Pricing – part 1: Determine the cost of your product

How do you Benefit from Knowledge about Pricing and Costs?

In this article, we’ll take a two-part look at how prices are composed and what you need to consider in order to determine a suitable price for your product. In the end, you will understand what factors influence prices and which consequences a too high or too low price will cause. To do this, we will first look at how prices are composed and what you need to know about your costs.

The Differentiation of Price and Cost

Prices and costs are two terms that are inseparable. The definition of prices will be no surprise to anyone, as we deal with them on a daily basis. It is, loosely speaking, the amount that the customer pays to acquire a product or service. To be able to offer a product in the long run it is important that the price for your product at least covers your costs and charges like taxes, so that you don’t make a loss. You probably want to make a profit yourself, which you can use for new investments or simply as a reserve. Simply said, the price of your product should include its costs, taxes and your profit:

Overview price composition
Overview price composition

So let’s look at costs first. Even though costs surround us every day, the understanding of them is not always as clear as that of prices. As costs we summarize everything that consumes value in the context of an entrepreneurial activity. The small but significant difference is that costs are not only created when you spend money, but also when materials or services are consumed.

Let’s illustrate this idea with the example of fuel for your company car. You buy the fuel at the gas station and pay for it immediately, but you do not consume it right away, only when you drive your car. You have, of course, already spent money when you paid for it, but since you also received fuel of the same value, no costs were generated. You can think of it as an exchange, where you exchanged money for fuel, but in this sense, nothing was consumed, and you could theoretically return the fuel back to money. It’s the same with all the other materials in your business. When we buy them, we already have to spend money, but it is only when we consume them that costs are realized. Understanding this is especially important when there is a significant time gap between the expenditure and the consumption. If you take the metro to work instead of the car and therefore buy an annual metro ticket, you have to spend the full price for it today, but you also get a service that you consume 1/12 every month. Accordingly, over the next 11 months, your costs will be the same as this month, even if you don’t have expenses anymore. You could also set aside 1/12 of the price of the annual metro ticket each month and then pay it all at once, to get the same result.

Costs as a Decision-Making Guide

Why is it important to distinguish between expenses and costs? Here’s an example. Imagine your company was able to sell above-average amounts due to the Christmas business in December, but had to pay all insurances and your annual metro ticket for the coming year in the same month. If you did not distinguish between costs and expenses, you would not be able to understand that your company made an above-average profit due to the high expenses. Because your profit is the difference between your sales and your costs. You would not only misrepresent the actual profit, but you would also run the risk of making the wrong decisions. For example, you might decide that the Christmas business is not worth the effort and that you would rather not go through the stress in the future. Then next December you would again have to pay for insurance and the metro ticket, this time without a high sales and you would probably make a loss. If you want to make financial decisions, it is important to know in which month or quarter you made which profit. Therefore, your costs have to be allocated to the right periods.

However, in all the euphoria, we must also remember that while we have the option of documenting each pen as a cost, we should always ask ourselves beforehand whether it justifies the effort. Are the costs for each item large enough to make it worthwhile to include them in a cost calculation, or can we neglect or summarize them in order to focus on the important cost drivers?

Determine own Costs and Sales Volumes

We can now distinguish when we make an expense and when we have costs. What stands out, however, is that the cost of the annual metro card is incurred regardless of whether and how much we use the metro, but the cost of fuel consumption is very much dependent on whether or not we drive our company car.

So costs are not equal to costs, but you can divide them into fixed and variable costs. As the name suggests, fixed costs such as the annual metro card are incurred regardless of your usage. You cannot influence them in the short term, but only in the long term, e.g. by deciding not to buy them next year. The amount of variable costs, on the other hand, depends on a reference parameter such as your production volume or your fuel and energy consumption. You can influence them in the short term by, for example, increasing or decreasing your production volume. Or, using the example of our company car, using it more or less.

Let’s take a look at this topic using the example of our own website. The individual costs and prices are fictitious and simplified here, because it is about understanding the principle.

For your website you rent a server, which costs you a fixed 100€ rent per month. Furthermore, the server operator charges you per click, which amounts to 0.01€ per click, including electricity consumption, maintenance and everything else. Let’s say you offer professional product reviews for sale on your website to help businesses and individuals choose products. You have product reviews on “eye-friendly monitors” (product 1) and “height-adjustable desks” (product 2), which you offer at 2 € and 3 € respectively. In the end, you want to know if your prices cover all costs and what profit you can expect. To do this, we look at what components make up a profit and what our previous information gives us.

Profit equation
Profit equation

We can write this simplified as:

Profit equation simplified
Profit equation simplified

As you can see, in the profit equation, both your revenue and the amount of your variable costs depend on your sales volume. Using the website as an example, this sounds strange at first because our variable costs depend on the clicks and not on the amount of products sold. We therefore need to relate the number of products sold to the variable costs. To do this, we determine how many times users click on your site on average until one of them decides to buy one of your products. As so often, data about your company is elementary. If you don’t have them yet, you have to look for comparable data or statistics or, in the worst case, estimate them. However, you have cleverly integrated a web analytics tool on your website. And since you don’t want to share your customers’ data with third parties, you use a free open-source version, which you can find via our search (link). Thanks to the web analytics tool, you know that for every 1,000 clicks you make an average of 15 sales, of which 67% are product 1 and 33% product 2. So you know your sales volume and variable costs, both of which are influenced by the same variables, which is the clicks on your website. This also allows us to calculate how many clicks it takes for a customer to buy product 1 or 2 from you and how many variable costs are incurred per unit. For example, for 1,000 clicks we can calculate the following:

Variable costs example
Variable costs example

This results in variable costs per unit (also called variable average costs) of 0.67 € per product 1 sold and 0.66 € per product 2 sold. So now you know how much money it costs you on average until a customer buys one of your reviews. If we now subtract these variable average costs from the price of our products, we are almost left with your profit per unit, however we still have the fixed costs of server rent to cover. The difference between the price and the variable average costs is called the contribution margin per unit, because it indicates how much each sold product contributes to cover your fixed costs.

Profit and contribution margin
Profit and contribution margin

For our two products, the contribution margin per unit is as follows:

Contribution margin example
Contribution margin example

Now we can see that it is much more profitable for you to sell product 2, because after deducting the variable average costs it brings you more revenue per unit than product 1. So what your products should at least cover, in order not to make a loss, are your monthly fixed costs for the server. But how many products do you have to sell to pay your server rent of 100€ or in other words to get a profit of 0€? If we substitute the contribution margin per unit into the profit formula from before, we get the following equation:

Profit equation
Profit equation

If we insert the 0 € profit, the contribution margins per unit of the two products and our fixed costs of 100 €, we obtain:

Break Even Analysis Example 1
Break Even Analysis Example 1

The only unknown variable in the equation is the sales volume. If we rearrange the formula according to this, we get the quantity of products we need to sell to cover all costs. This gives here:

Break Even Analysis Example 1
Break Even Analysis Example 1

This means that you have to sell a total of at least 60 products, 67% of which are divided into product 1 (about 40 units) and 33% of which are divided into product 2 (about 20 units), in order not to make a loss. Since you know from your web analytics that you sell an average of 15 products per 1,000 clicks, this means that you need at least 4,000 clicks per month on your website to not make a loss. From the product 61 on, you make a profit equal to the contribution margin per unit of the sold product, since your fixed costs are already covered. If you draw your relationship between clicks and your profit, you will see the connection as a straight line that leaves the loss zone at exactly 4,000 clicks.

Profit line
Profit line

The magical border from which on you have covered all costs and realize profits is also called break-even point and the calculation is called break-even analysis. This is a simple but powerful instrument to get an overview of your business. The characteristic of the break-even point is that it always calculates the sales quantity for a profit of 0 €. However, you can also use any other value as the target profit and determine your sales quantity for it. For example, if you want your website to generate 4,000 € in profit, you would have to achieve 164,000 clicks according to our equation. Such an analysis also shows you whether your current concept is really viable to generate a realistic income for you or whether you still need to improve your concept. What does this mean? If you come to the conclusion that your concept is not profitable, you must assess whether you can influence individual variables. You could, for example, increase your prices or look for a cheaper provider where you have to pay less for server rental and costs per click, or you could try to encourage your customers to buy more on your website.

As mentioned in the beginning, the example is a very simplified representation, both in terms of numbers and analysis, but also, for example, the exclusion of taxes and fees. If you are interested in this topic in more depth and want to look at a realistic example, the concepts of standard costing, activity-based costing and target costing are of interest to you. However, the approach shown here and what you will find under the terms have one thing in common, to help you make decisions on business issues.

Thanks to similar analysis and cost comparisons, we at WeValCo, for example, decided to build our own scalable IT infrastructure based on open-source technology and stayed away from more expensive turnkey solutions from large vendors. This means that we save about a factor of five of the costs, but in return we have to maintain the infrastructure ourselves and develop our own tools. In a comprehensive cost calculation, the costs for development and maintenance would of course have to be compared with the lower purchase prices. This small excursion should show you, that this method shows decision possibilities which you have to weigh in a further step and under consideration of relevant goals. How you deal with conflicting goals and what good tools there are to make decisions, we will show you in a later blog post. It should be said that this analysis is not a miracle cure, but can show you whether the extra effort is financially worthwhile for you.

The Target Cost Calculation

The figures from the example with your website were based on statistics from your web analysis tool and therefore on values from the past. From this, we knew that you were making an average of 15 sales per 1,000 clicks. But we also know that the past is not always a good indicator for the future and that we want to align ourselves with what is expected in the future, especially when investing.

One way to better plan for the future is the so-called target costing. Here you estimate, based on your processes, experience and information, the future costs and associated break-even quantities that will come your way in the coming month or market. This can help you to avoid unpleasant surprises and supports you in costing your products and services. If you assume e.g. based on the current news about an increasing inflation also 5-10% higher prices in the purchase, then you can plan this for you and react accordingly and adapt your analysis to the new circumstances. If you expect your server costs to increase from 100 € to 110 €, you can take this into account in your calculation and arrive at the following result:

Break Even Analysis Example 2
Break Even Analysis Example 2

You see that, all other things remaining constant, you need to sell about 6 more products to compensate for the increase in your server rental costs. This gives you a basis for deciding whether your sales prices are still realistic and sustainable, or whether you need to adjust them if necessary. You can use the method shown here as a guideline to calculate which cost corridor is acceptable for you and your company. In order to improve your calculations, it helps you to carry out an actual cost calculation as a control after the target cost calculation. Here you check which costs have actually been incurred and in what amount. This helps you to compare how good your forecasts were and to continuously improve them as an iterative process. This way you will find out, for example, that you tend to overestimate the expected changes and that your server costs have increased, but only to 105€. This knowledge helps you to better forecast the future and keep your analysis as accurate as possible. However, you must also keep in mind that even all the measures taken together are no guarantee to completely avoid losses or inefficient processes.

Conclusion and Outlook

In this article we have looked at what costs are and how they can affect your business. We also learned how you can determine your variable costs, contribution margins and break-even quantities and how these analyses can help you make decisions. Furthermore we discussed how you can deal with changes in the future to keep your analysis flexible and adaptable to the changing environment.

Knowing your costs and related processes is even more important the closer you are to the red. Here, cost accounting helps you to identify the cause of losses and determine their extent in order to fix them sustainably. But also, if you are planning to create a completely new product or to enter a new market with which you have no experience yet, a cost calculation helps you to make initial forecasts and to decide whether planned steps can be profitable.

After we looked in this article at the lower border you should set for your prices in order not to make a loss, we will look in the second part at what else you should consider when setting your prices.