Join Jim Stice for an in-depth discussion in this video Considering all of your costs (fixed, variable, and the contribution margin), part of Finance for Non-Financial Managers.
- What can be so hard about pricing a product? Don't you just figure out what your costs are and then add some sort of markup for profit? Oh, that it were that easy. If your price is too high, regardless of your cost, someone in the market will under price you, assuming that the quality of product or service is similar. In many cases, you will be a price taker and you will have to manage your costs so that you can earn a profit given a certain price is determined by the market. Now, let me say that again. In most instances, you don't price your product to cover your costs.
Instead you determine, if given a certain market price, you cost structure is such that you can earn a profit. The biggest mistake small business owners make in product pricing is not considering and covering all of their costs when entering a market. Now it is true that when you are initially trying to penetrate a market you may be willing to lose a little money to gain market share. But that strategy is not sustainable over time. Over the long term, you must cover all you cost. All you costs.
Now, let's consider a really simple example to illustrate a very complex point. It's summertime, and I'm going into the Snow Cone business. You know, finely crushed ice that is flavored. Perfect for those hot summer days. I have figured that on average the paper cone costs about $.03 per Snow Cone. The ice in the Snow Cone costs about $.02 per Snow Cone. That's five cents per cone. Oh, and let's not forget about the flavoring. I estimate, that on average, those flavors will cost about $.45 per cone.
So, the cost of a Snow Cone is about $.50 each. And I figure that on those hot summer days I can sell a Snow Cone for $2.00 each. After all, that's the going rate at other Snow Cone shacks. That means I will make a $1.50 per Snow Cone. That sounds like a money machine to me. But not so fast. To this point, I have only considered my Variable Costs. Those costs that vary depending on the number of cones I produce. Another way to think about is that these costs stay the same for each cone.
They vary in direct proportion to the number of cones I sell. The more cones sold, the higher the cost of cups, the cost of ice, and the cost of flavoring. But what about my Fixed Costs? Those costs that are fixed whether I sell one Snow Cone, or a thousand. Costs like the machine to crush the ice, the Snow Cone shack to house my equipment, the bottles holding the flavors, and then there are my employees. They get paid whether I have one customer, or a hundred customers.
These costs are incurred regardless of the number of customers. In other words, these costs are fixed. And these fixed costs have to be covered. So, the $1.50 I initially thought of as profit is actually a term called Contribution Margin. Contribution Margin is the difference between the selling price, $2.00 per Snow Cone in this example, and my variable cost, $.50. The Contribution Margin contributes to cover my fixed cost. Once my fixed costs are covered, then each subsequent sale is contributing a $1.50 towards profits.
But until my fixed costs are covered by the cumulative contribution margin, I'm not making any profits. These fixed costs are often considered Overhead Costs. And Overhead Cost must be covered. Now, why are they called Overhead Costs. Well, look up. Many of those costs are the costs over your head. The building, the lights, the other utilities. And they all have to be covered. Have you ever taken your car in to get the oil changed? You get four quarts of oil and a new oil filter, and someone takes 15 minutes to drain your oil and replace it.
And it costs you fifty bucks. Four quarts of oil at about $3.00 per quart, and a new oil filter for $5.00, and 15 minutes of someone's time. And you get charged $50.00. Someone is making some money there. But wait, what about the mechanics equipment, the building, the computer system to process payments and track your car's history, the other overhead items? All those costs have to be covered. And if they are not all covered, then this business is not going to be in business very long.
Now, back to the Snow Cone business. If I am not making enough money on the Snow Cone's I am selling then I will just raise the price. Remember, there are Snow Cone shacks all over. If your price gets too high, then your customers become someone else's customers. They will vote with their feet. Often, you cannot just set your price and assume people will pay what you are asking. It is a competitive environment out there. Whether you are selling Snow Cones, changing oil in cars, or selling software on the internet. It is very rare that one can simply ignore market forces and charge what they want.
The market is too competitive for that. More often than not companies are price takers. You must take the price that the market is offering, and then determine if your cost structure is competitive. And when you are considering your cost structure, you have to consider all of your costs.
- Interpret financial reports and make decisions based on available data
- Manage inventory and receivables
- Create an accurate budget
- Cost a product or service
- Analyze customers
- Understand your income taxes
- Communicate your contribution to the bottom line