1. Pricing and Costing

2. Roy Crosby, Business Advisor, CEiS James Finnie, Business Advisor, CEiS Alex Rooney, Business Advisor, CEiS

3. Today, we will cover 3 main areas: Costing Services/Projects Full Cost Recovery Pricing Methods Agenda

4. Costing

5. Why Classify Costs? It allows you to identify what you need to charge to cover all costs... and make a surplus It allows you to identify the profitable and unprofitable services you provide It allows you to tender with confidence that you CAN provide the services you are tendering for No Margin, No Mission!

6. Direct Costs Those costs that can be clearly, and without doubt, be allocated to a particular service or project (example: cost of a project worker’s Salary) Indirect Costs Those costs which are of a more general nature and relate to the organisation as a whole (example: Building Rent/Rates) Types of Costs

7. Direct and Indirect Costs can be further split: Fixed costs A cost that does not change with the volume of activity in the business (example: Audit & Accountancy Costs) Variable costs A cost that changes with the volume of activity (example: Vehicle Running Costs) Types of Costs

8. How do we go about costing a Service or Project?

9. 1.Gather all existing financial information to identify all the costs in your organisation (Budgets, Cash Flow...) 2.Identify both the Direct Services/Projects within the organisation, as well as the Indirect departments which incur costs 3.Allocate all relevant costs to these Services/Projects and Departments 4.Identify remaining costs to be shared amongst these Services/Projects and Departments 5.Review these costs and decide how to allocate over these Services/Projects and Departments (using an appropriate method of allocation – cost driver) 6.Use the relevant cost drivers to calculate the share of costs to each Service/Project and Department: - Allocate all joint costs to both the Direct Services/Projects and also the Indirect Departments - Allocate the revised costs of the Indirect Departments to each Service/Project - Allocate the Governance/Management Costs to each Service/Project 7.Add all the Direct Costs and the Indirect Costs to arrive at the Total Costs for each Service/Project Costing a Service or Project

10. Governance and Management Central Functions (HR, IT, Admin,etc.) Property and office costs Project AProject BProject C Indirect Costs } } Direct Costs Full Cost of Project A What is the total cost of providing Project A? Costing Structure

11. A Cost Driver is a fair and equitable means of allocating costs Different Cost Drivers are used to allocate different types of costs Examples of Cost Drivers: Floor Space used by Service or Department Headcount by Service or Department Time spent by each Service or Department Total Expenditure for each Service Cost Drivers

12. Now we’ll have a look at a practical exercise to cost the services of the social enterprise in our example - Springhill Community Services Cost Allocation Exercise

15. Step 1: Allocate Premises Costs over both the Direct Services and the Support Services Use the Appropriate method of calculation contained within the Information for allocating costs sheet Cost Allocation Exercise

19. Step 2: Allocate Administration Costs over both the Direct Services and the Support Services Use the Appropriate method of calculation contained within the Information for allocating costs sheet Cost Allocation Exercise

23. Step 3: Allocate the Support Services Costs over the Direct Services Use the Allocation by Use of Support Services percentages on the Information for allocating costs sheet Cost Allocation Exercise

27. Step 4: Calculate the percentage share of Total Costs for Each Service Cost Allocation Exercise

31. Step 5: Calculate the percentage share of Governance/Management Costs for Each Service Use the percentages just calculated in the previous step Cost Allocation Exercise

35. A total figure has now been calculated for each service:

36. Full Cost Recovery

37. Simple definition: Securing funding for all the direct and indirect costs involved in providing a contract or service, including the generation of a surplus to allow re-investment Full Cost Recovery

38. Full cost recovery is fundamental for organisations to be financially sustainable in the long-term Organisations that do not operate full cost recovery could create a deficit for their organisations which will have to be met through other funding sources Full Cost Recovery

39. Scottish Executive “buy-in” Moving towards full cost recovery, so that voluntary organisations realistically cost their services, and funders recognise that, to make organisations sustainable, a legitimate proportion of overhead costs should be included in funding agreements Strategic Funding Review Joint Statement, Scottish Executive, CoSLA, SCVO, 2005 Full Cost Recovery

40. Pricing

41. Why is Pricing Important? Pricing deals with how much you are going to charge your customers for your product or service. Price is the primary profit determinant. However, due to a lack of systematic and disciplined analysis, it is also the area where profits are most often left on the table. To be successful in business you need to be successful in pricing and organisations must have clear long-term strategies for pricing.

42. Pricing When setting a price, we need to take account of 3 critical points: Market Value – What is your product worth to your customers Cost structure – What it costs you to provide the product or service Competition – The price your competitors charge

43. Market Value Successful businesses maximise their profit by matching their pricing with the value customers put on their products or services The Cost is the total outlay required to create the product or service The Value is what the customer thinks the product or service is worth

44. Market Value Example: For a plumber to fix a burst pipe, it may cost: £10 for travel costs £5 for materials £20 for one hour’s labour However, the value to the customer who has water pouring down the stairway is far greater than the £35 cost. A plumber may, therefore, charge £50+ to fix a burst pipe, more so for an out of hours service Product pricing is often built around the “cost plus” price model, while service pricing is generally created on a perceived value basis. Both methods, however, do still require a full understanding of costs and the competition

45. Cost Structure Your cost structure provides a basis for what you need to charge...however it will not necessarily show what you can or should charge. Remember our Fixed and Variable costs? As long as the price you sell your product or service at is higher than the variable cost then each sale will make a contribution towards covering fixed costs and making profits.

46. Competition There are few monopolies around today so it is certain that you will face competition in some form. This provides you with the opportunity to benchmark your potential pricing. How? Get someone to phone or visit your rivals and ask for a price quote. Look at their published annual accounts to analyse their cost base.

47. Competition Use this information as a framework. You cannot set your prices too much lower or higher without good reason. Too low and you throw away profit, too high and you lose customers. Do not take the competitors price in isolation, consider other factors such as: Where they deliver the product or service How they deliver it The quality of their service provision

48. Pricing Pricing Models: Cost Plus Pricing Marginal Costing and Contribution Pricing Value Based Pricing A mixture of pricing strategies for differing situations

49. Pricing Models Cost-Plus Pricing This is the most common method and is based on two elements: The mark-up you must add to your costs to make the desired profit The mark-up used by competitors The mark-up is how much you add to your costs to arrive at your selling price. It is usually expressed as a % of the cost, e.g. Cost plus 50%. Different products and businesses apply hugely different mark-ups, e.g. Branded clothing: Cost plus 135% Jewellery: Cost plus 250%

50. Pricing Models Cost-Plus Pricing If the final price looks uncompetitive then review the size of the mark-up. Never remove the mark-up altogether to make the price competitive, instead look at reducing costs. Cost-plus pricing does however have pitfalls: It ignores the image and market position you are looking for It assumes you will achieve a sales target to make break even or better

51. Pricing Models Cost-Plus Pricing Example The costs involved in making a product are: Direct Materials£3 per unit Direct Labour £11 per unit Direct Expenses£2 per unit Indirect Expenses£4 per unit

52. Pricing Models Cost-Plus Pricing Example If we want a mark up of 30% on each unit, then: Full Cost = Direct Materials£ 3 Direct Labour£11 Direct Expenses£ 2 Indirect Expenses£ 4 Full Cost=£20 Mark Up=30% of £20£ 6 Selling Price=£26

53. Pricing Models Marginal Costing and Contribution Pricing The Marginal Cost approach takes a different view from the Cost Plus pricing method Instead of starting from the cost of the product or service, you start from the price that you can charge, and the amount of sales you can make at that price This technique will allow you to see whether you can cover costs and make a profit at a certain price

54. Pricing Models Marginal Costing and Contribution Pricing This approach to costs and pricing takes cost behaviour as the basis for allocating costs The categories of costs considered for this method are the variable and fixed costs This method also introduces the concept of contribution – the amount remaining after deducting the variable costs from the selling price This goes towards covering the fixed costs and any remainder goes to profit

55. Pricing Models Marginal Costing and Contribution Pricing Example Sales Price of a Product is £7.50 per item Variable Costs are £4.50 per item, and Fixed Costs are £2.90 per item

56. Pricing Models Marginal Costing and Contribution Pricing Example Contribution = Sales less Variable Costs = £7.50 - £4.50 Contribution= £3.00 per item Fixed Cost= £2.90 per item Profit= £0.10 So, to make 100 items, a profit of £10 would be generated.

57. Pricing Models Value Based Pricing States that the price should reflect the value of a product as customers perceive it (the “willingness-to-pay”) Value-based pricing is an effort to extract this perceived value from the market This involves quantifying perceived value and increasing it whenever possible—i.e., when the customer’s willingness to pay for the increased value exceeds the cost of delivering it

58. Pricing Models Value Based Pricing This perceived-value pricing takes a number of forms: Convenience: A convenient, local service will normally be able to charge more Brand: Many customers will pay more for a well marketed brand Competition: The less competition there is then the less choice the customer has Supply & Demand: More customer demand than there is supply will lead to the ability to charge higher prices However, be careful. Overcharging could alienate customers and could draw in competitors

59. Pricing Strategies Special Pricing – Offering the same product at a different price (e.g. Offering a lower price for regular customers) Volume Pricing – Offering a product at a reduced price if a high volume of products are purchased

60. Margins Margins indicate the % profit a business makes after applying a mark-up If an enterprise, for example, costs its product or service at £100 and marks it up by 50% to sell it for £150 then its profit margin is 33.3% (£50), i.e. the value of the mark- up (£50), divided by the selling price (£150) x 100 You must know your margins. They are good barometers of how important particular products or services are to the profitability of your business.

61. New service development, service and product quality, funding, marketing, meeting client needs, etc… are all vital to the development of any organisation. However, if the product or service is not costed and priced effectively then the organisation will run out of money. An effective costing and pricing strategy and process is essential for the development of a successful organisation and time and resources must be invested into getting this right. Costing & Pricing: Summary