Costing and Pricing

Costing and Pricing is often used as being one subject, in a matter of fact costing and pricing are two totally different things, which in an export company are handled by different people, even by different departments.

Costing.

Costing is calculating a cost price. In order to be able to calculate a cost price one needs to have complete information on the cost of raw materials, packing materials, labour cost, overhead expenses and all other cost components. One should furthermore be familiar with the production processes, production capacity, etc. Costing (or calculating a cost price) is a purely technical exercise. Imaginative power and creativity is not required to calculate an accurate cost price. Reliable information and a good calculator will be sufficient. Specialists make cost price calculations in the large companies, in SMEs it is done by the managing director, a production manager, a finance man, the production planner or the purchase manager.

Pricing

Pricing is a creative marketing exercise done by the marketing manager. Pricing is taking a decision about the price to be quoted in the market. It is the marketing manager who will decide whether he can sell (or wants to sell) a product at a very high price, or that he will quote a price which is 5% lower than the price of the main competitor. He may even have good reasons to sell below cost price and accept a loss.

Some cost price calculation considerations

Even today some smaller companies in the industrialised countries get away successfully by setting their (domestic) sales prices by simply undercutting the prices of large scale competitors with 5% or more, without even trying to make a serious calculation. This may work in cases where there is limited competition and if that competition comes from a few large companies since

• the high overhead costs of the large corporations nullify the advantage of the economics of scale at the purchasing level of raw materials.
• marketing costs are with the large corporati­ons normally much higher than with smaller companies.
• a low profile operation of the smaller companies works in their advantage.

This pricing policy does not work for exports however. Before attaching an export price label to a product we have to take a number of details in to consideration among which

1. the market segment
2. the promotional activities needed to penetrate that segment
3. price levels of comparable competing products
4. anticipation of a strike back from the competition
5. the considerations of high price/maximum profits or lower price/growing market share
6. Total strategy
7. actual cost price

Components of a cost price

A cost price comprises a number of components:

Fixed production cost:

All production costs not directly related to the size of the production such as depreciation of machinery, energy consumption for heating in the factory, maintenance, factory management and workers that can not be laid of even if there is no work for them, etc.)

Variable production cost:

Cost directly related to the production of a certain quantity of products: Raw materials, accessories, packing materials, direct production labour cost, energy to operate the machines, etc.

Overhead expenses

Non-production related fixed cost such as administration, maintenance of office buildings, non-production personnel, cars, representation, interest on general overdraft facilities or mortgages, etc.

Logistic expenses:

Transport from factory to the harbour, sea (air) transport, special packing materials, insurance, bank expenses, etc.

Marketing and distribution:

Agent´s commissions, ware housing, Promotion, service, trade fair participation, travelling, brochures, etc.

Hidden profits

Overhead expenses can contain sometimes a hidden profit. Let us presume that a company sold last year 200´000 pieces and the overhead expenses were $ 150´000. The overhead expense can be calculated at $ 0.75 per unit (150´000/200´000). If the company takes this

$ 0.75 for today´s calculation as well, but the expected sales volume for this year is 300´000 the actual overhead per piece drops to $ 0.50.

Exporting at a lower profit margin than obtainable in the local market can very well be a wise decision. The more or less hidden advantages are:

• the Economics of scale (lower prices for larger quantities of raw materials) this has a positive effect on the cost price for the locally sold products as well
• full utilisation of producti­on capacity. This results in lower fixed production cost per product unit.
• larger sales volume per year let the fixed general cost drop per unit.

Pricing

The cost-plus method

If an exporter receives an enquiry from an importer, he often takes the cost price as a basis (100), adds an acceptable profit (15% for example) and offers the importer a price of 115. This is the cost-plus method.

The exporter may get the order because the main competitor offered 195. If the exporter had offered 185 or 190 he would have got the order as well. By using the cost-plus method he missed the chance to make a very good price. If the exporter later finds out that his main competitor was quoting prices as high as 195 he will find himself in a very difficult spot. It is not easy to raise a price from 115 to 185. It may take him a long time before he can raise the price in conformity with the market.

The export could have found himself as well in a totally different situation. He does not get the order because the competitor is supplying the market at 114 (which he does not know). If he would have know this, he might have been happy to offer a price of 112 and do a regular business on that level.

Companies that do not have any information on the market use the Cost-plus method, but they should make a major effort to change as soon as possible to a different pricing strategy

Some alternative pricing strategies:

Profit oriented pricing:

Profit oriented pricing is a pricing strategy that aims at achieving a specific profit percentage on the turnover or absolute profit maximisation. Achieving a specific profit percentage is similar to the cost-plus, but means that the company will not consider a price that does not give the target profit.

Turnover oriented pricing.

The company sets the turnover they want to reach in a specific period. The price is set with the objective to realise the turnover objective. Obviously the company will aim at the highest possible price, but the turnover objectives have a higher priority.

Survival strategy

Simply surviving can be an objective in a market with a temporary oversupply and very strong competition. Under these circumstances the weaker companies will disappear and the stronger, healthier companies will survive. A pricing strategy under these difficult circumstances depends on a number of factors:

• In case the company is making sufficient profit in other markets it can consider to stay in that difficult market even at prices below cost price in order to wait for better times. Companies that have an important market share, may even consider to drop the prices further in order to push other competitors out of the market.
• If the company has no other profitable market, they either can stay in the market and loose money for a specific time in case they have the financial muscle to see the difficult period out. If this is not the case they will have to quote prices that at least cover the cost.

Competition oriented pricing

This strategy can go in two directions:

• quote prices that discourage others to come into the market
• quote prices that are related to the price of a market leader (just below the price of the market leader, or higher than the market leader in case the exporter has a much better product)

Image oriented prices

This is a pricing strategy that sets or supports a specific image of a product. A Swiss Omega watch is not necessarily a better quality watch than the Citizen watch from Japan. Omega wants to sell their watch however at a price that is many times higher than the Citizen prices.

In the mass consumer market there are retail chains that specialise in low priced products. These products are not always inferior to more expensive products. These companies calculate with extremely low unit profits but due to the large turnover the total profit is attractive.

The derivatives

Apart from these basic price strategies there are many derivative strategies:

• One can introduce a product at a very low price (penetration strategy) and after having captured part of the market raise the price to a more profitable level. This strategy can not be combined with image oriented prices, but could well blend with turnover oriented pricing.
• A Company can decide to enter the market at a high price and thus try to get the image of a very high quality product, a technologically advanced product or another superlative image. After the product is introduced and the image well set in the market, the price can be lowered in order to obtain volume.

Intel (computer chips) Nike (sport shoes) and other brand owners often make use of this strategy.

The pricing strategy is part of the market entry strategy and should not be taken too lightly. A price should not be set without looking at all marketing issues that influences the decision.

A good product, an excellent packaging and high quality documentation material must support a high price. A high quality / high priced product should not be put into the market by an importer whose salesmen are handling low end products as well.

Before a strategy is chosen, the exporter should carefully weigh and consider all other options and only than decide what he wants. The total market entry strategy should be balanced so that the price strategy blends nicely with all other strategic components.

Lezingen-A-L2 – costing-2

NBM-09/98