Before any sale can be made or any new product developed, there needs to be a foundation of accurate pricing models in place.
(article continues below)
Pricing models should contain detailed information regarding all costs related to the product and the subsequent margins based on various selling price.
While most small businesses create pricing models, the accuracy and thoroughness of these models can mean the difference between profitability and financial losses.
If your pricing models are missing information or have under allocated certain resources, the overall cost of the product may be significantly higher than what appears on paper. This will result in a lower selling price and ultimately lower margins. For this reason, the information contained within your pricing models need to be cross-verified for accuracy and completely up-to-date.
Larger companies have the benefit of MRP systems, which handle many of these calculations. Many small businesses create their own pricing models using Microsoft Excel or other programs, further stressing the need for detailed accuracy within the pricing models.
The pricing model should contain all of the direct-costs associated with the product. These direct-costs include raw materials, packaging materials and labor. There are a number of Managerial Accounting techniques that offer different ways to allocate costs to products or services.
Without getting too technical, you want to make sure that you've covered all resources that get poured into your product. These include indirect costs such as; administrative costs, set-up times, clean-up times and allowances for waste and/or downtime. Incorporating all of these factors will greatly improve the accuracy of your pricing models.
The person within your organization who is responsible for the creation of pricing models is another key piece to the puzzle. This person, typically in Accounting, must be unbiased and informed.
It is not uncommon for the Accountant to consult various departments in order to determine accurate pricing. This can be dangerous as well. For example, if the accountant asks the production manager how long it will take to complete the job, the production manager may overshoot the amount in order to gain some extra wiggle room. The final number should be reasonable and can be based on previous jobs with similar attributes.
When pricing models are created by biased parties there can be serious ramifications. I consulted for a company where the pricing models were being created by the Vice-President of Sales and Marketing. This individual was responsible for increasing sales and received commissions based on new customer sales. As a result, this individual would fudge and twist the numbers in order to achieve an acceptable profit margin.
Once the product was sold and sent to manufacturing, costs were significantly higher than anticipated and the company consistently lost money. The blame was mostly placed on production for under-performing when in fact they were performing at an acceptable level.
This example may seem devious but it happens. Sales can put pressure on those creating the pricing models in order to gain the sale. On the other hand, the production team can try and pad their numbers so they wind up looking good in the long run.
Because of these issues, the person creating the pricing model needs to be completely neutral and base their information on accurate data and historical performance. All departments need to understand the importance of accurate pricing and the detrimental effects of incorrect information.