The Importance Of Planning Product Cost And Pricing Right From The Start

Too many small companies don’t plan the costing of their products or services ahead of time with a wide area understanding of the now and future activities of a product. In other words a product needs to be priced as well as costed before you start selling it.

I had a phone call from a customer once, who ran into a new problem as his business of highly technical machinery products expanded into a “dealership” requirement. He had sold directly to the end user since he had started his company some five or six years earlier. He had kept his company small and slow-growing, running it by himself and keeping his products on a highly customized basis.

Now, with ads in global manufacturers directories, he was getting prospects from around the world wanting to buy his machines to resell to their customers. These new prospective dealers needed to make money on their deals and asked him to quote to the end-user directly with a higher figure than he had been quoting them.

This didn’t make sense to him and brought in a whole new series of difficulties and questions, both in costing and pricing, and that’s what prompted his call to me.

Another example is a music club who came out with a collection of songs and instrumental renderings from the members on a sample CD which they sold as one of the fund raising projects. They announced to the members that they could buy the CD’s for a particular price and then sell them to their friends and relatives.

But there was no indication as to what price they could sell the CD’s for. Different figures would get thrown around at meetings, but no one knew what that should be and everyone sold them for different prices.

In both cases, there needed to be simple costing and pricing formula put in place before selling. There had to be a retail sale price with ‘dealer’ (members) discount to follow.

I remember when I had a small manufacturing business at the time when there was a federal manufacturers tax in this country. The moment you registered as a manufacturer, the federal auditors would soon show up into your place of business to make sure you were incorporating this twelve percent levy into your costing.

As long as you could show them that you were using a standard formulae, that you followed consistently in order to come up with your costing/pricing, they were quite happy. This of course was later replaced by our infamous GST.

In the same manner, when pricing an item one must begin by thinking the end-user retail price, working from there backward to the cost of the item. Or else, you work your cost first, including the discounts you will give to your dealers, wholesalers and distributors, and work forward to the retail. Costing is one thing, done at the manufacturing or purchasing point; pricing is another, done after the costing is already taken care of.

For example:

I produce a widget that costs me $10.00 to manufacture (or to buy wholesale). Whether or not I am going to sell that directly to the end-user or not, I should think in terms of selling through dealers now because it is easier to bring the price down than to raise it up later. I can always give a discount to the buyer as an introduction limited-time offer.

If ever the item becomes popular, I may need to sell through dealers — I may even have to reach them through wholesalers or distributors. And the discount structure I give to a dealer is different from a wholesaler or a distributor.

By entering formula in a spreadsheet that calculates each of the expectant pricing, I get something like the following.

The starting figure is of course my cost. Then I make that times 3 (in this example). I give the dealer 40% discount, the wholesaler 50% and the distributor 60%. They make a profit of the difference between their cost and the retail price for the dealer, the dealer price for the wholesale and the wholesale price for the distributor, respectively.

And I make a profit of the difference between my cost and the retail price if and when I sell retail, my cost and the dealer cost when I sell to the dealer direct, my cost and the wholesaler cost when I sell to the wholesaler, and my cost and the distributor cost when I sell to the distributor. Of course, at the distributor price I make less per unit but they bring in volume.

This last figure of what I make at the distributor price, is the figure that I watch when I do my spreadsheet calculation. If it is below what I must make as a profit to cover my manufacturing costs and operating expenses, then I change the figure I used to multiply it into the retail price — in this case the ‘times 3’ used as an example, to times 4 or 5 or whatever the case may be).

If I sell retail for convenience to the end user, I should never sell below the retail price, in order to protect my dealers. The retail price of course is always a “suggested retail” price. Dealers will have to compete with one another and therefore some will be selling for less. But the suggested retail price the manufacturer comes up with is based on a costing/pricing as shown above — in its simplest form.

There would be a lot more to discuss in this area of finance but this is just to show the importance and the connection between the role of costing and pricing in establishing the selling price before the products is offered on the market – however small that market may be.

Every business is different and everything is relative to each their sizes from small one-man enterprises to multi-million dollar operations./dmh

Techniques for Controlling Your Production Costs

In the business of production and manufacturing, companies will have a hard time competing if it does not have a program in place to control production costs. It is vital for investments that production costs are kept under control to assess if the company is making more money than what it spends. This is especially true for companies who are just starting.

Producers who are able to manufacture quality products at relatively low production costs usually have more chances of succeeding in the long run. No company can actually survive when it keeps on adding extra expenditure at its production costs. Hence, here are some useful tips to keep those production costs at bay.

You have to be constantly looking for better but more affordable raw materials. Manufacturers do not necessarily need to pay extra costs just to keep their production going. Business management is best when it is done in a proactive manner. Hence, looking for raw materials in least costly ways (but still ensuring quality) is another way of saving money.

Purchasing decision should be made in a discerning manner in which financial concerns are prioritized. Manufacturer owners can always look for more affordable resources without necessarily sacrificing product quality. One way of doing this is to look for alternative options to expensive brands or resources. There are resources that give the same quality minus the big expense. Business services franchise coaches can train manufacturer owners to be capable enough to balance quality and reduced pricing costs.

Another is to pay extra costs on inventory systems. Having inventory computer programs that monitor your products is actually a good investment in which products are adequately monitored. These inventory systems help limit production based on what is within the budget and prevent wasting resources on needless production. Financial services franchise advisers can help manufacturers not only to manage their financial matters but also adapt the best practices in saving production costs.

If ever you incur loss in your production costs, this is not indicative that your business is going down the drain. When there is a surplus in your production you can find creative ways on how to sell them (like wholesale packages for example). You can also check with a variety of suppliers who can give you a hand in selling those surpluses. Just remember next time to keep the capital up and use them more carefully. Business services franchise personnel can coach you on how to be more conscientious when it comes to specific production costs.

Comforters and Duvets – Period Costs and Product Costs

A manufacturing business converts raw materials into finished, salable products. Comforters and duvets are goods purchased by retailers or wholesalers from manufacturers with the intention of reselling theme for profit. Thus, a merchandising business sells finished items acquired from other businesses.

Retail stores, wholesalers, and distributors are merchandising companies. A company that makes comforters and duvets is primarily a manufacturing company.

A merchandising company buys its goods in salable form and receives an invoice showing the cost for each item. A manufacturing company adds value to the raw material it buys, and must include these conversion costs in its cost of goods sold.

Evidently the problem of measuring cost of goods sold is more difficult in a manufacturing company.

In a manufacturing business, the cost of finished item consists of three things:

(1) Cost of raw materials used on that item

(2) Cost of labor used on that item

(3) A fair share of overhead or general costs associated with the manufacturing process.

These three costs are added together and make up the amount at which the finished item enters inventory, and hence the amount that will be added to the Cost of Goods Sold account at the time of sale. Thus if a comforter requires $5 worth of labor, $7 worth of material, and $3 of overhead to complete it, the comforter will enter the Inventory account at $15.

The process of collecting these three types of manufacturing costs and attaching them to goods as the latter flow through the manufacturing process is called cost accounting. The details of this process of cost accounting are outside the scope of this article, but I will say a few words about the major problems.

It is relatively easy to keep track of the first two elements of cost of a finished item mentioned earlier; the labor and the materials.

However, the determination of overhead costs presents some problems. Overhead costs are divided into two categories, each of which is treated differently for purposes of accounting:

(1) Product costs – those which are associated with the manufacture of products, and

(2) Period costs – those which are associated with general sales and administrative activities.

For example, the cost of heating the offices of the sales department would be considered a period cost. The cost of heating the manufacturing plant itself would be a product cost.

As indicated earlier, the overhead costs that are classified as product costs are added to the direct labor costs and material costs in order to make up the amount at which the items are valued in the company’s inventory, and hence the amount at which they enter the Cost of Goods Sold when the items are sold.

Thus if $10,000 is spent on product cost overhead during 2009, and if $100,000 is spent on direct labor and $20,000 on materials, and if no items are sold, the inventory item on the balance sheet will increase by $130,000.

Product costs do not affect the income statement until the inventory they helped to create is sold. At that time they are a part of the cost of goods sold. Thus if $10,000 of overhead is treated as a product cost in 2009, and if the inventory with which these products costs were associated is sold in 2010, the $10,000 will appear as part of the cost of goods sold in 2010.

On the other hand, overhead costs that are classified as period costs are treated as part of the operating expenses of the period during which they are incurred. For example, if Bed Linens Company classifies $5,000 of the overhead costs of 2009 as period cost, and if the duvets and comforters it manufactured in 2009 are not sold until 2010, the $5,000 of period cost will be an expense in 2009.

Suppose that in January 2009 the total overhead costs in Comforters Manufacturing Company are $10,000. Suppose, too, that 40% of this total is associated with the manufacturing activities of the business and 60% with the general and administrative activities.

In this example, the amount of overhead that is a period cost is $6,000 and the amount of product cost is $4,000.

Since Comforters Manufacturing Company recognizes $6,000 of period costs for January 2009, this amount will be charged as an expense in January 2009.

Now consider the $4,000 of product costs incurred during January 2009. If in addition to these product overhead costs, the raw material and direct labor costs for goods manufactured in January were $10,000, the total cost of the goods added to inventory during January is $14,000.

In this way, the product costs incurred during January 2009 becomes a part of inventory. Therefore, these product costs will affect the income statement whenever the goods manufactured in January are sold.

Sometimes it is difficult to decide whether a given item of overhead should be treated as a period cost or as a product cost. For example, some accountants believe that part of the president’s salary should be considered as part of the cost of manufacturing products. Others do not.

Period costs affect the income statement in the period in which the costs are incurred. Product costs affect the income statement in the period in which the goods in question are sold, which is often a future period.

A company which treats a relatively large amount of its overhead as product costs recognizes proportionately less expense in the current period. A company that treats a relatively large amount of its overhead costs as period costs recognizes proportionately more expense in the current period.

Another problem regarding overhead is how to allocate the total product cost overhead among the various products manufactured. For example, it is hard to say how much of the cost of heating a factory belongs to any given unit of product made in the factory.

There are many methods that may be used to solve this problem of overhead allocation. Usually these methods make use of an overhead rate, such as the ratio of overhead cost to direct labor cost.

Consider the case of Comforter Manufacturing Company, discussed earlier, which incurred $4,000 of manufacturing overhead costs during January 2009. If 1000 hours of direct labor were used during the period in question, then $4 of overhead cost is attributable to each hour of direct labor.

Thus if a given item requires 2 hours of direct labor, and if the overhead rate is $4 per direct labor hour, the amount of overhead costs attributable to that item is $8.

Suppose the raw materials used in a given manufactured item cost $3. Two hours of direct labor at $2 per hour are also used. The overhead rate is $4 per direct labor hour. The cost of the item is recorded as $15.

It should be noted that there are many other kinds of overhead rates, such as a rate per machine hour, a rate per labor dollar, and a rate per material dollar. As a result there can be a considerable difference in the way different companies accumulate the cost charged to each product.