I had a client call me earlier in the week with product pricing questions for a potential wholesale agreement. Owner labor and future growth can be important considerations in this type of analysis for a small business (especially when the owner does all or some of the labor in producing the product).
There are a few different ways to arrive at a price for a product (both retail and wholesale price). Often the price is set by the market and the business has no real leverage to adjust it but in some cases the business does have the ability to determine a sales price. In these instances price setting is critical. A price too high will stifle demand and a price too low could stimulate so much demand that production would be inadequate or the price would be at a level where no profit can be made. When the business has the ability to set its own price a cost plus markup system is often used. Basically a desired profit margin is added to the cost of producing the product. This is an excellent strategy but caution should be taken to include ALL the expenses of the product.
Here is a quick list of what a small business should consider as product costs:
- Raw materials
- Direct Labor
- Supplies (labels, containers, small uninventoried raw materials)
- Benefits on direct labor (often applied as a percentage of direct labor cost)
- Direct overhead (equipment cost, electricity for equipment, rent for production space)
- Indirect Labor
- Indirect Overhead
If pricing for a wholesale transaction you would use the above accumulated cost and then add a percentage for a desired profit. If the price were for retail you would take the above cost and add additional cost for selling expenses (advertising, marketing, sales staff) and then you add the profit percentage. In the retail case your final profit percentage might be higher than in the wholesale situation.
Problems arise when small business owners only include raw materials and direct labor before calculating the price. If an owner is doing all the production labor they may use only the cost of raw materials. This allows for a lower price and more sales but it would make it extremely difficult to earn a normal profit if the business grows and the owner needs to hire additional staff for production. If new labor is needed and the price is difficult to change once it is set in the market then the desired profit will be eroded by the additional labor costs.
In a cost plus markup situation the owner should take great care to price the product to include compensation (at least at a market rate of labor) for the production work they are doing AND the desired profit. This will create a proper business pricing model for the company. The model will be effective for the current situation and if the product demand grows and new labor is needed.
There could be situations where the price is intentionally lowered to drive traffic and build a customer base. This can be an excellent strategy but remember it is a business or marketing strategy. Time and effort should be taken to calculate the accurate cost of production. That cost should be used to create and monitor the pricing strategy as well as create a potential ‘exit strategy’ from the temporary discount pricing model.