Running a Small Business

Lesson 1: Setting Prices

Costs of production

The factor that affects your price more than anything else is the cost of producing what you sell. Many small businesses seem to be quite profitable based on order costs but, when everything is added up at the end of the year, there's nothing left. Generally the problem is that costs are underestimated and not all costs are included in the calculation.

What you need is a clear idea of what it costs you to produce the goods or services you are selling. The test whether it belongs in cost of production or overhead is whether it increases linearly with the amount of business that you do. A cost of production should approximately double if you sell twice as much. All costs that behave this way have to be included in cost of production.

The easiest example is if you're making products to sell. You have the cost of the material you buy, the labour to produce your product and the cost of delivering the product to the customer. What about the cost of ordering the material? What about the cost of receiving it, checking it, processing the invoices and writing the cheques? What about billing, credit card charges, returns and warranty? If it goes up as you do more business, it should be assigned to the cost of production. If it stays the same no matter how much you sell, it's overhead.

Many businesses treat this separation as just book-keeping. They say that it doesn't really matter where the cost ends up - it has to be paid in any case. This is certainly true for businesses focused on their operations and on themselves as many are. For businesses which are focused on their customers, it makes a big difference. That's because your cost of production is directly linked to the order your customer places while your overhead has no such link.

This means that, when your customer places an order, he has generated the appropriate cost of production in your business. If you know that he doesn't value some of the things you have included, you can eliminate them and reduce the cost of production. If you know he would place value in something additional, you can include it and increase the cost. That's the direct link to your customers.

That way, if your customers would like home delivery, you can ask them how much they think such a service would be worth. Then you can check how much it would add to your costs. If your cost is lower, it makes sense to provide it. On the other hand, you may be buying a specially expensive material. Look at why you are using it and what the effect is for your customers. Ask them how much they value this and then determine whether it makes sense to continue paying more for this material.

This is why isolating the costs of production and breaking them down is important for a customer-oriented business. You should be discussing your product with your customers and the feedback you get has to be translated into what they value versus what it costs you to do. You'll only know what it costs you if you look at your cost of production breakdown.

The same applies to businesses which don't produce things themselves or which sell services. If it costs more when you sell more, those costs can be optimized with regard to what your customer values. If you do this consistently you'll have what your customers value most of all - good value for the money.

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