Pricing and Costing. Roy Crosby, Business Advisor, CEiS James Finnie, Business Advisor, CEiS Alex...

Pricing and Costing

Roy Crosby, Business Advisor, CEiS

James Finnie, Business Advisor, CEiS

Alex Rooney, Business Advisor, CEiS

Today, we will cover 3 main areas:• Costing Services/Projects• Full Cost Recovery• Pricing Methods

Agenda

Costing

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!

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)

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)

Types of Costs

How do we go about costing a Service or Project?

1. Gather all existing financial information to identify all the costs in your organisation (Budgets, Cash Flow...)

2. Identify both the Direct Services/Projects within the organisation, as well as the Indirect departments which incur costs

3. Allocate all relevant costs to these Services/Projects and Departments4. Identify remaining costs to be shared amongst these Services/Projects and

Departments5. Review these costs and decide how to allocate over these Services/Projects and

Departments (using an appropriate method of allocation – cost driver)6. 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

Costing a Service or Project

Governance and Management

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

Property and office costs

Project A Project B Project C

Indirect Costs}} Direct Costs

Full Cost of Project A

What is the total cost of providing Project A?

Costing Structure

• 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

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

Cost Allocation ExerciseExpenditure Listing

£

Direct Costs 252,200 Indirect Costs 177,100

Split: Split:

Employment Services Direct Costs Support Services CostsSalaries and On-costs of staff 90,000 (Includes Chief Executive, Finance Officer, Personnel Officer, Admin Staff)Telephone, Fax and Postage costs 2,200 Materials and Equipment 2,500 Salaries and On-costs of staff 95,000

94,700 Telephone, Fax and Postage costs 2,000 Travel & Subsistence Costs 1,800 Materials and Equipment 3,200

Counselling Services 102,000

Salaries and On-costs of staff 75,000

Telephone, Fax and Postage costs 3,500 Materials and Equipment 5,000 Joint Costs

83,500 Premises CostsBuilding Rent 45,000

Welfare Rights Services Direct Costs Utitlities charges 8,500 Salaries and On-costs of staff 69,000 Cleaning costs 2,200 Telephone, Fax and Postage costs 1,200 Building Maintenance costs 3,500 Materials and Equipment 3,800 Council Tax charges 2,000

74,000 Insurance costs 2,500 Total Premises Costs 63,700

Administration CostsStationery and Office costs 6,500 Total Administration Costs 6,500

Total Joint Costs 70,200

Governance/Management CostsAudit and Statutory Accounts 2,500 Legal and Professional Fees 1,500 Bank Charges 900 Total Organisation Costs 4,900

Total Costs 429,300

Cost Allocation ExerciseCost Allocation Exercise

Welfare

Total to be Employment Counselling Rights Support

Allocated Services Services Services Services

Allocation Basis £ £ £ £ £

Total Costs 94,700 83,500 74,000 102,000

Direct Services

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 ExerciseAllocation of Premises Costs

Allocation by Floor Space sq. ft. sq. ft. % share

Employment Services

Employment Services Office 1,200

Interview Rooms 300 1,500 31%

Counselling Services

Counselling Services Office 900

Interview Rooms 200 1,100 23%

Welfare Rights

Welfare Rights Office 600

Interview Rooms 200 800 16%

Support Services

Support Services Office 750

Boardroom/Training Room 700 1,450 30%

Total 4,850 100%

Cost Allocation ExerciseAllocation of Premises Costs

Premises

Allocation by Floor Space sq. ft. sq. ft. % share Costs

Employment Services

Employment Services Office 1,200

Interview Rooms 300 1,500 31% 19,747£

Counselling Services

Counselling Services Office 900

Interview Rooms 200 1,100 23% 14,651£

Welfare Rights

Welfare Rights Office 600

Interview Rooms 200 800 16% 10,192£

Support Services

Support Services Office 750

Boardroom/Training Room 700 1,450 30% 19,110£

Total 4,850 100% 63,700£


Welfare




Total Costs 94,700 83,500 74,000 102,000

Allocation of Joint Costs:

Total Premises Costs Floor Space 63,700 19,747 14,651 10,192 19,110

Direct Services

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



Allocation of Administration Costs

no. of

Allocation by Staff Numbers staff % share

Employment Services 6.0 33%

Counselling Services 4.0 22%

Welfare Rights 3.0 17%

Support Services 5.0 28%

Total 18.0 100%


Allocation of Administration Costs

no. of Administration

Allocation by Staff Numbers staff % share Costs

Employment Services 6.0 33% 2,145£

Counselling Services 4.0 22% 1,430£

Welfare Rights 3.0 17% 1,105£

Support Services 5.0 28% 1,820£

Total 18.0 100% 6,500£


Welfare




Total Costs 94,700 83,500 74,000 102,000



Total Administration Costs Staff Numbers 6,500 2,145 1,430 1,105 1,820

Total Joint Costs 21,892 16,081 11,297 20,930

Total before Support Services Costs 116,592 99,581 85,297 122,930

Direct Services

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



Allocation of Support Services Costs

Allocation by Use of Support Services % share

Employment Services 50%

Counselling Services 20%

Welfare Rights 30%

Total 100%


Allocation of Support Services Costs

Support

Allocation by Use of Support Services % share Services Costs

Employment Services 50% 61,465£

Counselling Services 20% 24,586£

Welfare Rights 30% 36,879£

Total 100% 122,930£


Welfare




Total Costs 94,700 83,500 74,000 102,000






Share of Support Service Costs Use of Support Services 122,930 61,465 24,586 36,879

Total before Governance/Management Costs 178,057 124,167 122,176 424,400

Direct Services

Step 4: Calculate the percentage share of Total Costs for Each Service



Calculation of Split of Expenditure

Allocation by Expenditure Levels

Employment Services 178,057£

Counselling Services 124,167£

Welfare Rights 122,176£

Total 424,400£


Calculation of Split of Expenditure

Allocation by Expenditure Levels % share

Employment Services 178,057£ 41.9%

Counselling Services 124,167£ 29.3%

Welfare Rights 122,176£ 28.8%

Total 424,400£ 100.0%


Welfare




Total Costs 94,700 83,500 74,000 102,000








% Share of Total 41.9% 29.3% 28.8%

Direct Services

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

Use the percentages just calculated in the previous step



Allocation of Governance/Management Costs

Allocation by Expenditure Levels % share

Employment Services 41.9%

Counselling Services 29.3%

Welfare Rights 28.8%

Total 100.0%


Allocation of Governance/Management Costs

Governance

Management

Allocation by Expenditure Levels % share Costs

Employment Services 41.9% 2,053£

Counselling Services 29.3% 1,436£

Welfare Rights 28.8% 1,411£

Total 100.0% 4,900£


Welfare




Total Costs 94,700 83,500 74,000 102,000








% Share of Total 41.9% 29.3% 28.8%

Share of Governance/Management Costs % Share of Total 4,900 2,053 1,436 1,411

Full Cost of Direct Services 180,110 125,603 123,587 429,300

Direct Services


A total figure has now been calculated for each service:

Total Cost of Direct Services

Service £

Employment Services 180,110

Counselling Services 125,603

Welfare Rights 123,587

Total 429,300

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

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

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

Full Cost Recovery

Pricing

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.

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

• 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 ValueExample:

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

• 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

• 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.

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

Pricing

Pricing Models:

• Cost Plus Pricing

• Marginal Costing and Contribution Pricing

• Value Based Pricing

• A mixture of pricing strategies for differing situations

Pricing ModelsCost-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 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 Models

Cost-Plus Pricing Example

The costs involved in making a product are:

Direct Materials £3 per unitDirect Labour £11 per unitDirect Expenses £2 per unitIndirect Expenses£4 per unit

Pricing ModelsCost-Plus Pricing Example

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

Full Cost = Direct Materials £ 3Direct Labour £11Direct Expenses £ 2Indirect Expenses £ 4

Full Cost= £20

Mark Up=30% of £20 £ 6Selling Price= £26

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 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 Models

Marginal Costing and Contribution Pricing Example

Sales Price of a Product is £7.50 per itemVariable Costs are £4.50 per item, andFixed Costs are £2.90 per item

Pricing ModelsMarginal 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 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 ModelsValue Based PricingThis 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

• 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

MarginsMargins 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.

• 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.

Costing & Pricing: Summary

Date post:	21-Dec-2015
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