Product Pricing

Covering fixed and variable costs

Every business needs to cover its costs in order to make a profit. Working out your costs accurately is an essential part of working out your pricing.

Divide your costs under two headings: fixed and variable.

Fixed costs are those that are always there, regardless of how much or how little you sell, for example rent, salaries and business rates.

Variable costs are those that rise as your sales increase, such as additional raw materials, extra labour and transport.

When you set a price, it must be higher than the variable cost of producing your product or service. Each sale will then make a contribution towards covering your fixed costs – and making profits.

For example, a car dealership has variable costs of £9,000 per car sold and total fixed costs of £200,000 a year that must be covered. If the company sells 80 cars each year, it needs a contribution towards the fixed costs of at least £2,500 per car (£200,000 divided by 80) to avoid making a loss.

Using this structure, you can assess the consequences of setting different price levels:

  • If the car dealership sells cars at less than £9,000 (the variable cost per car), it will make a loss on each car it sells and not cover any of its fixed costs.
  • Selling 80 cars at £9,000 will mean a loss of £200,000 per year as none of the fixed costs will be paid for.
  • Selling cars at £11,500 will result in breaking even, assuming the target of 80 cars are sold, ((£11,500-£9,000=£2,500) x 80 = £200,000 = fixed costs).
  • Selling cars at £12,000 will result in a profit, assuming 80 cars are sold, ((£12,000-£9,000=£3,000) x 80 = £240,000 (£40,000 above fixed costs)).
  • If more or fewer than 80 cars are sold, profits will be correspondingly higher or lower.

This Product Pricing business advice article is Crown Copyright © 2004-2013

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