by Alan Hauff
Competitive pricing is always an important concern. This article outlines how to calculate overhead percentages and how to use them to determine product pricing.
Competitive pricing is always a hot button with business owners. They know competitive prices will attract customers. They also know that price is usually one of the first pieces of information buyers collect. If they can make a favorable first impression, they feel increased sales and loyal customers will follow.
The downside of competitive pricing is that many business owners establish prices without analyzing their costs. They simply use their competitor's price as a benchmark and make the assumption that it will cover costs and provide a margin for profit. Unfortunately, this assumption is seldom correct, especially if they choose to price themselves below the competition, which is quite common. Everybody's costs and profit margins are different and what may be acceptable for one business may result in a loss for another. Often, business owners will say, "I'll raise my prices later, after I have customers," or "I'll make up for lower prices with volume." Most of the time, this does not work because of market factors.
Business owners need to have a good understanding of their business expenses and how these expenses impact the overall pricing structure of their business. Most owners understand the cost of individual items but many lack a methodology that insures all these costs are captured in their selling price. They encounter difficulty when they try to factor overhead items such as indirect labor, interest, rent and utilities into their price. These costs are not easily attributable to a particular product or service and often one or more is overlooked.
A preferred method of capturing costs is to calculate an overhead percentage. The overhead percentage provides an easy way to factor overhead expenses into a selling price and a convenient way to monitor the impact changing costs has on prices. It provides the business owner with a means to allocate overhead expenses proportionately to the direct labor dollars billed to each customer. Although the overhead percentage formula is simple to use (divide the overhead expenses by direct labor), it requires an understanding of pricing terminology and a working knowledge of the process for calculating it.
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