Product Pricing

Posted by PITHOCRATES - December 10th, 2012

Economics 101

The First Thing a Business has to do to Determine their Selling Price is Determining their Costs

Did you ever think about how businesses price their products?  Do they just pull numbers out of the air?  Do they just charge as much as they want?  No, they don’t.  Because they can’t.  For if one gas station charges $12 for a gallon of gasoline while the station across the street is only charging $3.50 guess where people are going to buy their gas from.  So free market competition prevents businesses from charging whatever they want.  So how do they determine what to charge?

Well, some look at what their competitors are charging and match it.  Or charge a little less.  To steal customers away from the competition.  Which can work.  But it can also bankrupt a business.  For if a business owner doesn’t know his or her costs selling at the market price could fail to recover all of their costs.  The market price limits what they can charge.  But if their costs are too great to stay in business selling at the prevailing market price they have to do something about reducing their costs.  Which they can’t do if they don’t know their costs.  So the first thing a business has to do to determine their selling price is determining their costs.  Like this.

This is an abbreviated fictional income statement showing last year’s results.  And forecasting next year’s results.  EBT stands for earnings before taxes.  Income taxes for this year are based on the 2011 federal tax tables.  Income taxes for next year are based on the proposed Obama tax rates (increasing the top marginal rate from 33% to 39.6%).  The business is a subchapter-S where the business earnings pass through to the owners’ personal income tax returns.  The owner does not draw a salary but draws $125,000 from retained earnings to support him or herself, his or her stay-at-home spouse and their 3 children. The percentages show each number as a percentage of revenue.

You need to Sell at the Right Price and at the Right Volume to Pay all of the Bills

The difference between this year and next year is the rise in costs.  Obamacare and other business regulations increase the cost of sales (direct labor, benefits, direct supplies, etc.) by 2%.  And they increase fixed overhead (rent, utilities, administrative labor, benefits, etc.) by 2%.  They will have to recover these higher costs in higher prices.  Which will likely reduce unit sales.  But because each unit will sell for more we assume sales revenue remains the same.

The higher costs cause EBT to fall.  A lower EBT means lower federal income taxes.  But it also means less retained earnings to invest back into the business.  The reduction in retained earnings is $36,604.28.  Which limits investments to grow the business.  And leaves a much smaller cash cushion after some of those retained earnings are reinvested into the business.  To pay for the unexpected.  Like a new piece of equipment that fails and halts production.  Things worked well in the current year.  The business owner would like to have things work as well in the following year.  Which means not exposing themselves to such a dangerous cash position.  And how do they do that?  By raising their prices to make next year’s retained earnings as large as this year’s.  By recovering those retained earnings in higher prices.  Like this.

Let’s assume these numbers are for a coffee shop that sells only one type and size of drink (say a large espresso-based drink) to simplify this discussion.  If we subtract this year’s cost of sales from revenue we arrive with the markup on our direct costs.  Dividing this number into cost of sales we get a markup percentage.  For this year it was 72%.  In the current year let’s assume they sold 302,406 cups of coffee.  Which comes to about one cup a minute.  Dividing the costs of sales by the number of cups of coffee sold gives a unit cost of $2.58 for a cup of coffee.  Adding the 72% markup to this cost brings the selling price to $4.45.  Coffee sold at this price and at this volume produced enough revenue to pay all the bills, provided an income for the owner and his or her family while leaving enough left over to invest back into the business.  And provide a cash cushion for the unexpected.  As well as paying state income taxes, city income taxes, etc.

A Business must bring their Cost Structure in Line to be able to Sell at the Prevailing Market Price

To arrive at the new selling price we added the loss of retained earnings to next year’s revenue.  And re-crunched all of these numbers.  Because we are raising the price we can expect a small fall in revenue as customers buy less.  The higher costs and lower unit sales volume raised the unit cost.  The markup percentage is 1 percentage point lower but because the unit cost is higher so is the markup amount in dollars.  Which raises the selling price by $0.32.  Increasing the price of a cup of coffee to $4.77.  But is it enough?  As it turns out, no.  Because the new price raises revenue enough to push the business into a higher tax bracket.  Taking the business owner back to the numbers.

Because of the higher tax bracket, and the higher top marginal tax rate, this higher price still results in a loss of retained earnings.  About another $30,000.  So going through the whole process again brings the selling price up to $4.87.  Adding a total of $0.43 to this year’s price.  As long as the prevailing market price is around $4.87 for a large espresso-based drink this business owner should be able to keep his or her cost structure in place and stay in business.  However, if this exceeds the prevailing market price the business owner will have to make some spending cuts to bring his or her cost structure in line to sell coffee at the prevailing market price.  Make some assumptions.  And some adjustments.  Then crunch these numbers again.  And again.  For getting this price right is very important.  Too high and people will go elsewhere to buy their coffee.  To low and they won’t be able to pay all of their bills.

This may not be how all businesses determine their selling price.  But however they do it they have to bring their cost structure in line to be able to sell at the prevailing market price.   Because if their price is too high no one will buy from them.  If it’s too low everyone will buy from them.  Making them happy.  Until they realize they can’t pay all of their bills because their prices are too low.  The above example was complicated.  And that was with only one product.  Imagine a store full of products to sell.  And trying to calculate new prices on numerous products to cover the costs of new taxes and new regulations.  It’s not easy.  Which is why business owners don’t like big change coming from Washington.  For this change requires important decisions to make.  And if they get these decisions wrong and don’t find out until 6 months or so later they may dig themselves into a hole they won’t be able to get out of.  Putting them out of business.

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