Setting Prices to Cover Costs

As a small business owner one of the main things you need to think about is ensuring that your pricing model is covering the costs of doing business. I see a lot of clients that come in and when I ask how they are determining the price for their product they tell me it cost them $35 in supplies to make it so they doubled that and are selling it for $70. But are you actually covering your costs that way? Costs for your business can be broken down into these three categories:

Direct Materials

These are the materials you are using to create your product. If you are making a painting this is your canvas, your paints, and any other materials that you can directly tie to your product. If you are making cakes this is your supplies for your batter, your fondant, etc.

Direct Labor

This is the cost associated with the labor going into directly making the product. How many hours did it take for someone to produce the item? What is their hourly rate? Let's say you have a contractor who makes $24 per project and you expect to make approximately $20 per hour. You worked 2 hours on a project and paid your contractor $24, your total direct labor costs are $64 ($24 for your contractor and $20 per hour for you).


This is anything that cannot be directly tied to a product or job. This is going to be a sort of catch all category for fees associate with your company website, your accounting software, your secretary, advertising, your company phone bills, company internet access, machinery/materials that cannot be directly linked to a specific project, etc. It can also include general supplies (such as an easel for a painter, or a new set of brushes, a pottery wheel, etc).

Allocating Your Overhead

It's easy to see how direct materials and direct labor tie into the cost of a project, but what about overhead? You need to be able to allocate your overhead. Overhead is typically allocated based on the number of direct labor hours or machine hours. For example, you may run a ceramics company and you typically have 500 direct labor hours that go into producing your products in any given month. A project for a client takes 5 direct labor hours. You estimate your overhead for the month to be $6,000. To calculate the amount of overhead you should allocate to that project you would take $6,000 (your estimated overhead for the month) divided by 500 (your estimated total direct labor hours for the month) and multiple it by 5 (the number of direct labor hours that went into that particular project). You would get $60 of overhead to allocate to that piece. Add in your direct labor and direct material costs and that number reflects a more accurate picture of the cost of the project.

Estimating Your Costs

Applying these numbers to get an exact cost before pricing an item is not realistic for most businesses. How often are you able to get a custom order or offer a tailored service and know exactly how much your direct labor, direct materials, and overhead for that month are going to cost you? This is where estimates come in. Estimating direct labor and direct materials comes from knowing your product, getting a clear understanding of the project you are bidding, and experience. Estimating overhead can prove to be more difficult. Overhead can be estimated based on the overhead from prior periods and fluctuations that you know will be occurring. For example, if you know that you normally spend $200 on electricity for the month, but your rate has just increased by 5% you should estimate that your overhead will be increasing by $10 due to the increase in electricity costs alone. $10 might not seem like a big deal, but if you have multiple costs that are going to fluctuate continuously it adds up. A simple way to estimate your overhead is to use prior period amounts and adjust according to known fluctuations.

Mark Up and Competitive Pricing

Once you determine your costs you need to decide what amount of profit you want to make on the product/service. Some people set a percentage that they mark all of their products/services up by. For example some people double their cost, while others take their cost and multiply it by 150%. Others consider each individual project and what they believe it is worth, make sure they cover their costs, and go from there. There is no right or wrong way for marking up your product/service. The factors that go into determining a successful pricing plan are too numerous to cover in a blog entry. Remember to make sure you are covering your costs and allowing enough room for fluctuation in your overhead. You will also want to research your competitors and make sure your pricing is appropriate for your target customer. Again, deciding if you want to be in line with your competitor's pricing, below it, or above it is all part of a pricing strategy that should be developed for your business.

"I Can't Compete"

If you are finding that you cannot compete with your competitors when it comes to pricing without incurring a loss on your products/services you need to look at what they are doing differently. Is the quality of the product/service the same? Is the quality a deciding factor for potential customers, that is will most customers be willing to pay more for a higher quality product/service? If you find that you want to cut costs you need to go back to the three main categories. Direct material costs can sometimes be cut by changing vendors/materials. If this will cause you to sacrifice quality, take a close look at how this will effect your reputation and business. Direct labor costs can sometimes be cut by outsourcing labor, increasing efficiency, or paying yourself less per hour (if your labor costs are being included in this calculation). Again make sure if you will be sacrificing quality you look at how this will effect your customer satisfaction. Finally cutting overhead costs may be an option, analyze what you are spending where and how you can reduce that. Increasing quantity may be an option to spread your overhead costs over a higher output, but an in-depth cost analysis needs to be done prior to doing this so you don't end up increasing costs without increasing profit and potentially losing more money. As hard as it is sometimes a small business cannot compete with a larger business with purchasing power and access to more resources. Sometimes adjusting your target market to a slightly different set of customers removes that competition and allows you to flourish in a different market.

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