Small Business Marketing:
Pricing In a Manufacturing Firm
Source:
Managing a Small
Business
In setting
prices, the goal should be to maximize profit. Although some owner-managers feel that an
increased sales volume is needed for increased profits, volume alone does not mean more
profit. The ingredients of profit are costs, selling price, and the unit sales volume.
They must be in the proper proportions if the desired profit is to be obtained.
No one pricing formula will produce the greatest profit under all conditions. To price
for maximum profit, the owner-manager must understand the different types of costs and how
they behave. You need the up-to-date knowledge of market conditions because the
"right" selling price for a product under one set of market conditions may be
the wrong price at another time.
The "best" price for a product is not necessarily the price that will sell
the most units. Nor is it always the price that will bring in the greatest number of sales
dollars. Rather the "best" price is one that will maximize the profits of the
company.
The "best" selling price should be cost orientated and market orientated. It
should be high enough to cover your costs and help you make a profit. It should also be
low enough to attract customers and build sales volume.
A Four Layer Cake
In determining the best selling price, think of price as being like a four layer cake.
The four elements in your price are:
(1) the direct costs,
(2) manufacturing overhead,
(3) nonmanufacturing overhead, and
(4) profit.
Direct costs are fairly easy to keep in mind. They are the cost of the material and the
direct labor required to make a new product. You have these costs for the new product only
when you make it.
On the other hand, even if you don't make the new product, you have manufacturing
overhead such as janitor service, depreciation of machinery, and building repairs, which
must be charged to old products. Similarly, nonmanufacturing overhead such as selling and
administrative expenses (including your salary) must be charged to your old products.
Direct Costing
The direct costing approach to pricing enables you to start with known figures when you
determine a price for a new product. For example, suppose that you are considering a price
for a new product whose direct costs - materials and direct labor - are $3. Suppose
further that you set the price at $5. The difference ($5 minus $3 = $2) is
"contribution." For each unit sold, $2 will be available to help absorb your
manufacturing overhead and your non-manufacturing overhead and to contribute toward
profit.
Price-Volume Relationship
Any price above $3 will make some contribution toward your overhead costs which are
already there whether or not you bring the product to market. The amount of contribution
will depend on the selling price which you select and on the number of units that you sell
at that price. Look for a few moments at some figures which illustrate this
price-volume-contribution relationship:
Selling Price $5 $4 $12
Projected sales in units 10,000 30,000 5,000
Projected dollar sales $50,000 $120,000 $60,000
Direct costs ($3 per unit) $30,000 $90,000 $45,000
_______ _______ _______
Contribution $20,000 $30,000 $15,000
In this example, the $4 selling price, assuming that you can sell 30,000 units, would
be the "best price" for your product. However, if you could sell only 15,000
units at $4, the best price would be $5. The $5 selling price would bring in a $20,000
contribution against the $15,000 contribution from 15,000 units at $4.
With these facts in mind, you can use a market-orientated approach to set your selling
price. Your aim is to determine the combination of selling price and unit volume which
will provide the greater contribution toward your manufacturing overhead, nonmanufacturing
overhead, and profit.
Complications
If you ran a nonmanufacturing company and could get as much of a product as you could
sell, using the direct costing technique to determine your selling price would be fairly
easy. Your success would depend on how well you could project unit sales volume at varying
selling prices.
However, in a manufacturing company, various factors complicate the setting of a price.
Usually, the quantity of a product that you can manufacture in a given time is limited.
Also whether you ship directly to customers or manufacture for inventory has a bearing on
your production and financial operation. Sometimes your production may be limited by
labor. Sometimes by the availability of raw materials. And sometimes by practices of your
competition. You have to recognize such factors in order to maximize your profits.
The direct costing concept enables you to key your pricing formula to that particular
resource - labor, equipment, or material - which is in the shortest supply. The Gail
Manufacturing Company provides an example.
Establish Contribution Percentage
In order to use the direct costing approach, Mr. Gail had to establish a contribution
percentage. He set it at 40 percent. From past records, he determined that, over a
12-month period, a 40-percent contribution for each price would take care of manufacturing
overhead and profit. In arriving at this figure, Mr. Gail considered sales volume as well
as overhead costs.
Determining the contribution percentage is a vital step in using the direct costing
approach to pricing. You should review your contribution percentage periodically to be
sure that it covers all your overhead (including interest on money you may have borrowed
for new machines or for building an inventory of finished products) and to be sure it
provides for profit.
Mr. Gails' 40-percent contribution meant that direct costs - material and indirect
labor - would be 60 percent of the selling price (100-40=60). Here is an example of how
Mr. Gail computed his minimum selling price:
Material 27c
Direct labor +10c
_____
37c
The 37 cents was 60 percent of the selling price which worked out to 62 cents (37 cents
divided by 60 percent). The contribution was 25 cents (40 percent of selling price):
Selling price 62c
Direct costs -37c
_____
25c
In this approach, raw material is given the same importance as direct labor in
determining the selling price.
Value of Material
The value of the material used in manufacturing the product has a bearing on the
contribution dollars that will accrue from each unit sold. Suppose, in the example above,
that the material costs are only 15 cents instead of 27 cents while the direct labor costs
remain the same - 10 cents. Total direct costs would be 25 cents.
In order to get a maximum contribution of 40 percent - as Mr. Gail did - the direct
costs must not exceed 60 percent of the selling price. To arrive at the selling price,
divide the total direct cost by 60 percent (25 cents divided by .60). The selling price is
42 cents. With this new selling price, the contribution is 17 cents (42 cents minus 25
cents for direct costs.)
The point to remember is that when the material costs are less, the contribution will
be less. This is true even though the same amount of direct labor and the same amount of
machine use is required to convert the raw material into the finished product.
Contribution Per Labor Hour
What happens if Mr. Gail is unable to operate the equipment fully at all time? In order
to maximize profits, he must realize the same dollar contribution per direct labor dollar,
regardless of the cost materials. To do this, Mr. Gail could use the "Contribution
per Labor Hour" Formula for setting his selling prices.
In this formula, you determine a mark-on percentage to use on your direct labor costs.
This mark-on will provide the required contribution as percentage of selling price. For
example, if direct labor is 10 cents and contribution is 25 cents, then contribution as a
percentage of direct labor will be:
25
____ = 250%
10
The mark-on factor to use on direct labor costs is 250 percent of direct labor costs.
Now suppose that material is 15 cents and direct labor cost is 10 cents. The selling
price would be 50 cents, figured as follows:
Material costs 15c
Direct labor +10c
________
25c
Contribution +25c
_________
Selling Price = 50c
The "Contribution per Labor Hour" approach assures Mr. Gail a 25 cent
contribution for each 10 cents of labor (250 percent) used to make a product regardless of
the value of the raw material used.
Contribution-Per-Pound
If, and when, raw materials are in short supply and are the limiting factor, then the
base to use is the dollar contribution-per-pound of material. This formula is similar to
the one for contribution per labor hour. The difference is that you establish the
contribution as a percentage of material cost rather than as a percentage of direct labor
cost.
Contribution-Per-Machine-Hour
Determining the contribution-per-machine-hour can be a more involved task than figuring
the contribution-per-pound. If different products are made on the same machine, each may
use a different amount of machine time. This fact means that the total output of a certain
machine in a given time period may vary. As a consequence, the dollar
contribution-per-machine-hour that a company realizes may vary from product to product.
For example, products A, B, and C are made on the same machine and their
contribution-per-machine-hour is:
$28.80 for product A
$26.00 for product B
$20.00 for product C.
When machine capacity is the limiting factor, you can maximize profit by using dollar
contribution-per-machine-hour when setting prices. When selling to customers, you should
give priority to products that give the greatest dollar contribution-per-machine-hour. In
the above example, your salesrep would push product A over products B and C.
To use this pricing approach means that you have to establish a base dollar
contribution-per-machine-hour for each machine group. You do it by determining the total
number of machine hours available in a given time period. You then relate these machine
hours to the manufacturing and nonmanufacturing overhead to be absorbed in that period.
For example:
Total machine hours available in 12 months = 5,000
Total manufacturing and nonmanufacturing overhead = $100,000
Contribution required per machine hour to cover manufacturing
and nonmanufacturing overhead = $20*
* $100,000 divided by 5,000 hours
In this example, during periods when the company can sell output of all of its
available machine hours, it must realize a return of $20 per machine hour in order to
cover its manufacturing and nonmanufacturing overhead. When the full 5,000 hours are used,
the $20 per-hour return will bring the company to its breakeven point. When all the
company's available machine hours cannot be sold, its return per-machine-hour must be more
than $20.
Notice that in the above example, only the breakeven point is considered. There is no
provision for profit. How do you build profit into this pricing formula?
Return-on-investments is a good approach. If the Gail Manufacturing Company, for
example, has $300,000 invested and wants a 10 percent return, its profit before taxes
would have to be $30,000. Mr. Gail can relate this profit goal to the machine-hour
approach by dividing the $30,000 by 5,000 (the available machine hours). This means that
he needs $6 per machine hour as a mark-up for profit.
Selling Price For Product C
now suppose that Mr. Gail wants to use the contribution-per-machine-hour and
profit-per-machine hour approach to set a price for product C. For product C, the direct
labor cost per unit is $1.80. Machine output (or units per hour) is 1.25, required
contribution per machine hour is $20, and desired profit per machine hour is $6. The
formula to set the unit selling price is:
Material cost 21.37
Direct labor 1.80
Contribution per Unit 16.00*
________
Price before profit 39.17
Desired profit 4.80 ($6
x .80*)
___________
Desired selling price $43.97
*Calculated as follows: With a machine output of 1.25 units per hour, .80 of a machine
hour is needed to produce 1 unit; the required contribution per-machine-hour is $20;
therefore, $20 x .80 = $16.
If Mr. Gail is to get a 10 percent return on his investments before taxes, the selling
price must be $43.97
But suppose competitive factors mean that Mr. Gail cannot sell product C at $43.97. In
such a case, he might:
- Not make product C if he can use the machine time to manufacture another product which
will give his company its profit of 10 percent - provided, of course, that he has orders
for the second product.
- Reduce the selling price, if refusing orders for product C means that the machines will
be idle. Any price greater than $39.17 will generate some profit which is better than no
profit.
But suppose that $39.17 is also too high. Should Mr. Gail turn down all orders for
product C at less than $39.17? Not necessarily. If he has no orders to run on the
machines, he should accept orders for product C at less than $39.17 because $16 of that
price area contributes to manufacturing and nonmanufacturing overhead. He has to pay these
costs even when the machines are idle.
Keep in mind that the direct costing method of setting a price gives you flexibility.
For example, Mr. Gail has to get $43.97 for product C in order to make his desired profit.
But his price for that product can range from $23.17 to $43.97 (or higher, depending on
market conditions.)
Any price above $39.17 brings in some contribution toward profit. Mr. Gail can break
even at 39.17. Any price between $39.17 and $23.17 brings in some contribution toward his
overhead. And in a pinch, he can sell as low as $23.17 and recover his direct cost -
material and direct labor.
However, Mr. Gail must use this flexibility with care. It takes only a few transactions
at $23.17 (recovering only direct costs) to keep him from maximizing profits over a
12-month period. |