Pricing and Costing

1
Pricing and Costing
2
Roy Crosby, Business Advisor, CEiS James
Finnie, Business Advisor, CEiS Alex Rooney,
Business Advisor, CEiS
3
Agenda

• Today, we will cover 3 main areas
• Costing Services/Projects
• Full Cost Recovery
• Pricing Methods

4
Costing
5
Why Classify Costs?

• It allows you to identify what you need to
  charge to cover all costs... and make a surplus
• It allows you to identify the profitable and
  unprofitable services you provide
• It allows you to tender with confidence that you
  CAN provide the services you are tendering for
• No Margin, No Mission!

6
Types of Costs

• Direct Costs
• Those costs that can be clearly, and without
  doubt, be allocated to a particular service or
  project
• (example cost of a project workers Salary)
• Indirect Costs
• Those costs which are of a more general nature
  and relate to the organisation as a whole
• (example Building Rent/Rates)

7
Types of Costs

• Direct and Indirect Costs can be further split
• Fixed costs
• A cost that does not change with the volume of
  activity in the business
• (example Audit Accountancy Costs)
• Variable costs
• A cost that changes with the volume of activity
• (example Vehicle Running Costs)

8

• How do we go about costing a Service or Project?

9
Costing a Service or Project

• Gather all existing financial information to
  identify all the costs in your organisation
  (Budgets, Cash Flow...)
• Identify both the Direct Services/Projects within
  the organisation, as well as the Indirect
  departments which incur costs
• Allocate all relevant costs to these
  Services/Projects and Departments
• Identify remaining costs to be shared amongst
  these Services/Projects and Departments
• Review these costs and decide how to allocate
  over these Services/Projects and Departments
  (using an appropriate method of allocation cost
  driver)
• Use the relevant cost drivers to calculate the
  share of costs to each Service/Project and
  Department
• - Allocate all joint costs to both the Direct
  Services/Projects and also the
• Indirect Departments
• - Allocate the revised costs of the Indirect
  Departments to each Service/Project
• - Allocate the Governance/Management Costs to
  each Service/Project
• 7. Add all the Direct Costs and the Indirect
  Costs to arrive at the Total Costs for each
  Service/Project

10
Costing Structure
What is the total cost of providing Project A?
Full Cost of Project A

Project A
Project B
Project C
Direct Costs

Property and office costs
Central Functions (HR, IT, Admin,etc.)
Indirect Costs
Governance and Management
11
Cost Drivers

• A Cost Driver is a fair and equitable means of
  allocating costs
• Different Cost Drivers are used to allocate
  different types of costs
• Examples of Cost Drivers
• Floor Space used by Service or Department
• Headcount by Service or Department
• Time spent by each Service or Department
• Total Expenditure for each Service

12
Cost Allocation Exercise

• Now well have a look at a practical exercise to
  cost the services of the social enterprise in our
  example - Springhill Community Services

13
Cost Allocation Exercise
14
Cost Allocation Exercise
15
Cost Allocation Exercise

• Step 1 Allocate Premises Costs over both the
  Direct Services and the Support Services
• Use the Appropriate method of calculation
  contained within the Information for allocating
  costs sheet

16
Cost Allocation Exercise
17
Cost Allocation Exercise
18
Cost Allocation Exercise
19
Cost Allocation Exercise

• Step 2 Allocate Administration Costs over both
  the Direct Services and the Support Services
• Use the Appropriate method of calculation
  contained within the Information for allocating
  costs sheet

20
Cost Allocation Exercise
21
Cost Allocation Exercise
22
Cost Allocation Exercise
23
Cost Allocation Exercise

• Step 3 Allocate the Support Services Costs over
  the Direct Services
• Use the Allocation by Use of Support Services
  percentages on the Information for allocating
  costs sheet

24
Cost Allocation Exercise
25
Cost Allocation Exercise
26
Cost Allocation Exercise
27
Cost Allocation Exercise

• Step 4 Calculate the percentage share of Total
  Costs for Each Service

28
Cost Allocation Exercise
29
Cost Allocation Exercise
30
Cost Allocation Exercise
31
Cost Allocation Exercise

• Step 5 Calculate the percentage share of
  Governance/Management Costs for Each Service
• Use the percentages just calculated in the
  previous step

32
Cost Allocation Exercise
33
Cost Allocation Exercise
34
Cost Allocation Exercise
35
Cost Allocation Exercise
A total figure has now been calculated for each
service
36
Full Cost Recovery

37
Full Cost Recovery

• Simple definition
• Securing funding for all the direct and indirect
  costs involved in providing a contract or
  service, including the generation of a surplus to
  allow re-investment

38
Full Cost Recovery

• Full cost recovery is fundamental for
  organisations to be financially sustainable in
  the long-term
• Organisations that do not operate full cost
  recovery could create a deficit for their
  organisations which will have to be met through
  other funding sources

39
Full Cost Recovery

• Scottish Executive buy-in
• Moving towards full cost recovery, so that
  voluntary organisations realistically cost their
  services, and funders recognise that, to make
  organisations sustainable, a legitimate
  proportion of overhead costs should be included
  in funding agreements
• Strategic Funding Review Joint Statement,
• Scottish Executive, CoSLA, SCVO, 2005

40
Pricing
41
Why is Pricing Important?

• Pricing deals with how much you are going to
  charge your customers for your product or
  service.
• Price is the primary profit determinant. However,
  due to a lack of systematic and disciplined
  analysis, it is also the area where profits are
  most often left on the table.
• To be successful in business you need to be
  successful in pricing and organisations must
  have clear long-term strategies for pricing.

42
Pricing

• When setting a price, we need to take account of
  3 critical points
• Market Value What is your product worth to your
  customers
• Cost structure What it costs you to provide the
  product or service
• Competition The price your competitors charge

43
Market Value

• Successful businesses maximise their profit by
  matching their pricing with the value customers
  put on their products or services
• The Cost is the total outlay required to create
  the product or service
• The Value is what the customer thinks the product
  or service is worth

44
Market Value

• Example
• For a plumber to fix a burst pipe, it may cost
• 10 for travel costs
• 5 for materials
• 20 for one hours labour
• However, the value to the customer who has water
  pouring down the stairway is far greater than the
  35 cost. A plumber may, therefore, charge 50
  to fix a burst pipe, more so for an out of hours
  service
• Product pricing is often built around the cost
  plus price model, while service pricing is
  generally created on a perceived value basis.
  Both methods, however, do still require a full
  understanding of costs and the competition

45
Cost Structure

• Your cost structure provides a basis for what you
  need to charge...however it will not necessarily
  show what you can or should charge.
• Remember our Fixed and Variable costs? As long as
  the price you sell your product or service at is
  higher than the variable cost then each sale will
  make a contribution towards covering fixed costs
  and making profits.

46
Competition

• There are few monopolies around today so it is
  certain that you will face competition in some
  form. This provides you with the opportunity to
  benchmark your potential pricing.
• How?
• Get someone to phone or visit your rivals and ask
  for a price quote.
• Look at their published annual accounts to
  analyse their cost base.

47
Competition

• Use this information as a framework. You cannot
  set your prices too much lower or higher without
  good reason. Too low and you throw away profit,
  too high and you lose customers.
• Do not take the competitors price in isolation,
  consider other factors such as
• Where they deliver the product or service
• How they deliver it
• The quality of their service provision

48
Pricing

• Pricing Models
• Cost Plus Pricing
• Marginal Costing and Contribution Pricing
• Value Based Pricing
• A mixture of pricing strategies for differing
  situations

49
Pricing Models

• Cost-Plus Pricing
• This is the most common method and is based on
  two elements
• The mark-up you must add to your costs to make
  the desired profit
• The mark-up used by competitors
• The mark-up is how much you add to your costs to
  arrive at your selling price. It is usually
  expressed as a of the cost, e.g. Cost plus 50.
• Different products and businesses apply hugely
  different mark-ups, e.g.
• Branded clothing Cost plus 135
• Jewellery Cost plus 250

50
Pricing Models

• Cost-Plus Pricing
• If the final price looks uncompetitive then
  review the size of the mark-up. Never remove the
  mark-up altogether to make the price competitive,
  instead look at reducing costs.
• Cost-plus pricing does however have pitfalls
• It ignores the image and market position you are
  looking for
• It assumes you will achieve a sales target to
  make break even or better

51
Pricing Models

• Cost-Plus Pricing Example
• The costs involved in making a product are
• Direct Materials 3 per unit
• Direct Labour 11 per unit
• Direct Expenses 2 per unit
• Indirect Expenses 4 per unit

52
Pricing Models

• Cost-Plus Pricing Example
• If we want a mark up of 30 on each unit, then
• Full Cost Direct Materials 3
• Direct Labour 11
• Direct Expenses 2
• Indirect Expenses 4
• Full Cost 20
• Mark Up 30 of 20 6
• Selling Price 26

53
Pricing Models

• Marginal Costing and Contribution Pricing
• The Marginal Cost approach takes a different view
  from the Cost Plus pricing method
• Instead of starting from the cost of the product
  or service, you start from the price that you can
  charge, and the amount of sales you can make at
  that price
• This technique will allow you to see whether you
  can cover costs and make a profit at a certain
  price

54
Pricing Models

• Marginal Costing and Contribution Pricing
• This approach to costs and pricing takes cost
  behaviour as the basis for allocating costs
• The categories of costs considered for this
  method are the variable and fixed costs
• This method also introduces the concept of
  contribution the amount remaining after
  deducting the variable costs from the selling
  price
• This goes towards covering the fixed costs and
  any remainder goes to profit

55
Pricing Models

• Marginal Costing and Contribution Pricing Example
• Sales Price of a Product is 7.50 per item
• Variable Costs are 4.50 per item, and
• Fixed Costs are 2.90 per item

56
Pricing Models

• Marginal Costing and Contribution Pricing Example
• Contribution Sales less Variable Costs
• 7.50 - 4.50
• Contribution 3.00 per item
• Fixed Cost 2.90 per item
• Profit 0.10
• So, to make 100 items, a profit of 10 would be
  generated.

57
Pricing Models

• Value Based Pricing
• States that the price should reflect the value of
  a product as customers perceive it (the
  willingness-to-pay)
• Value-based pricing is an effort to extract this
  perceived value from the market
• This involves quantifying perceived value and
  increasing it whenever possiblei.e., when the
  customers willingness to pay for the increased
  value exceeds the cost of delivering it

58
Pricing Models

• Value Based Pricing
• This perceived-value pricing takes a number of
  forms
• Convenience A convenient, local service will
  normally be able to charge more
• Brand Many customers will pay more for a well
  marketed brand
• Competition The less competition there is then
  the less choice the customer has
• Supply Demand More customer demand than there
  is supply will lead to the ability to charge
  higher prices
• However, be careful. Overcharging could alienate
  customers and could draw in competitors

59
Pricing Strategies

• Special Pricing Offering the same product at a
  different price (e.g. Offering a lower price for
  regular customers)
• Volume Pricing Offering a product at a reduced
  price if a high volume of products are purchased

60
Margins

• Margins indicate the profit a business makes
  after applying a mark-up
• If an enterprise, for example, costs its product
  or service at 100 and marks it up by 50 to sell
  it for 150 then
• its profit margin is 33.3 (50), i.e. the value
  of the mark-up (50), divided by the selling
  price (150) x 100
• You must know your margins. They are good
  barometers of how important particular products
  or services are to the profitability of your
  business.

61
Costing Pricing Summary

• New service development, service and product
  quality, funding, marketing, meeting client
  needs, etc are all vital to the development of
  any organisation. However, if the product or
  service is not costed and priced effectively then
  the organisation will run out of money.
• An effective costing and pricing strategy and
  process is essential for the development of a
  successful organisation and time and resources
  must be invested into getting this right.