Pricing for Profits
Raw Cost, Burden, Mark-Up and Margin
Raw Cost:
Joe, you look frustrated, what’s up?
Joe looks up from his desk, take off his glasses, rubs his eyes and forehead and says, I am trying to price our new widgets that we are making on line 2 and want to bring to market in June.
I look down at his calculations on a crude spreadsheet on his computer screen and tell him, it looks like you have already calculated all of the raw costs pretty nicely. Do you have every ounce of labor with its associated employer taxes and benefits?
He nods yes.
Do you have all of the supplies, including packaging?
He gives me the thumbs up.
How about any associated costs for selling the product, like commissions, shelf space charges, etc.?
It’s all there, trust me I have gone over this 10 times to make sure that I am not forgetting anything. But the problem I am having is what do I add for profit?
Perfect Joe, now that you know digits of the widgets, the next step is to add burden to cover all the overhead here at the company… Each widget sold must carry the load.
Burden:
To determine our Burden rate, we can use historical Profit and Loss Statements or next year’s projected budget. In either case we need two important numbers.
If we divide the Total Overhead by the Total COGS it will equal the amount we need to add to each dollar of Raw Cost, in order to cover the Burden of the Overhead.
Joe gives me a questioning look and says, why?
I say, look Joe you buy tons of plastic and enlist several people in the production of those widgets, right?
He nods yes.
Then you calculate how much of each you need for each widget to determine what your raw costs are. Correct?
He says, right!
Well, it cost a lot more than all that to run this company, such as rent and your salary, to name only two expenses. I see him nodding so I continue. What I am trying to show you is the way to divide huge cost up and figure out how much we need to add to each widget in order to cover that overhead.
Just like each widget has to share in the cost of tons of the plastic you buy, each also has to share in the cost of the rent, the utilities, the insurance, etc. If we didn’t do this, we would soon go broke.
I see the lightbulb start to flicker in Joe’s eyes so a figure I better give him an example:
Joe, let’s say that:
What we need to figure out is how much to add to our Raw Cost to equitably share the load of the Burden which is $400,000 in this example. Raw Cost is equivalent to COGS but on a per unit basis. So, if we take the $400,000 Overhead and divide it by the COGS of $1,000,000, we find that for every dollar of Raw Cost we need to add 40 cents.
Therefore, if we take your Raw Cost per widget or $50 and add 40 cents times 50, we now know that we need to add $20 to the $50 to get our “Loaded Cost” for a total of $70 before we add the profit that we wish to make. This is what we call “Loaded Cost”
Joe then complains about how much management spends on overhead and wines about why he should have to add $20 to a $50 cost. He wonders if covering the overhead is making the widget noncompetitive in the marketplace.
I explain, that is why when we are all done here calculating what the price should be that he should then survey the market to see if this new widget is viable.
Mark-Up and Margin:
After his caveaching about having to carry the burden of overhead Joe immediately realizes that we have not included profit into the calculation and asks, hey, what about profit?
I say, glad you asked. What are the typical margins that we make on other products and what are the typical margins that our competitors in the marketplace earn? After some discussion he determines that we should be looking for a 20% Margin and then says, so what do we do now? Do we just take that $70 Loaded Cost and multiply times 1.2?
Joe, if it were only that easy. He interrupts and says, is this how you keep your job and make the big bucks? By making things complex…
I can see that this is frustrating Joe, and I am not sure if it’s the complexity of the calculations or the fact that he will need to charge more than he thought he would in order to sell the widget to the consumer. I think he is mostly worried that the new widget won’t be competitively priced. So, I assure him that if his market survey shows that the price is too high then we can either sharpen our pencil, being careful to find more efficient ways of doing things while making sure that we are not lying to ourselves, which is easy to do when our heart is set on going to market, OR we choose not to go into this market thereby avoiding a major business mistake. And if the later, then the bonus is that we let our competition work in this not so profitable arena, which will strain their finances rather than ours.
Joe asks, okay tell me why it isn’t as easy as multiplying times 1.2 to get a 20% margin?
Joe, we need to remember that we are working with our Loaded Cost, not our final price. Margin is how much you keep of the Total Price, not the Loaded Cost. Margin is a top-down calculation, whereas “Mark-Up” is a bottom-up calculation. With a little math however, we can convert the top-down Margin percentage to a bottom-up Mark-Up percentage.
So, what would the Mark-up equivalent percentage be for a 20% Margin, Joe asks.
It is a simple formula (100*.2)/(100-(100*.2). Take the Margin you want (20% or .2) multiply times 100. Then divide that number by, 100 minus 100 times the Margin. In this case your 20% Margin is the equivalent of a 25% Mark-Up. So instead of multiplying the Loaded Cost of $70 time 1.2 it is 1.25 which gives us a Market Price of $88.
I write all this down, and Joe says that he now understands but wants to take the notes with him so that he can incorporate these new formulas into his spreadsheet.
I say, congratulations, you have now created an accurate pricing proforma. He smiles and gets back to work. The next day I see him showing off his new proforma spreadsheet to his boss and it was my turn to smile.
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