Would you like to judge the price of a product or service appropriately, but you don’t know its corresponding overhead costs? In contrast to direct costs, overheads such as factory rental costs cannot be directly assigned to a product or service. Instead, you must calculate the overhead rate to determine the appropriate percentage of overhead costs and, subsequently, the total expenses which...
One of the most important questions an entrepreneur must answer is how much they should charge for their product or service. However, this price calculation should by no means be left to gut instinct. Instead, its basis must be a precise calculation in order to determine an appropriate price for the product or service, considering various different factors.
Ideally, you’ll have completed the price calculation before product development is concluded, or before you begin offering your service. In order to determine at an early stage whether you’ll be able to be competitive on the market with what you’re offering, it’s advisable calculate the price while you draft your business plan.
Price calculation: Step by step
Several factors play a role in price calculation. In addition to the acquisition and manufacturing costs, the market situation and the competition are also crucial. What do competing businesses require and what prices are customers willing to pay?
Step 1: Target group analysis
First, you should focus on those who will ultimately be paying: potential customers. Market research offers the right tools for this. In market research, you analyze your audience and focus on this group’s characteristics. Relevant information to describe your target group is not limited to gender, age, and civil status – it can also include income, profession, and education level as well as interests and wishes. With these characteristics, you can estimate how much money the potential buyers have for your product, and how much they are willing to pay.
This analysis is usually followed by a survey. Questions for potential buyers about the new product may include, “Are you interested in the product? If so/not, why?” In addition, the survey names a possible price and asks the participants if they consider it reasonable. In this case, the respondents’ reasons are of particular interest. Using the information you’ve acquired, you can then establish a suitable price range for your product or service. The comprehensiveness of your survey depends on the resources you have at your disposal. Many entrepreneurs and SMEs, for example, don’t have the resources to conduct a large-scale study. However, you can still collect useful information even with only 10 to 20 well-selected participants.
When it comes to market research, you are not on your own. The Sinus Milieus – a segmentation of social groups developed by the Sinus Institute – already enables you to obtain good insight into different target groups.
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:
- Cost of materials: To manufacture your product, you must regularly purchase raw, operating, and auxiliary materials.
- Manufacturing costs: This incorporates both the wages of the employees that make the product, and the machine and storage costs.
- Development costs: Developing the product or service costs time and money. (Experts, however, advise against incorporating these costs into the final price, as this would drive them up too high.)
- Services costs: For performing the service. Consulting and product transport, however, also generate additional costs.
- Marketing costs: Marketing and sales also cost money. You should consider this too when calculating your price.
- Administrative costs: Overhead costs, such as accounting.
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 different costs types can be classified into two groups. The first is direct costs, which are the costs that each individual product generates. This is often the case with material costs – for example, exactly how many screws a piece of furniture requires. Overhead costs, on the other hand, cannot be assigned to a specific product, but are instead divided among all the produced products. This way, for example, the costs for the purchase and operation of a saw are allocated to all tables that are produced with it.
If you add up the direct costs and divide the total costs by the number of cost units, then you have your product or service’s prime costs.
If you offer services, the price you calculate is most likely an hourly rate. Even then, you must include all the items that are used for the actual service. You should also consider vacation and sick days on which you might not be able to earn any money. These days must be absorbed by the 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 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 in such a way that you will also still be able to make a profit during future discount campaigns. So that a short-term price reduction doesn’t eat up your profit, take the discount into account when setting the price. Also, you should factor in the amount of the cashdiscount (a price reduction for a product or service within a determined period) during the original pricing. While trade discounts can range from 5 to 50 percent, a cash discount is usually 2 or 3 percent.
Calculating the sales price: Price calculation Excel template and example
In this example, we will take you through all the steps above and calculate a specific price. The entrepreneur in our example has developed a new type of chair made of a material that has never before been used in chairs. During a target group analysis, the entrepreneur found out that potential customers are eager to pounce on the new product and are willing to spend up to 100 dollars per item. The market analysis has revealed that prices for other suppliers of high-quality chairs range from 80 to 120 dollars.
Now we have to address the cost calculation. The expenses for raw materials play an especially important role here. In addition to the entrepreneur himself, there are two employees who work on producing the chair. Costs for the machines, production, and storage spaces, office work, logistics, and marketing are also added. In addition to these prime costs, the businessperson calculates a profit margin of 35% and a discount of 15%. Since it’s just starting out, the new business would like to use affordable prices to get the customer’s attention.
|Material direct costs||USD 22,00|
|+ Material overhead costs||USD 6,00|
|= Material costs||USD 28,00|
|+ Manufacturing direct costs||USD 13,00|
|+ Manufacturing overhead costs||USD 8,50|
|= Production costs||USD 49,50|
|+ Administrative overhead costs||USD 8,00|
|+ Sales overhead costs||USD 3,50|
|= Prime costs||USD 61,00|
|+ Profit margin: 35%||USD 21,35|
|+ Discount: 15%||USD 12,35|
|= Retail list price||USD 94,70|
Even with a relatively high profit margin of 35% and a discount of 15% factored in, the customer is probably willing to pay, as the listed sales price of USD 94,70 is still under USD 100. The following year, the company might be able to increase sales, which would sink the overhead costs and as a result further increase profit.
In order to simplify the calculation of the sales price for you, we have put together an Excel template for calculating the price. You can download the file at no cost and use it as you wish.
Pitfalls: Things to be mindful of when calculating 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 instinct: Too many entrepreneurs rely solely on their instinct when calculating a price and as a result usually get it wrong. A thorough price calculation prevents nasty surprises.
- Overlooking costs: Determining costs is a very complex process. For many items, one hardly even thinks about it. Take your time when calculating.
- Incorrectly estimating demand: It’s important when calculating that you base it on realistic sales figures. If you can’t sell your complete inventory, then the calculation should not go up.
- Generating costs that are too high: Some entrepreneurs would like to bring a perfect product onto the market. However, it is usually too expensive to do this, and often too expensive for the target group. This is why the target group analysis is so important at the beginning.
- Forgetting your own income: You work as an entrepreneur and also need to be paid. The sales price must therefore cover this as well. Take this into consideration when calculating.
- Not factoring in vacation and sick days: Even if you as an SME offer services, you must factor in vacation and sick days into the sales price.
- Developing a revenue model that is too complex: Anyone who implements a subscription model rather than offering their product or service at a fixed price, for example, should be aware of its potential consequences. For each price option, thoroughly consider whether the offering is profitable.
Do not take price calculation lightly. Rather, invest the time and energy when setting your sales price. Only in this way can your product, service, and company be competitive in the long run.