Costing and Pricing determining the Break Even Point by Madhura by ramhood1

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									Costing and Pricing, determining the Break-Even Point
                                                                 by Madhura Chatrapathy


Business or an enterprise can be defined is an undertaking engaged in production and
delivery of goods and services in return for a PROFIT. Thus the purpose of business is
profit.


                                         PROFIT




                      COST                                    PRICE


Cost, Price and Profit form the 3 corners business. Is it simple to arrive at a price that will
result in profitability? What about the cost, the key determinant? What are the ways of
working these 3 business determinants?

Though a much used and known term cost, it is best that it is defined. It can be defined as
a measurement, in monetary terms, of the amount of resources used for the purpose of
production of goods or rendering services.

One of the business mantras Cost for everything, nothing comes free to the enterprise
therefore the enterprise must also get paid in tangibles or intangibles for all it does!


Three categories of Costs to remember

1.     Production Costs (Direct Costs)
          • Raw Materials
          • Labour
          • Overhead (heat, light, power)
          • Repair and maintenance


ESCAP- Regional Training Workshop on Entrepreneurship and e-business
Development for women Cooperatives 27-30 November ,2007 Bali Indonesia
Three categories of Costs to remember

2.     Production Costs (Direct Costs)
          • Raw Materials
          • Labour
          • Overhead (heat, light, power,water)
          • Repair and maintenance

3.     Selling Costs

           •   Salaries and commission of employees, agents, distributors etc.
           •   Sales and distribution costs
           •   Advertising ad promotion

4.     Administrative and Financial Costs ( Over heads)

           •   Management compensation: salaries
           •   Benefits (insurance etc.)
           •   Office salaries
           •   Professional fees (Consultants, lawyers, accountants)
           •   Office expenses (supplies, cleaning etc)
           •   Telephone/Fax etc.
           •   Rent, mortgage payments
           •   Interest on loans and other bank charges (cost of money)
           •   Depreciation of furniture, fixtures, building (if owned)
           •   Depreciation of equipment

Definition: Depreciation is a tax and accounting principle that recognizes that equipment
that is used in the business wears out over a specified period of time. If a machine costs
$1000 and will last only 5 years, you will be allowed to deduct a certain amount from
your income as a business expense, (the percentage amount on different types of
equipment differs from country to country). For example, if the percentage amount is
20% on a straight line basis, you could deduct $200 a year for five years. On a declining
balance basis you calculate the deduction each year as follows: Year I: 20% x 1,000 =
$2000, Year 2: 20% x (1000-200) = $160, Year 3 = 20% x (1000-360) = $128 etc. A
simple understanding of depreciation is a must.

Costs are simply defined also as

• Fixed costs - Costs that remain the same in any time period despite changes in
Business activity. These include rent, insurance, utilities, office supplies, salaries,
depreciation, legal services, accounting and property taxes. These expenses are
ESCAP- Regional Training Workshop on Entrepreneurship and e-business
Development for women Cooperatives 27-30 November ,2007 Bali Indonesia
usually called overhead.

• Variable costs - Costs that usually vary in proportion with business activity. These
include materials used in manufacturing, goods purchased for resale, labor and
Commissions. In a service business, labor may not be variable.

Calculating the Cost of a Service

Normally entrepreneurs find it difficult to arrive at a cost for service provided. A simple,
easy-to-understand method of calculating the cost of a service is by basing the cost on
billable hours. Because services must be provided by people, begin by determining the
number of hours available for billing in a year. Then calculate the break-even point by
dividing the overhead and labor charges by the billable hours and adding the cost of any
materials used. Your desired profit is then added to the break-even point.

Again in the retail business, there are two types of costs: the cost of acquiring the goods,
called cost of goods, and the cost of operating the business, called operating expenses.

Cost of Goods (Variable Cost)

Cost of goods is known as a variable cost or expense because it varies depending upon
the amount of goods purchased for resale and the price of the goods. Cost of goods
includes the price paid for goods, freight charges, import duties, handling charges and
any commissions.

Operating Expenses (Fixed Cost)

Operating expenses are a fixed cost because they usually do not vary with the volume of
business. Operating expenses include wages, management salaries, rent, utilities, office
supplies, insurance and any other costs attributed to the operation of the business.


PRICING

How many units--products or hours of service- have to be sold to cover the costs? If the
price is too high, will the customers cringe and walk away, if price it too low, and will
they perceive it as second-rate. What is the right price point; This is a question that
daunts best of entrepreneurs. At the same time it needs to be remembered, the right to
establish price is that of entrepreneurs.

 The following pricing strategies can be used. Broadly there are three approaches to
pricing any product depending on the demand, competition and costs.

When the product is has a demand, it is sellers market then the pricing formula will be

ESCAP- Regional Training Workshop on Entrepreneurship and e-business
Development for women Cooperatives 27-30 November ,2007 Bali Indonesia
                   Costs + Profit Margin = Price

When the competition is on the increase and price becomes the tipping point then it is
the entrepreneur is likely to strategize to capture the market in the following way

                   Price –Costs = Profit Margin

               RRP may be fixed discounts are provided in a variety of ways as
               promotional effort and as a part of pricing strategies

But if the entrepreneur is unable to or unwilling to compromise on the profit margin
then the equation becomes

                   Selling Price - Profit Margin = Costs
this means cost efficient management

The three pricing strategies

Cost oriented pricing often referred as cost plus pricing, where the total costs of making
and selling a product are calculated, and a profit margin added on.

Demand oriented pricing, where the product is sold based mainly on the high or low
demand it may have. A product that is in high demand may be priced higher, while a
product with low demand would be priced lower. Sometimes the same product may be
priced differently at different times or places, as demand may be different at different
times or places, e.g., fans are priced low in winter and higher in summer.

Competition oriented pricing, where the price one can charge for a product depends on
what the competitors are charging. For example, there may be a good demand for fans,
but if a competitor is charging low prices, for a comparative quality, to capture the
market, the entrepreneur should also have to charge a low price, otherwise the product
may not have any sales

Here are 5 simple ways to determine the price and the break even point which is key
business survival and success

1. Determining the per-unit selling price and direct costs of the product or service that
is provided. Direct costs are classified as the costs that go into creating the product or
service (that is, direct materials and direct labour). So let's say the business is ‘a gift
basket’ business, the direct costs would be the price of the basket, the items in the basket,
the wrap for the basket, and the labour involved in putting the basket together.

2. Calculating the contribution margin in dollars per unit. Once the selling price is
known and direct costs of each product or service unit that will be sold is determined, the
contribution margin in dollars per unit can be calculated. This is the amount of money
ESCAP- Regional Training Workshop on Entrepreneurship and e-business
Development for women Cooperatives 27-30 November ,2007 Bali Indonesia
that would be got over and above the direct costs for each unit that is sold. (You can
define the unit as either a product or hour of service.) Again, using the gift basket
business as an example, if the selling price was $50 and the direct costs added up to $40,
then the contribution margin in dollars would be $50 less US $ 40 = $10 per unit. This is
the amount that can be contribute towards the overhead costs from each sale of the
product or service.

3. Calculating overhead costs. What are all the other costs that is incurred in the
business that need to be covered before the it can start earning a profit? Overhead costs
include such things as insurance, indirect labor, rent, taxes, dues and subscriptions,
advertising, office supplies and so on. This is calculated in total, not on a per-unit basis.
How much money it takes to run the business needs to be arrived at, because these costs
in addition to the direct costs needs to be earned before the business can start making a
profit.

4. Determining the break-even point. Once your overhead costs are known, total
number is divided by the contribution margin in dollars per unit (the answer from Step 2
above). For example, if the overhead costs were $1,000 and the contribution margin from
each unit that is sold is $10, then the break-even in units would be $1000/$10 or 100
units. So, to continue with the gift basket business example, 100 gift baskets at $50 each
need to be sold to break even.

There's no profit in the business until the direct and indirect (overhead) expenses are
covered. Only after selling 100 units will the break even point be attained. Starting with
the 51st unit, the will be earning a profit. If that is determined, based upon market
predictions, if only 40 items per month can be sold, then the business will never earn a
profit. The business idea or the pricing needs to be reconsider Increasing the pricing and
trying to trim costs may just increase the contribution and profitability margins enough to
keep the business going. (See handout for another example)

5. Recalculating break-even point on a regular basis. As the selling price, direct costs
and indirect costs change, so will the break-even point. It’s absolutely imperative that the
price is recalculated whenever the other costs of doing business change. Without
knowing the break-even point, it will possible to know just needs to be done to do make a
profit.

Calculating the break-even point is something that needs to be incorporated as part of the
pricing policy to ensure that money is made on every unit that’s sold and that the business
to be profitable is based on the costs and the sales. Profitability is the purpose of the
business.

Every type of business can incorporate this equation into the pricing module. It does not
matter, whether it is a service- or product-based business, there has to be a good
understanding of direct and indirect costs and how they affect the pricing and profitability
models. It might just mean the difference between a profitable and non-profitable year.
ESCAP- Regional Training Workshop on Entrepreneurship and e-business
Development for women Cooperatives 27-30 November ,2007 Bali Indonesia
Is the aim is to be a low-price leader, or should the product command a premium price to
reflect its high quality or extra features? How the product fits into the market needs to be
determined by i) looking at it objectively from the buyer's point, ii) asking for an unbiased
opinion by an outsider why they would or would not buy the product at the proposed price
and iii) what price is the nearest competitor, in terms quality or value of similar product or
service, is selling

To set the right price point for the product or the market need to be understood in the
local context and need understand the perceived value of the product or service. This is
when entrepreneurs themselves have to take a call based on preferred business approach.

Pricing below competitors often backfires because every cost component must be
constantly monitored and adjusted. Competitors can retaliate by matching the lower
prices, at which point both businesses lose.

Ultimately entrepreneur needs to take the call on pricing.




ESCAP- Regional Training Workshop on Entrepreneurship and e-business
Development for women Cooperatives 27-30 November ,2007 Bali Indonesia
                                  BREAKING-EVEN
                         MANUFACTURING TEDDY BEAR*
A.   Production & Selling Costs: (Variable Costs)                           Unit Cost ($)

       Raw Material for 1 Bear                                                      4.00
       Fabric to clothe 1 Bear                                                      1.70
       Labour =1 hour x $3 per hour                                                 3.00
       Packaging 1 box per bear                                                     0.30
       Distribution/transportation cost per bear                                    1.00
       Sales commission to sales agents pr bear                                     2.00
                                                 Total unit variable cost          12.00

       It takes 1 hour to make a bear and labour costs are
       $3.00 per hour

B.   Total Variable Costs per Annum
       $12.00 per bear x 1000 bears
                                                                               12,000.00
C.   Administrative and Financial Costs: (Fixed Costs)
       Total Per annum
                                                                               45,000.00
D.   Fixed costs per Bear = $ 45,000 /1000                                         45.00

E.   Total Costs per Bear:
       Variable costs per unit + fixed costs = 12.00 + 45.00                       57.00
       This is the break even price without profit

F    Profit per Bear                                                                5.00
     $ 5.00 is used as an example of a profit amount. Explain the
     variables that go into determining profit. The owner might want to
     put money back into the company for research and development
     of a new product, purchase new equipment, expand the
     marketing plan, purchase more raw materials, take out more profit
     for personal use, remain competitive, etc

G.   Selling Prices: Total cost per Bear + Profit                                  62.00

H.   Profit margin or Gross profit:
        Selling price less variable cots: $62.00 – 12.00                           50.00

I.   Gross profit is break-even production                                     900 Bears
       Fixed costs / Profit Margin (45,000/50.00

J.   Break-Even Revenue =
       Break-even Production x Selling Price (900 x 62.00)                     55,800.00
*Source: entrepreneurship you can bank on

ESCAP- Regional Training Workshop on Entrepreneurship and e-business
Development for women Cooperatives 27-30 November ,2007 Bali Indonesia

								
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