Establish Price based on Gross Margin
One effective means of establishing selling price is based on gross margin. Using this approach, it is imperative that you have a good understanding of all the costs – direct labor, material, and overhead (burden). Overhead rates are determined as a percent of labor. Therefore, your labor cost must be accurate to avoid errors in pricing. The gross margin goal should be the percentage sum of all other operating costs and desired operating income. That is, if your G&A, engineering and other operating expenses are 20% of sales and your goal for operating income is 15%, the gross margin should be set at 35%. To establish the selling price, divide the total cost by the reciprocal of the targeted gross margin (1 – 0.35)/1. For example, a cost of $65 with a 35% gross margin equals a $100 selling price ($65/0.65=$100).
The advantage to using this approach is that it allows you to maximize profitability. The risk is you can price yourself out of the market, especially if it’s a competitive industry or your costs are inaccurate. Generally, this method should be used as a check and balance to your costs and pricing unless you have little or no competition.
Price at Market
The other, more common approach is to price the product or service at market. In this situation, the market has already established acceptable price point(s), so you must meet them to compete. Premium price points can be achieved by offering value added services, unique features and benefits, better or improved technology or offering a new design.
Contribution margin is the best gauge for evaluating the acceptability of market pricing for a specific product or service. Contribution margin differs from gross margin in that it only includes the variable overhead and not the fixed overhead with the labor and material costs. Using contribution margin enables you to measure profitability based on actual out of pocket costs or the cash required to build the product or provide the service. The logic being that fixed overhead remains the same whether you accept the business or not. Separating out fixed and variable overhead costs can often be difficult because there is so much gray area between the two. To simplify the exercise, you can assume variable overhead is equal to labor cost and the remaining overhead is fixed. This is a relatively safe approach to establishing price points as it should keep you competitive and cover all out of pocket costs. The risk in this approach lies in not understanding exactly how your product or service stacks up to the competition. You could be leaving profits on the table!
Parts and Accessories Pricing
Pricing for aftermarket parts and accessories is very different. Depending on the complexity and uniqueness of the part and its ease or difficulty to obtain elsewhere, often dictates the margin ranges that should be applied to the part. The matrix below (Fig.1) is representative of how it works. For example, block 1 represents a part that is commonly available from multiple sources and is a pass-through item with no value add provided. In this situation, gross margins could be as low as 10-15%. However, on the extreme side, block 9 represents a highly engineered component that is a custom design and not available anywhere else. In this case, margins should be much higher, up to 80%.
|Commodity||Technical Design||Highly Engineered|