reduced or, alternatively, can the job be done in less time?
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