Price calculation: How to calculate cost of sales
It’s best to calculate your pricing as part of your business plan. To do this effectively, you need a precise and well-thought-out calculation that considers key factors to determine the optimal price for your product or service.
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How to calculate the sales price step by step
Price calculation depends on several important factors. Along with acquisition and manufacturing costs, the market environment and competition play a key role. What are your competitors charging, and what prices are your customers willing to pay?
Step 1: Target group analysis
First, focus on those who will ultimately pay the calculated price: your potential customers. As part of market research, analyze who your product is suitable for and identify the characteristics of this group. Information such as gender, age, marital status, income, occupation, education level, as well as interests and desires, help define your target audience. Based on these characteristics, you can estimate how much money potential customers have available for your product and how much they are likely willing to pay.
You can estimate your target group’s willingness to pay through surveys and analysis of past sales. Pay close attention to the reasons provided by respondents and the feedback from your customers, as these insights are particularly valuable. With this information, you can define a price range that aligns with your audience’s expectations. The extent of the survey will depend on your available resources. For instance, while large-scale studies may be out of reach for many entrepreneurs and small businesses, meaningful insights can still be obtained by engaging 10 to 20 carefully chosen participants.
You are not alone when it comes to market research: the Sinus-Milieus – a classification of societal groups developed by the Sinus Institute – offer valuable insights into different target audiences.
Step 2: Competitor analysis
If you know that your potential customers are theoretically willing to pay for your new product, then you should also gather and evaluate information on the competition. No one will offer the exact same product or service as you, otherwise you wouldn’t need to bring your idea onto the market. Nevertheless, there will be providers of products and services that are at least very similar. It’s important to consider what challenges they pose to your business, and what their price/performance ratio is. In addition, it’s not just the product that plays a role – additional services such as a support hotline also need to be factored in.
In your competitor analysis, you can also examine whether the price range determined after the target group survey was realistic. Because you and your competitors appeal to the same target market, the price ranges for the different competitors ought to be approximately the same.
Step 3: Determining the cost
When you calculate sales prices, you must of course check whether you could actually cover all the costs at the determined price. This involves adding together the different cost categories to get the total cost:
- Material costs: Producing your product typically requires purchasing raw materials, operating supplies, and auxiliary materials.
- Manufacturing costs: These include the wages of employees who manufacture the product, as well as expenses for machinery and storage.
- Development costs: Developing your product or service took time and money, however, experts recommend against directly incorporating these costs into the final price, as it could make the price unreasonably high.
- Service costs: Delivering the service, as well as activities like consulting and transporting products, generates additional expenses.
- Sales costs: Marketing and sales also incur costs, which should be factored into your pricing calculation.
- Administrative costs: Background operations, such as accounting, also generate expenses.
The weighting of specific cost types depends on the type of company you have. For example, if you offer a service, the material costs are generally a lot lower than they are for manufacturing a product.
The various types of costs can be broadly divided into two categories: direct costs and overhead costs. Direct costs are those directly associated with each individual product, such as material costs—for example, the exact number of screws required for a piece of furniture. Overhead costs, on the other hand, cannot be attributed to a specific product but are distributed across all products produced. An example would be the costs of purchasing and operating a saw, which are allocated to the prices of all tables manufactured with it.
When you sum up the direct costs and distribute the total overhead costs across all cost carriers, you arrive at the total production cost of a product or service.
If you offer services, the price you charge will most likely be an hourly rate. In this case, you also need to account for all the items that occur around the actual service. Don’t forget to factor in your vacation and sick days, during which you may not earn any income. These times must be compensated for within your hourly rate.
Step 4: Profit margin
Since the aim is to turn a profit on your product or service, rather than simply break even, you must now decide on a profit margin. When doing this, many entrepreneurs make the mistake of orienting themselves too heavily on the common industry margin. This may cause them to miss out on the possibility that customers were actually willing to pay a higher price. If you have already researched the price your potential customers are likely willing to pay, it is easier to estimate how much you can add to the prime costs.
Step 5: Discounts
Set your list price to ensure profitability even during future discount campaigns. To prevent short-term price reductions from cutting into your profits, include the discount in your initial price calculation. Likewise, factor in any cash discount—a price reduction offered for payment within a specific timeframe—when creating your pricing strategy. While discounts often range from 5 to 50 percent, cash discounts are typically set at 2 or 3 percent.
How do you price a product? Formula and approach
Let’s walk through all the steps mentioned earlier with a concrete pricing example. Our example entrepreneur has developed an innovative chair made from a material that has never been used for chairs before. During the target audience analysis, the founder discovered that potential customers respond well to the new product and are willing to pay up to $100 per item. The market analysis revealed that prices for high-quality chairs from other providers range between $80 and $120.
Now it’s time for the cost calculation, where all individual factors are added up. The raw material plays a particularly significant role here. In addition to the founder, two employees are involved in the production of the chairs. Costs for machinery, production and storage facilities, office work, logistics, and marketing are also included. The entrepreneur adds a profit margin of 35% and a discount of 15% to these production costs. As a new business, the company aims to attract customers with competitive pricing, especially in the beginning.
| Item | Price |
|---|---|
| Direct material costs | $22.00 |
| + Indirect material costs | $6.00 |
| = Material costs | $28.00 |
| + Direct manufacturing costs | $13.00 |
| + Indirect manufacturing costs | $8.50 |
| = Production costs | $49.50 |
| + Administrative overhead | $8.00 |
| + Sales overhead | $3.50 |
| = Total production costs | $61.00 |
| + Profit margin: 35% | $21.35 |
| = Total | $82.35 |
|
$12.35 |
| = List selling price | $70.00 |
Even with a relatively high profit margin of 35% and an included discount of 15%, the list selling price of $70 is still below the $100 that customers are likely willing to pay. In the following year, the company might be able to increase sales, which would reduce overhead costs and further boost profits.
What to be mindful of when calculating sales prices
Inexperienced entrepreneurs, in particular, often make the same mistake when calculating a price. For example, setting the price too low and jeopardizing their entire business as a result. This is because once the sales price is set too low, it is difficult to change it again. Customers are usually not best pleased about price increases – especially when the product or service doesn’t have any new features or improvements. So that you don’t fall into the same traps, we’ve listed the most common mistakes for you.
- Trusting your gut feeling: Too many entrepreneurs rely solely on their instincts when calculating prices, often leading to incorrect estimates. A precise pricing calculation helps avoid unpleasant surprises.
- Overlooking costs: Cost determination is highly complex, and many items are often overlooked initially. Take your time with the calculation.
- Misjudging demand: It’s crucial to base your calculations on realistic sales figures. If you can’t sell your entire inventory, the calculation won’t work.
- Generating excessive costs: Some entrepreneurs aim to launch the perfect product, which often comes at a high price—too high for the target audience. This is why a target audience analysis is essential from the start.
- Forgetting your own earnings: Your work as an entrepreneur must also be compensated. The selling price should cover this as well. Keep this in mind when calculating prices.
- Not accounting for vacation and sick days: Especially if you’re an SME offering services, you need to factor in vacation and sick days when determining the selling price.
- Creating overly complex revenue models: If you’re not simply offering products or services at a fixed price but, for instance, implementing a subscription model, be aware of the consequences. Carefully consider whether each pricing option is financially viable.
Do not underestimate the importance of price calculation. Instead, invest the necessary time and effort when determining your sales price. This is the only way to ensure that your product, service, and business remain competitive in the long term.
Please note the legal disclaimer for this article.
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