Video: Module 6 – Pricing Products
Presenter: Wayne Schwitzer
This section is on pricing products for retailers, for service businesses, or for manufacturers. Those are the three main business categories that businesses encounter, but what we're going to deal with today will be the manufacturing side. It seems to be the most complicated part, and the lessons lender in this section will certainly be applicable to a service business or a retail business.
Starting a business has its own challenges when calculating your minimum selling price. Arguably, the manufacturing has more variables when calculating selling price. So that what we're going to look at here, a manufacture company needs to deal with the following key areas in order to develop the pricing strategy.
First of all, they need to deal with raw materials. They're going to have to deal with labour costs, overhead costs, and profit. "Profit's" also referred to as "return on investment."
With all these areas are pretty self-explanatory. There should be some cautions that are needed to be dealt with in each category, though. Raw materials, be sure to include all costs, such as freight, insurance, those things that expenses that to get your product to your manufacturing facility. Don't forget to count the non-useful waste; for example, the things that you've cut off and throw away. You've paid for it, but it's still a cost to you even though it doesn't go into the finished product.
Under "labour," one of the key areas that entrepreneurs tend to forget are such things as WCB costs, employer's EI and CPP costs, Employment Insurance and Canada Pension Plan, vacation pay, the cost of statutory holidays, and any other benefits that you provide to your employees. These combined, can easily total 15 to 20 percent of your labour costs, and they need to be added into your production costs.
For yourself, make sure you count all of your time. Include the evening phone calls, the time you spent setting up your facility so your employees can work efficiently, the time you spend marketing. And if you're going to work for 10 hours a day, you should at least be compensated for that. You'd pay an employee, so why not pay yourself?
How do you decide how much to pay yourself? Well, ideally, start with a personal budget. Figure out all of your personal expenses as what you need out of this business, and then go and add 20 to 25 percent on top of that to cover the monthly costs that unexpected surprises. Allow for the usual rent, utilities, auto expense, medical and such, but don't forget important things like birthday and Christmas gifts, and those annual insurance bills that tend to sneak up on you.
You have more risk than anyone else in this business, so you should be paid more than even your more most skilled employee. Take a rate that your employees would earn and add 25 to 30 per cent for yourself. If you don't require it, you can always reinvest the surplus. If you don't plan for it, though, this could be one of the major reasons that your business will get in trouble.
Overhead costs would be categorized as such things as rent, utilities, marketing, property taxes, equipment leases, professional services like accounting and legal, interest on bank loans, just to name a few.
You would divide your total monthly overhead dollars by your expense, your expected monthly units produced, but be conservative, and I'll cover more details later.
Profit. Isn't that the reason you are in business? It's one of the sweetest words an entrepreneur can ever hear. Your business should also do more than just earn a wage for you. It needs to earn a profit on top of the wages in order to pay loans, buy new equipment, and cover your items that get worn out in the manufacturing process.
Methods of calculating profits include fixed profit per unit, percent of cost (you'll often hear to it referred to as mark up), and return on investment.
Let's look at an example here. Consider an entrepreneur that has a high-speed knitting machine to make sweaters for ski shops. The owner has two employees, plus herself doing sales, manufacturing, packaging, and shipping. She has a machine that cost her $25,000, and approximately $5,000 worth of raw materials. So her total investment is 30,000. She operates out of a rental facility and hires a bookkeeper to do most of her administrative functions.
Now, this is pricing is going to be a four-step process for this manufacturing. The first step, determine your overhead cost on a per month basis. Step 2 would be, determine your raw material costs per unit. Step 3 would be to determine your labour production costs. And then step 4, determine the production capacity: how many sweaters can you make per day?
Now, your overhead costs. We're going to assume in this entrepreneur's case, the monthly costs that we discussed earlier would come to about $1100 per month, plus the owner's wages for about two hours a day, averaging 21 days a month, and her rate, assuming that she pays herself more than her highest paid employee, would be $17.16 an hour. So the cost of the entrepreneur involved in these functions would be about $720 per month. And we'll discuss this rate later.
Raw materials. Cost per unit of the materials used in each sweater would be calculated, and we're going to use here $27.10. You need to do an accurate, measured calculation for each product you make. So if you make 10 products, you need to do a very accurate estimate of each product you make.
Then add a percentage to waste. In this case, we're going to use 10 percent waste. So $27.10 plus 10 percent comes to $29.81 per sweater. That's just the raw materials going into it. Each employee is earning $15 per hour. Based on your own personal budget, you feel that you can live on the same amount, but don't feel you have to work more than eight hours a day in this business.
Then you need to add the payroll costs that we talked about earlier. Employers have to match the amount of Canada Pension Plan premiums that the employees pay. When the employees pay EI premiums, the employer has to put in 1.4 times as many dollars as the employees put in. So a $10 EI premium for the employee would be $14 for the employer. Then there's the other costs we talked about earlier: WCB, vacation pay, etc.
So for the employees, $15 an hour times eight hours a day, $120 each. Two employees, so your total cost for employees is $240. Plus their benefits: Canada pension, 4.95 percent; EI 2.73 percent is the employer's cost; Workers' Compensation, I've used 2 percent here. That's about an average, but you'll have to determine your own exact rate. Vacation pay costs you 4 percent of whatever the employees earn; statutory holidays: I won't bore you with the calculation, but it works out to 3.46 percent per year. So the employees cost you, on top of their regular wages, an extra 17.14 percent.
So now what have we got? We've got the cost of the employees' wages of $240, plus $41.14 of overhead cost. Now, it's your turn for wages. Another $120. Payroll costs for you are a little less because you don't get to the participate in Employment Insurance premiums. So your cost is another 14.41 percent. So total wage cost works out, for the three of you, including overhead, $418.43 a day.
Now, you need to pull all of this together. So your overhead costs we've determined were $1100 plus the two hours a day that you spent. So $1820.72. We determined that you can make 315 units a month. That's 15 units a day; that's 21 days. So your cost per unit, for overhead, is $5.78. Raw materials, we determined it was 27.10 plus 10 percent waste. So $29.81 is your cost of raw materials going into one sweater. Your labour cost. We've just talked about $483 a day. Works out to $8,787 a month. Divide that by 315 sweaters that you can manufacture per month, comes to $27.90. Your total direct costs, before profit, $63.49 each.
Now, don't forget about your profit. Now, there's three key ways that entrepreneurs tend to add profit to their product. First of all, they'll apply at flat rate; in this case, say, $5 per unit. Based on a percentage of cost is another way, and some people will take costs at 10 percent or 15 percent. We're going to use 10 percent in this example.
Other people will take the amount they've got invested in the business. In this case, she has $25,000 in a knitting machine, $5,000 worth of raw materials, so she has $30,000 worth of invested in this business. So she says, "Well, I want at least a 15 percent return on this because I've got risk." So that would work out to about $4,500 per year. Doesn't seem like a lot of profit, but remember that profit is to cover the repayment of the loans and to cover replacement of equipment.
So in all these calculations we've assumed 21 days of production per month, 15 sweaters a day, or 315 a month, or 3,780 sweaters per year. Now, for each of the items above, the selling prices is using method A: By just adding a $5 surcharge on each sweater as your profit, will work out to $68.49. That's just an indicated minimum price.
63.49 plus 10 percent, if you're using a 10 percent mark up method, $69.84 is what those sweaters would cost you, or be available to your customers at. And if you used the return on investment method, or the 15 percent of the investment of 30,000, the sweaters would be valued at $64.48.
This is where you need to look at your competitors. Now, what are they selling their products for? Remember, if you're selling the product or selling your customers one unit at a time, remember that your sales costs are considerably higher than if you're selling to retailers who are buying from you maybe a dozen units at a time. Above all be honest with your costs. No one benefits from you going out of business or having underestimated your expenses. So overestimate your expenses; underestimate your production ability, if anything.
I'd suggest trying this exercise again using 10 units a day. I'll tell you what you end up with is system A: $85.32 a unit; system B: $88.35 a unit; system C: $82.11.
Now, how do you compare to your competitors?
Transcript provided by: Accurate Realtime Reporting Inc.