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Pricing and Costing. Roy Crosby, Business Advisor, CEiS James Finnie, Business Advisor, CEiS Alex Rooney, Business Advisor, CEiS. Agenda. Today, we will cover 3 main areas: Costing Services/Projects Full Cost Recovery Pricing Methods. Costing. Why Classify Costs?.

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Presentation Transcript
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Roy Crosby, Business Advisor, CEiS

James Finnie, Business Advisor, CEiS

Alex Rooney, Business Advisor, CEiS

slide3

Agenda

Today, we will cover 3 main areas:

  • Costing Services/Projects
  • Full Cost Recovery
  • Pricing Methods
slide5

Why Classify Costs?

  • It allows you to identify what you need to charge to cover all costs... and make a surplus
  • It allows you to identify the profitable and unprofitable services you provide
  • It allows you to tender with confidence that you CAN provide the services you are tendering for
  • No Margin, No Mission!
slide6

Types of Costs

Direct Costs

  • Those costs that can be clearly, and without doubt, be allocated to a particular service or project

(example: cost of a project worker’s Salary)

Indirect Costs

  • Those costs which are of a more general nature and relate to the organisation as a whole

(example: Building Rent/Rates)

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Types of Costs

Direct and Indirect Costs can be further split:

Fixed costs

  • A cost that does not change with the volume of activity in the business

(example: Audit & Accountancy Costs)

Variable costs

  • A cost that changes with the volume of activity

(example: Vehicle Running Costs)

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Costing a Service or Project

  • Gather all existing financial information to identify all the costs in your organisation (Budgets, Cash Flow...)
  • Identify both the Direct Services/Projects within the organisation, as well as the Indirect departments which incur costs
  • Allocate all relevant costs to these Services/Projects and Departments
  • Identify remaining costs to be shared amongst these Services/Projects and Departments
  • Review these costs and decide how to allocate over these Services/Projects and Departments (using an appropriate method of allocation – cost driver)
  • Use the relevant cost drivers to calculate the share of costs to each Service/Project and Department:

- Allocate all joint costs to both the Direct Services/Projects and also the

Indirect Departments

- Allocate the revised costs of the Indirect Departments to each Service/Project

- Allocate the Governance/Management Costs to each Service/Project

7. Add all the Direct Costs and the Indirect Costs to arrive at the Total Costs for each Service/Project

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Costing Structure

What is the total cost of providing Project A?

Full Cost of

Project A

}

Project A

Project B

Project C

Direct Costs

}

Property and office costs

Central Functions (HR, IT, Admin,etc.)

Indirect Costs

Governance and Management

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A Cost Driver is a fair and equitable means of allocating costs

Different Cost Drivers are used to allocate different types of costs

Examples of Cost Drivers:

Floor Space used by Service or Department

Headcount by Service or Department

Time spent by each Service or Department

Total Expenditure for each Service

Cost Drivers

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Now we’ll have a look at a practical exercise to cost the services of the social enterprise in our example - Springhill Community Services

Cost Allocation Exercise

slide15
Step 1: Allocate Premises Costs over both the Direct Services and the Support Services

Use the Appropriate method of calculation contained within the Information for allocating costs sheet

Cost Allocation Exercise

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Step 2: Allocate Administration Costs over both the Direct Services and the Support Services

Use the Appropriate method of calculation contained within the Information for allocating costs sheet

Cost Allocation Exercise

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Step 3: Allocate the Support Services Costs over the Direct Services

Use the Allocation by Use of Support Services percentages on the Information for allocating costs sheet

Cost Allocation Exercise

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Step 5: Calculate the percentage share of Governance/Management Costs for Each Service

Use the percentages just calculated in the previous step

Cost Allocation Exercise

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Cost Allocation Exercise

A total figure has now been calculated for each service:

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Full Cost Recovery

Simple definition:

  • Securing funding for all the direct and indirect costs involved in providing a contract or service, including the generation of a surplus to allow re-investment
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Full Cost Recovery

  • Full cost recovery is fundamental for organisations to be financially sustainable in the long-term
  • Organisations that do not operate full cost recovery could create a deficit for their organisations which will have to be met through other funding sources
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Full Cost Recovery

Scottish Executive “buy-in”

  • Moving towards full cost recovery, so that voluntary organisations realistically cost their services, and funders recognise that, to make organisations sustainable, a legitimate proportion of overhead costs should be included in funding agreements

Strategic Funding Review Joint Statement,

Scottish Executive, CoSLA, SCVO, 2005

why is pricing important
Why is Pricing Important?
  • Pricing deals with how much you are going to charge your customers for your product or service.
  • Price is the primary profit determinant. However, due to a lack of systematic and disciplined analysis, it is also the area where profits are most often left on the table.
  • To be successful in business you need to be successful in pricing and organisations must have clear long-term strategies for pricing.
pricing42
Pricing

When setting a price, we need to take account of 3 critical points:

  • Market Value – What is your product worth to your customers
  • Cost structure – What it costs you to provide the product or service
  • Competition – The price your competitors charge
market value
Market Value
  • Successful businesses maximise their profit by matching their pricing with the value customers put on their products or services
  • The Cost is the total outlay required to create the product or service
  • The Value is what the customer thinks the product or service is worth
market value44
Market Value

Example:

For a plumber to fix a burst pipe, it may cost:

  • £10 for travel costs
  • £5 for materials
  • £20 for one hour’s labour
  • However, the value to the customer who has water pouring down the stairway is far greater than the £35 cost. A plumber may, therefore, charge £50+ to fix a burst pipe, more so for an out of hours service
  • Product pricing is often built around the “cost plus” price model, while service pricing is generally created on a perceived value basis. Both methods, however, do still require a full understanding of costs and the competition
cost structure
Cost Structure
  • Your cost structure provides a basis for what you need to charge...however it will not necessarily show what you can or should charge.
  • Remember our Fixed and Variable costs? As long as the price you sell your product or service at is higher than the variable cost then each sale will make a contribution towards covering fixed costs and making profits.
competition
Competition
  • There are few monopolies around today so it is certain that you will face competition in some form. This provides you with the opportunity to benchmark your potential pricing.
  • How?
    • Get someone to phone or visit your rivals and ask for a price quote.
    • Look at their published annual accounts to analyse their cost base.
competition47
Competition
  • Use this information as a framework. You cannot set your prices too much lower or higher without good reason. Too low and you throw away profit, too high and you lose customers.
  • Do not take the competitors price in isolation, consider other factors such as:
    • Where they deliver the product or service
    • How they deliver it
    • The quality of their service provision
pricing48
Pricing

Pricing Models:

  • Cost Plus Pricing
  • Marginal Costing and Contribution Pricing
  • Value Based Pricing
  • A mixture of pricing strategies for differing situations
pricing models
Pricing Models

Cost-Plus Pricing

  • This is the most common method and is based on two elements:
    • The mark-up you must add to your costs to make the desired profit
    • The mark-up used by competitors
  • The mark-up is how much you add to your costs to arrive at your selling price. It is usually expressed as a % of the cost, e.g. Cost plus 50%.
  • Different products and businesses apply hugely different mark-ups, e.g.
    • Branded clothing: Cost plus 135%
    • Jewellery: Cost plus 250%
pricing models50
Pricing Models

Cost-Plus Pricing

  • If the final price looks uncompetitive then review the size of the mark-up. Never remove the mark-up altogether to make the price competitive, instead look at reducing costs.
  • Cost-plus pricing does however have pitfalls:
    • It ignores the image and market position you are looking for
    • It assumes you will achieve a sales target to make break even or better
pricing models51
Pricing Models

Cost-Plus Pricing Example

The costs involved in making a product are:

Direct Materials £3 per unit

Direct Labour £11 per unit

Direct Expenses £2 per unit

Indirect Expenses £4 per unit

pricing models52
Pricing Models

Cost-Plus Pricing Example

If we want a mark up of 30% on each unit, then:

Full Cost = Direct Materials £ 3

Direct Labour £11

Direct Expenses £ 2

Indirect Expenses £ 4

Full Cost= £20

Mark Up= 30% of £20 £ 6

Selling Price= £26

pricing models53
Pricing Models

Marginal Costing and Contribution Pricing

  • The Marginal Cost approach takes a different view from the Cost Plus pricing method
  • Instead of starting from the cost of the product or service, you start from the price that you can charge, and the amount of sales you can make at that price
  • This technique will allow you to see whether you can cover costs and make a profit at a certain price
pricing models54
Pricing Models

Marginal Costing and Contribution Pricing

  • This approach to costs and pricing takes cost behaviour as the basis for allocating costs
  • The categories of costs considered for this method are the variable and fixed costs
  • This method also introduces the concept of contribution – the amount remaining after deducting the variable costs from the selling price
  • This goes towards covering the fixed costs and any remainder goes to profit
pricing models55
Pricing Models

Marginal Costing and Contribution Pricing Example

Sales Price of a Product is £7.50 per item

Variable Costs are £4.50 per item, and

Fixed Costs are £2.90 per item

pricing models56
Pricing Models

Marginal Costing and Contribution Pricing Example

Contribution = Sales less Variable Costs

= £7.50 - £4.50

Contribution = £3.00 per item

Fixed Cost = £2.90 per item

Profit = £0.10

So, to make 100 items, a profit of £10 would be generated.

pricing models57
Pricing Models

Value Based Pricing

  • States that the price should reflect the value of a product as customers perceive it (the “willingness-to-pay”)
  • Value-based pricing is an effort to extract this perceived value from the market
  • This involves quantifying perceived value and increasing it whenever possible—i.e., when the customer’s willingness to pay for the increased value exceeds the cost of delivering it
pricing models58
Pricing Models

Value Based Pricing

This perceived-value pricing takes a number of forms:

    • Convenience: A convenient, local service will normally be able to charge more
    • Brand: Many customers will pay more for a well marketed brand
    • Competition: The less competition there is then the less choice the customer has
    • Supply & Demand: More customer demand than there is supply will lead to the ability to charge higher prices
  • However, be careful. Overcharging could alienate customers and could draw in competitors
pricing strategies
Pricing Strategies
  • Special Pricing – Offering the same product at a different price (e.g. Offering a lower price for regular customers)
  • Volume Pricing – Offering a product at a reduced price if a high volume of products are purchased
margins
Margins

Margins indicate the % profit a business makes after applying a mark-up

  • If an enterprise, for example, costs its product or service at £100 and marks it up by 50% to sell it for £150 then
  • its profit margin is 33.3% (£50), i.e. the value of the mark-up (£50), divided by the selling price (£150) x 100
  • You must know your margins. They are good barometers of how important particular products or services are to the profitability of your business.
costing pricing summary
Costing & Pricing: Summary
  • New service development, service and product quality, funding, marketing, meeting client needs, etc… are all vital to the development of any organisation. However, if the product or service is not costed and priced effectively then the organisation will run out of money.
  • An effective costing and pricing strategy and process is essential for the development of a successful organisation and time and resources must be invested into getting this right.