Pricing and Costing

1. Pricing and Costing

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

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

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. Types of Costs 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)

7. Types of Costs 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)

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

9. Costing a Service or Project • Gather all existing financial information to identify all the costs in your organisation (Budgets, Cash Flow...) • Identify both the Direct Services/Projects within the organisation, as well as the Indirect departments which incur costs • Allocate all relevant costs to these Services/Projects and Departments • Identify remaining costs to be shared amongst these Services/Projects and Departments • Review these costs and decide how to allocate over these Services/Projects and Departments (using an appropriate method of allocation – cost driver) • 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

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

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

13. Cost Allocation Exercise

14. 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

16. Cost Allocation Exercise

17. Cost Allocation Exercise

18. 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

20. Cost Allocation Exercise

21. Cost Allocation Exercise

22. 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

24. Cost Allocation Exercise

25. Cost Allocation Exercise

26. Cost Allocation Exercise

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

28. Cost Allocation Exercise

29. Cost Allocation Exercise

30. 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

32. Cost Allocation Exercise

33. Cost Allocation Exercise

34. Cost Allocation Exercise

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

36. Full Cost Recovery

37. Full Cost Recovery 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

38. Full Cost Recovery • 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

39. Full Cost Recovery 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

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