The Most Comprehensive Business Management Manual Available Online
by Meir Liraz
In setting prices in a Manufacturing Firm, 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 st prices 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.
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) non-manufacturing overhead, and
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, non-manufacturing overhead such as selling and administrative expenses (including your salary) must be charged to your old products.
The direct costing approach to setting prices 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.
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, non-manufacturing overhead, and profit.
Setting Prices Complications
If you ran a non-manufacturing 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:
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):
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:
____ = 250%
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:
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.
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.
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 sales rep 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 non-manufacturing overhead to be absorbed in that period. For example:
Total machine hours available in 12 months = 5,000
Total manufacturing and non-manufacturing overhead = $100,000
Contribution required per machine hour to cover manufacturing
and non-manufacturing 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 non-manufacturing overhead. When the full 5,000 hours are used, the $20 per-hour return will bring the company to its break even 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 break even 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:
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 non-manufacturing 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.
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