Meir Liraz - How to Set Prices in a Manufacturing Business: A Step by Step Guide to Pricing in a Manufacturing Company

How to Set Prices in a Manufacturing Business

A Step by Step Guide to Pricing in a Manufacturing Company

By Meir Liraz

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Copyright by Meir Liraz. All rights reserved.

I n setting prices in a Manufacturing Firm, the goal should be to maximize profit. Although some owner-managers feel that an increased sales volume is needed for increased profits, volume alone does not mean more profit. The ingredients of profit are costs, selling price, and the unit sales volume. They must be in the proper proportions if the desired profit is to be obtained.

No one set prices formula will produce the greatest profit under all conditions. To price for maximum profit, the owner-manager must understand the different types of costs and how they behave. You need the up-to-date knowledge of market conditions because the "right" selling price for a product under one set of market conditions may be the wrong price at another time.

The "best" price for a product is not necessarily the price that will sell the most units. Nor is it always the price that will bring in the greatest number of sales dollars. Rather the "best" price is one that will maximize the profits of the company.

The "best" selling price should be cost orientated and market orientated. It should be high enough to cover your costs and help you make a profit. It should also be low enough to attract customers and build sales volume.

I n determining the best selling price, think of price as being like a four layer cake. The four elements in your price are:

(1) the direct costs,

(2) manufacturing overhead,

(3) non-manufacturing overhead, and

(4) profit.

Direct costs are fairly easy to keep in mind. They are the cost of the material and the direct labor required to make a new product. You have these costs for the new product only when you make it.

On the other hand, even if you don't make the new product, you have manufacturing overhead such as janitor service, depreciation of machinery, and building repairs, which must be charged to old products. Similarly, non-manufacturing overhead such as selling and administrative expenses (including your salary) must be charged to your old products.

Direct Costing

The direct costing approach to setting prices enables you to start with known figures when you determine a price for a new product. For example, suppose that you are considering a price for a new product whose direct costs - materials and direct labor - are $3. Suppose further that you set the price at $5. The difference ($5 minus $3 = $2) is "contribution." For each unit sold, $2 will be available to help absorb your manufacturing overhead and your non-manufacturing overhead and to contribute toward profit.

Price-Volume Relationship

Any price above $3 will make some contribution toward your overhead costs which are already there whether or not you bring the product to market. The amount of contribution will depend on the selling price which you select and on the number of units that you sell at that price. Look for a few moments at some figures which illustrate this price-volume-contribution relationship:

I n this example, the $4 selling price, assuming that you can sell 30,000 units, would be the "best price" for your product. However, if you could sell only 15,000 units at $4, the best price would be $5. The $5 selling price would bring in a $20,000 contribution against the $15,000 contribution from 15,000 units at $4.

With these facts in mind, you can use a market-orientated approach to set your selling price. Your aim is to determine the combination of selling price and unit volume which will provide the greater contribution toward your manufacturing overhead, non-manufacturing overhead, and profit.

I f you ran a non-manufacturing company and could get as much of a product as you could sell, using the direct costing technique to determine your selling price would be fairly easy. Your success would depend on how well you could project unit sales volume at varying selling prices.

However, in a manufacturing company, various factors complicate the setting of a price. Usually, the quantity of a product that you can manufacture in a given time is limited. Also whether you ship directly to customers or manufacture for inventory has a bearing on your production and financial operation. Sometimes your production may be limited by labor. Sometimes by the availability of raw materials. And sometimes by practices of your competition. You have to recognize such factors in order to maximize your profits.

The direct costing concept enables you to key your pricing formula to that particular resource - labor, equipment, or material - which is in the shortest supply. The Gail Manufacturing Company provides an example.

Establish Contribution Percentage

In order to use the direct costing approach, Mr. Gail had to establish a contribution percentage. He set it at 40 percent. From past records, he determined that, over a 12-month period, a 40-percent contribution for each price would take care of manufacturing overhead and profit. In arriving at this figure, Mr. Gail considered sales volume as well as overhead costs.

Determining the contribution percentage is a vital step in using the direct costing approach to pricing. You should review your contribution percentage periodically to be sure that it covers all your overhead (including interest on money you may have borrowed for new machines or for building an inventory of finished products) and to be sure it provides for profit.

Mr. Gails' 40-percent contribution meant that direct costs - material and indirect labor - would be 60 percent of the selling price (100-40=60). Here is an example of how Mr. Gail computed his minimum selling price:

Material.......27c

Direct labor...+10c

.................._____

....................37c

The 37 cents was 60 percent of the selling price which worked out to 62 cents (37 cents divided by 60 percent). The contribution was 25 cents (40 percent of selling price):

Selling price...62c

Direct costs....-37c

.................._____

....................25c

In this approach, raw material is given the same importance as direct labor in determining the selling price.

Value of Material

The value of the material used in manufacturing the product has a bearing on the contribution dollars that will accrue from each unit sold. Suppose, in the example above, that the material costs are only 15 cents instead of 27 cents while the direct labor costs remain the same - 10 cents. Total direct costs would be 25 cents.

In order to get a maximum contribution of 40 percent - as Mr. Gail did - the direct costs must not exceed 60 percent of the selling price. To arrive at the selling price, divide the total direct cost by 60 percent (25 cents divided by .60). The selling price is 42 cents. With this new selling price, the contribution is 17 cents (42 cents minus 25 cents for direct costs.)