Costs (direct or indirect) are the expenses that a business incurs in bringing a product or service to market. The selling price is the amount a customer pays for that product or service. The difference between the price that is paid and the cost that is incurred is the profit the business makes when the item sells. If a customer pays £10 for an item that costs the company £5 to produce and sell, the company makes a £5 profit.
If only it were that simple!! When calculating the cost of goods sold, a business must add the cost of absolutely everything necessary to produce that item. In the case of an appliance for instance, this calculation would include parts, materials, the labour to assemble the item, heating, lighting, power, salaries, administrative costs, packaging and the appliance's transportation from the factory to the retail location. There are obviously fluctuations in the cost price over time and this will affect at what price you can comfortably sell to make a profit. When is the right time to pass on these changes to your customers – immediately or waiting a while if you fear that by raising your selling price, customers might fade away? It's always a fine balancing act to find the right time to pass on any increase in your costs to your buyers – and your costs are only one part of the pricing equasion.
Most customers and consumers can understand for instance when a hike in fuel prices means a rise in the selling price. If you have just given a pay rise to your employees then this can affect your selling price – but this particular increase in your costs is not always obvious to your buyers – nor would they necessarily have sympathy for your plight. To be blunt, customers don't care too much about how much something costs you to make but they do care about how much value you’re providing.
There are two basic methods of pricing products and services: cost-plus and value-based pricing. The best choice depends on your type of business, what influences your customers to buy and the nature of your competition.
Cost plus Pricing
Cost plus pricing method refers to that pricing strategy under which a company adds all costs which have gone into making a product and then adds some percentage of profit margin to arrive at a price for a product.
Advantages of Cost plus Pricing
- Biggest advantage of this is that you should know exactly the amount of expenditure incurred on making a product and therefore you can add a profit margin accordingly. So for example if your company has incurred expenses of £100 and you want to earn a profit margin of 10 % than you will sell the product at £110.
- It is the simplest method to decide the price for a product.
- Since you are using your own data for deciding your costs it makes it easier to evaluate the reasons for escalations in expenses and therefore you can take corrective action immediately
Disadvantages of Cost plus Pricing
- This method does not take into account the future demand for a product which should be the base before deciding the price of a product.
- It also does not take into account competitor actions and its effects on pricing of the product, because in today's competitive world if one solely depends on cost plus pricing it can lead to a failure of your product in the market.
- It can result in a company overestimating the price of a product because this method includes sunk costs and ignores opportunity costs.
- Ignores your image and market positioning. Hidden costs are easily forgotten, so your true profit per sale is often lower than you realise.
Remember, cost is only one relatively small factor to consider when pricing your product or service and very few companies should use cost plus pricing for the reasons given above.
2016 gas and electricity price changes
By mid-February 2016, all of the big six suppliers had announced they would be cutting prices amid demand that bill costs reflect the falling wholesale gas prices.
The announcements kicked off with E.ON in January, and by 11th of February, all big six had committed to dropping prices by roughly 5%. However, these cuts were met with criticism for a few reasons:
- Price cuts were around 5% from each supplier, while wholesale gas costs had dropped about 23%.
- The price cuts only affected customers on standard plans, and the difference between suppliers' standard plans and their own cheapest plan was more than £300 in most cases.
- Some suppliers announced the cuts in January, but didn't implement the change until after winter was over - when customers' energy use invariable goes down considerably.
Drop in price of Gas not passed on to Consumer
Ann Robinson, Director of Consumer Policy at uSwitch, said of the price cuts:
“Consumers will be exasperated at yet another small cut from the big six which, quite frankly, is too little too late. Hard-pressed customers should be seeing double-digit cuts to bills, to help stay warm and keep the lights on this winter. Token-gesture price cuts demonstrate that loyalty simply doesn’t pay. Standard tariff customers should make their own price cut by switching to a cheaper fixed deal, saving more than £320 a year.”
This focuses on the price you believe customers are willing to pay, based on the benefits your business offers them. If you have clearly-defined benefits that give you an advantage over your competitors, you can charge according to the value you feel you offer your customers. While this approach can prove very profitable, it can alienate potential customers who are driven only by price - and can also draw in new competitors.
You do need to be able to "prove" the benefits you are providing. Think about how much your coffee costs in Starbucks. Do you honestly believe that it costs that much to make? And yet, you're happy to pay because you enjoy the ambience, the choice available and the whole coffee-drinking experience that Starbuck provides. Starbucks are therefore able to reinvest their profits to make locations what they are and where they are – and we are satisfied with this long-term value.
Price Elasticity of Demand (PED)
Gathering data on how consumers respond to changes in price can help reduce risk and uncertainly. More specifically, knowledge of PED can help your firm forecast its sales and set prices.
Knowing PED helps you decide whether to raise or lower a price or whether to price discriminate. Price discrimination is a policy of charging consumers different prices for the same product. If demand is elastic, revenue is gained by reducing price, but if demand is inelastic, revenue is gained by raising price. When PED is highly elastic, your firm can use advertising and other promotional techniques to reduce elasticity.
No one pricing formula will produce the greatest profit under all conditions. To price for maximum profit, you must understand the different types of costs and how they behave. However, a rise in your costs whould not always lead to a rise in your selling price. You also 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.