## Tuesday, August 3, 2010

### Margin of Error

How do we calculate a price for something?

More often than not business calculates the price of its products or services by some method of Mark-Up. It is a common practice that relies on the assumption that if you take the costs of labor and material and “bump them up” by some percentage, you will make the profit you want. However, Mark-Up pricing leaves “money on the table” and in some cases may result in what we will call a negative profit.

The reason for that is the assumption itself. Even though labor and material are considered Direct Costs, they are pretty much fixed. From an accounting point of view they are, anyway, but in life we know that commodities the prices for steel, petroleum, and transportation change, although they tend to go up more often than down. Our pricing has to absorb those differences as they occur.

We also know that the cost of labor is more than just the wage paid to an employee, which is the major part. Burdened wages include other costs, like SUTA, FUTA, FICA and paid vacation time. They also have to be absorbed by our pricing. Therefore, we have to look at pricing as changes occur and not assume that Mark-Up automatically recovers such costs.

My purpose is to introduce Gross Margin Pricing which prevents leaving “money on the table” by recovering all of our costs however they may change. In order to make it make sense, I am going to us a napkin on the table to illustrate the point. My theory is based on my experience which says that if it can’t be done of the back of a napkin, then it is too complicated.

Let’s look at the difference between Mark–Up and Gross Margin pricing. The following example shows the significance. To demonstrate, let’s assume a \$7.00 product cost and look at the difference.

an analogue PowerPoint

MARK – UP

30% Mark-Up pricing simply multiplies costs by 1.3: \$7.00 X 130% = \$9.10 revenue (price).
Revenue minus cost equals gross margin: \$9.10 minus \$7.00 = \$2.10 or 23% gross, or profit.

GROSS MARGIN

This pricing system divides the cost by the reciprocal (100% - 30% = 70%) of the desired gross margin, the profit percentage you want.
Cost divided by the reciprocal of profit equals price: \$7.00/0.7 = \$10.00 revenue (price).

Using MARK–UP pricing rather than GROSS MARGIN pricing produces a suggested selling price that is 7% less than the correct selling price. Just to keep the numbers simple, on a sales volume of \$1M that would be like leaving \$70,000 on the table. It must be a big table.

You can make my napkin presentation into a PowerPoint presentation

The Mark-Up theory of pricing is the way the model worked from after WWII into the late part of the century. It worked because the other components of pricing remained less variable than they are today. There are lot more add-on costs today than there were for business in the 50’s and 60’s. However, Mark-Up pricing is inflexible and does not absorb all of the costs, which in turn erodes profit.

This goes to a quick discussion of how often should prices be calculated. Rather than say, “That depends,” which would be a cop-out, the answer is “regularly.” Every time something impacts costs, prices need to be considered and changes made accordingly. For example, in the aftermath of Hurricane Katrina, transportation costs skyrocketed to almost five times what they cost before, all of which had to be passed on to consumers.

I have a spreadsheet I use called “The Electronic Deal Napkin.” The idea came from working with people who did their calculations on paper napkins with a pen, instead of on a computer. The fundamentals are the same. By the way, a pen is a hand-held, friction-driven, fluid-medium, analogue, scribing-devise. It is now updated.

How does one price things? Don’t multiply, divide by the reciprocal. It works every time.