The Price is Right: Quantifying Your Indirect Costs to Determine Product Pricing
Each day, pallets of your product roll out of your manufacturing plant. Workers load them onto trucks, which are taken to customers, who have agreed to pay a pre-negotiated price for them.
As head of the shop, you’re constantly assessing whether the price you negotiated is the right one. You want to charge a fair price – one that will allow your company to extend its profit margins, but you don’t want to gouge your customers, who are always on the lookout for competing suppliers offering better deals.
To determine how much to charge for your product, you need to figure out how much it costs your company to make each product unit. That means calculating the true total cost to convert each unit from raw material to a finished product, and then ship that product to your customer’s loading dock.
Find your pricing sweet spot
Calculating the direct costs tied to a product is relatively easy with the help of spreadsheets and the dedicated staff involved in producing your product line. But that’s not the full story. There are other, indirect costs tied to your products, and you won’t have a full pricing picture without gaining an understanding those costs.
The easiest way to estimate indirect costs is to come up with a cost pool, says Dave Shealy, president of The Shealy Group.
“Your cost pool is a set of all manufacturing costs that aren’t direct costs, divided by an activity measure,” Shealy says. “The most common activity measures in manufacturing are direct labor dollars, direct labor hours and machine hours.”
If you calculate a monthly expense of $100,000 in indirect costs – including overhead items such as labor burden, taxes, insurance and utilities – and 10,000 machine hours per month, the mathematical dividend comes out to $10 per machine hour per month in indirect costs. You then allocate that cost to the inventory you’re producing, Shealy says.
It’s important to note that the indirect cost figure is usually only associated with inventory items that are considered work-in-process or finished goods. You should not allocate this cost to raw materials.
Playing the numbers game
The end goal of quantifying your indirect costs is to estimate your profits, and subsequently, your profit margins, so that you price your products correctly. If you only calculate prices based on a product’s direct cost, you aren’t getting an accurate picture of the cost involved with bringing a product to market – and you could be under-pricing your products, unwittingly eating into your margins.
That means you’ll have additional numbers to track and calculate. But the good news is, if you’re a small or mid-sized manufacturing operation, the pricing process doesn’t need to be complicated.
“Big manufacturers might have many different activity measures they need to use, but if you’re a smaller outfit, the biggest advice I could give is to keep it as simple as possible,” Shealy says. “Pick measures of activity that make sense for your business. It should be an area where you have a lot of data to draw from, and an area that everyone in the company understands. If you have a lot of data on machine hours, that’s a good place to start.”
And don’t overstate your numbers. Overestimating, or rounding up the figures to the nearest $1,000, isn’t a good idea.
“It’s OK if the measure is conservative – in fact, you should try to be conservative with your numbers,” Shealy says. “Overstating the activity measure can mean you’re dividing by too big of a number and allocating smaller costs than you should. Don’t estimate that you’re producing more product than you actually are.”
The more you know about what goes into your operation, and the costs involved, the more you can make informed, strategic decisions about your pricing to set competitive prices for your products.
“It’s like any other part of your business,” Shealy says. “You need to understand what’s important and how to measure it. You’re simply taking the principles of good business and applying them to how you track your indirect costs.”