Aligning Cost Based Pricing to your Business Strategy

Though there are many ways to run production, most owners and business managers in the sign and graphics industries are confident they understand production.  Design, marketing, accounting, and even sales are concepts that – even if not completely mastered – are felt to be competently understood by most. Of all of the areas that I encounter, the area that results in the most uncertainty is pricing. Even among successful captains of the industry, pricing often feels arbitrary and random.  Though quality of service matters in the price (and profitability), there is seldom an established relationship between how the price is set and the goals of the business.

The purpose of this paper is to examine aligning your cost-based pricing approaches to your business strategy.  In doing so, the company explicitly influences the orders it wins (and those it loses) in a manner consistent with its overall goals. Note: Nothing in this article is intended to tell you the best way to price. This article describes how to make your pricing consistent with your strategy; determining that underlying strategy is up to you!

Pricing Approaches

Pricing is difficult in any industry.  Determining what the customer will pay is based on material and labor production costs, competitive reaction, and an assessment of customer psychology. Each of these aspects is highly variable by itself; combined they are formative to master. There is very little literature in the sign and graphics industries on pricing. This is true for most industries characterized by custom production in small quantities in small businesses. Rather than rely on the science of pricing, businesses are forced to rely on what is available – convention. There are two major conventions concerning pricing in the sign and graphics industries: area pricing (a.k.a. square foot) and cost-based pricing.

Area based pricing is the most common example of rule of thumb pricing (a.k.a. proxy pricing), where an indirect aspect of the product is used to determine the price.  In this case, the Area of the product is a proxy for the price that should be charged. For example, the price for a given print may be calculated at $30 plus $10 per square foot printed.

It is important to understand that in Area based pricing there is not necessarily any underlying relationship to cost.  In fact, there is not necessarily any underlying relationship to anything except the rule of thumb variable. I have seen many products that were sold at a higher price than a similar product which was more expensive to produce. Vinyl Lettering may be the best known example of this, though there are many others.

Since area based pricing, trying only to reflect the market price, is not reliant on computing the exact costs it is most commonly used when the direct costs are less important than the competitive, the business doesn’t have a reliable system for pricing quickly and/or psychological factors that make up the market price. The quick sign industry, for example, with an 18-25% direct cost for production is one such example. Here the market price is more related to competitive proximity that the differences in the cost of production between two producers.

In contrast to proxy pricing, cost based pricing tries to directly compute the price from the underlying costs of production. The basic form of this equation uses the direct costs of production and applies some multiplier to arrive at the price, as in: [insert equation] This formula (and the more complex variations of it we will see later) downplays the competitive and psychological factors that make up the price and focus almost solely on the costs of production.  As such, cost based pricing makes sense:

• When direct costs are a substantial part of the final cost
• For mature products, when the costs of production are similar among players.
• When competitive pressure is very high so that no “monopoly margin” can be obtained.
• When the margins are low and/or the dangers of under-pricing are high.
• When the cost of computing the cost is less than the typical error range in estimating. For these reasons, cost-based pricing dominates the electric sign and screen-print segments.  Large format printers predominantly used area based pricing approach historically. With the maturing of the industry and the advent of tools (like Cyrious Control) that automate the costing, however, we are quickly seeing that industry transition to cost based approaches.

Cost Based Pricing

In the preceding formula, we lumped all direct costs together.  In practice, it is more common to come across a version of the formula like: [insert equation] Here, a multiplier is applied to each type of direct cost. There are often fewer categories than listed here or entire categories omitted, but we will address those items later. For now, it is good enough to say that we apply a separate multiplier2 to different types of costs.

In this form, this formula still leaves us with two questions: 1. What multipliers should I use?  2. Where does overhead belong? These two questions are intricately related but the answers are far from obvious.  In addition, how you answer the second question changes the answer to the first. In many cases, the overhead is not explicitly considered. In these cases, the multiplier used for the material includes a factor for overhead as well, as in the following formula: [insert equation] Determining how to allocate your overhead into these multipliers to support your goals is the essence of strategic pricing.

Strategic Pricing

Aligning your cost based pricing to your strategy requires understanding the relationship between the cost multipliers and their impact on your business.  How you allocate these numbers will determine the answers to the following questions:

• Which jobs are priced competitively?
• Which jobs are priced profitably?
• Where does internal investment return the best and fastest return?
• What are your most valuable assets?

Allow me to use a brief example to illustrate how this all fits together. You determine for a particular job, Company A’s costs are as follows:

• Material  = $1,000
• Labor  = $1,000
• Equipment = $1,000

Company A determined (never mind how just yet) to set their multipliers for materials, labor, and equipment all to 2, so that the price you charge is: Company A, Scenario 2 (2,2,2) Materials  $1,000 x 2 = $2,000 Labor $1,000 x 2 = $2,000 Equipment $1,000 x 2 = $2,000 Total   = $6,000 Based on this price, you win the order and a post-order analysis reveals that the order profitability was in the expected range.

Does this example indicate that your multiples were correct?  Not necessarily, since the multipliers of (2, 3, 1) also yield the same price. Company B, Scenario 2 (2,3,1)  Materials  $1,000 x 2 = $2,000  Labor $1,000 x 3 = $3,000  Equipment $1,000 x 1 = $1,000  Total   = $6,000 So which multiples are the correct ones? Obviously we can’t determine the answer with one simplistic example, but you may see now that different allocations can still give you acceptable answers. Suppose either company could rent a machine for $500 that will reduce labor costs by 50% ($500).  

Let’s see how this decision might look for these two companies. Company A, Scenario 2 (2,2,2)  Materials  $1,000 x 2 = $2,000  Labor $ 500 x 2 = $1,000  Equipment $1,500 x 2 = $3,000  Total   = $6,000 Company B, Scenario 2 (2,3,1)  Materials  $1,000 x 2 = $2,000  Labor $ 500 x 3 = $1,500  Equipment $1,500 x 1 = $1,500  Total   = $5,000 Based on this simple analysis, who would rent the equipment and who would not?  In practice, Company A is neutral about the outcome (it has 0% ROI) and so probably would not decide to do it.

Company B is likely to rent the machine and is more likely to win the work. If they bumped their prices by 10% (to $5,500) they would still likely win the work and realize better margins than in the original case. Wait!  Did I say realize better margins?  Does this seem arbitrary?  In the second scenario, Company B charged less yet they think they are more profitable than in scenario A. If you find this troubling, you are not alone.

If you haven’t gone through this analysis before, you should find this troubling.  This simple example illustrates the arbitrary nature of allocation and why you must explicitly determine how you approach this part of your business. In the first scenario, one dollar spent on any means of production was equivalent to one dollar spent on any other means of production. To Company A, decreasing labor costs by $500 was unexciting if equipment costs increased similarly.  A dollar is a dollar is a dollar. To Company B, a dollar spent on labor is more expensive than a dollar spent on equipment. Does this make sense?  

Perhaps a better question might be, “When does this make sense?” For companies in a tight labor market at or near production capacity, adding more labor might not be a short-term option.  In these cases, a dollar of extra labor is more expensive because you will have to pay overtime or external labor rates. Further, reduced labor on a job might mean you can take on more overall work – increasing the overall profitability of the company. This “opportunity” cost can often be greater than the pure cost of the resource. If labor were constrained in both scenario 1 and 2, which company will be able to produce more with the people they already have? Clearly Company B, which could produce 2 of these orders (resulting in $10,000+ in revenue) for each order that Company A accepts. Therefore, even at a “lower” price Company B might be able to achieve greater revenue and (possibly) profitability.

 

Overhead

Before going on, I should clarify one item.  When would two orders at $7,000 each be worse than one order at $8,000?  The answer, as you probably have already guessed, is when there is very little overhead. If my direct costs total $6,800 for that order, then I make only $400 in contribution for both orders of $7,000, while I make $1,200 in contribution for the one order of $8,000.  In this case I am clearly better off keep the prices high and winning few jobs. The key difference in these cases is the percentage of overhead allocation that makes up the total.

So what is overhead?  Overhead represents all the expenses necessary for the functioning of the business that are not tied to specific orders. This commonly includes things like rent, utilities, management and admin salaries, etc.3  All costs that are not direct costs are considered overhead for purposes of this discussion.  

Divvying up your overhead between orders (to ensure you are recouping enough) is the process of “allocating” these costs. [insert equation] Some of the most common methods of allocation are discussed in the following paragraphs. One approach is to allocate overhead based on labor only.4 The first step is to determine what the standard overhead cost should be for each labor hour or dollar estimated.

A typical example of this approach is to review total overhead and actual orders for the last three months and divide the total overhead by the number of production-hours worked or labor dollars spent. This yields an “standard overhead cost” that is then added to each future order based on the number of estimated labor hours required for that job. No additional overhead is frequently added for materials, equipment, or other resource types.

This approach has several resulting affects:

• Overall profitability of the company is highly dependent on working at least as many production-hours as was estimated.
• The company must adjust pricing whenever it adjusts the workforce.
• Jobs with high labor content that are won are more important than those with low labor content.

Another overhead allocation strategy frequently used equipment only.5  This is most commonly deployed among businesses that have a large equipment cost compared to other costs.

One common approach in these cases is to include the cost of the machine operators as overhead for the machine, so that the pricing formula becomes simply: [insert equation] The cost of the equipment on an hourly rate is often referred to as the Budgeted Hour Rate (BHR)6 and the formula is written as: [insert equation] The last common approach to overhead allocation is to spread it evenly across all inputs to the production process, effectively allocating it by dollar. This if often done without explicitly realizing it by those who ignore overhead directly. In that case, the multipliers used must be large enough to pay for the overhead cost of operating the business. Just because it isn’t in the formula doesn’t make the costs go away!

 

Strategic Application

Every business faces constraints and limited resources. One role of your strategy is to serve as a guiding principle in the allocation of these limited resources.  In my experience, however, few owners make an explicit link between their strategy and the pricing model they use. Since the pricing model affects how resources are used, not recognizing this link makes the implementation of strategy unnecessarily difficult.  When properly aligned, your pricing model makes the implementation your strategy much easier.

An Example

An example can illustrate the affect of pricing on your strategy.  Assume you have a strategy of high equipment utilization and low labor content in your business.  Your overhead is relatively fixed (for a short period of time anyway), so the allocation of your overhead should be heavily weighted on the labor costs. Stop for a moment and think about why I am asserting this. I stated that we wanted high equipment utilization (which probably means we are buying a lot of equipment) but I’m slanting the overhead towards labor. At first glance, this may seem counter intuitive.  

The gut response is often to place a high multiplier on equipment in order to pay for the reinvestment.  An equipment based strategy would seem to beg for an equipment dominated pricing model. Let’s look at an equipment dominated pricing model (and take it to the extreme): [insert equation] Here we recover our actual direct material costs and then build all of our labor, overhead, profit, etc. into the cost of the equipment.   What happens with this pricing model?  

Orders that require a lot of equipment time become very expensive.  Orders that require a lot of labor or a lot of materials become pretty cheap.  This will skew the won orders to those that are labor and material intensive with little equipment – hardly supporting the high equipment utilization strategy that was desired.  A high equipment utilization strategy must be supported by a pricing model that makes you comparatively cheaper for this type of business. Therefore, you should slant the overhead away from the machines and onto the labor, materials, or some other factor. This is an extreme example, but the exaggeration makes the point easier to see. In reality there are a few principals you should keep in mind. Allocation is arbitrary.  

There is no “right” way to allocate overhead and/or profit. This is perhaps the most difficult notion for management to shake.  Allocating the operations manager’s salary onto materials is no more or less “right” than allocating it to direct labor or any other measure. It only matters that you build a pricing system where you are recouping all costs (direct and overhead). Allocation is a continuum.  In the above example we allocated no overhead to labor. This may be appropriate in businesses with very little labor cost. In most cases, however, allocation isn’t an all-or-nothing decision.  It is a question of how much should be allocated where.  The tweaking of your pricing is usually done by changing how much is allocated to each factor, not which factors are used. You must be consistent in your ROI calculations.  

One final note is that the consistency of your strategy must also reflect in your return on investment calculation.  It is not enough to change your pricing to match your strategy. When you are determining whether a new printer or truck will pay for itself, you must also consider the overhead that will be shifted as a result.  Very often only direct costs are used in this calculation – resulting in investment decisions that are not aligned with your strategy or pricing models. Implementation The implementation of strategic pricing normally follows these steps:

• Understand Your Strategy.  While obvious, without an explicitly stated strategy you can’t align your pricing to it.  In fact, you need to write down your strategy if you haven't already.  The process of writing it out will help you to refine it.  You will certainly have an implicit pricing strategy, but it won’t be your strategy.
• Gather Data. Unless someone in the business has been thinking about this, you may not have the data you need to make informed decisions.  You’ll need information on direct labor, materials, and equipment as a minimum; plus indirect costs broken down by department.
• Know Your Current Pricing Models.  Before you change anything, make sure you fully understand the existing models.  Unless you are a new business, you can’t afford to gut your existing pricing immediately.
• Change Slowly Over Time. Once you have your strategy, data, and existing pricing models you can start shifting the allocation methodology used.  Doing so will change much of your existing pricing.  You will probably not want to shock your existing customers, salespeople, etc. with radically new pricing.  Instead, plan to tweak the “how much” aspect by shifting the allocation gradually over a period of 12-24 months.  This time may be too short if you have very repetitive customers with big jobs; or too long is you have short jobs with infrequently ordering customers.

Summary

A great percentage of the sign company owners and managers I encounter are uneasy with their pricing - not because they can’t do the math but because the recapture of indirect costs (overhead) seems arbitrary. They are looking for a formulaic way to translate their costs into a fair price. Unfortunately, most are looking for an accounting solution to a strategy problem. Allocation is arbitrary.  Different businesses can be equally successful with different allocation methods. The “right” way to make these decisions should be driven by your strategy – not your accountant. This paper explored how to approach allocation decisions so that the business won reflected the business desired at the top level. Failure to align your pricing method with your strategy will blunt the leading edge of your strategy. Fully aligning the pricing will accelerate the business in that strategic direction.

 

Footnotes

The topic of the “cost of estimating” is very relevant to the decision of which pricing method is appropriate but is beyond the scope of this article. ² I use the term “multiplier” rather than markup for two reasons:  (1) it makes the math easier to follow, and (2) it avoids having to define whether I mean margin on cost or margin on price each time. Refer to the appendix for formulas to convert from one format to another. ³ The subject of what to include in overhead is bigger than this paper so we won’t dive deeper into this topic here.

This technique is most commonly (though not exclusively) deployed by the electric sign manufacturing segment. ⁵ This technique is commonly (though not exclusively) deployed by the printing industry, the electric sign service industry, and sizable large-format companies. ⁶ Detailed information on the use of Budgeted Hourly Rate techniques is easily available on the Internet from by searching for “Budgeted Hourly Rate."

Appendix

Direct Burden

Many companies use different categories of overhead.  The idea of “direct burden” or “labor burden” or even “equipment burden” is often used. These burdens attempt to gather semi-variable costs and associate them with a correlated direct cost.  One common example is taking all the sick days, vacation, health insurance, and similar off-job employee expenses and lump them into “labor burden.” This separate category of overhead is then added to the direct cost for labor. [insert equation] This modification works well as long as the costs included in the burden are highly correlated to factor they modify.  Including costs that are not highly related may work for the accountant, but are not explicitly supporting your strategy and may actually be impeding it.

 

Multiplier v Markup

I’ve used the term Multiplier intentionally instead of Markup in this article.  Both are functionally equivalent (as shown below), though the Multiplier seems to avoid some ambiguity in the calculation and so I have favored it here. Advertising personnel use the term markup to the percent of the final price that is represented by the increase over costs. As such, the formula for [price] markup is: [insert equation] The markup to an advertiser will always be less than 100%, and will be negative when the price is less than the cost of production.  For production, however, the key comparison tends to be on the cost and so it is not uncommon to find the term markup used to refer to the markup on cost. The formula for [cost] markup is: [insert equation] The formula to compute the multipliers from the markup you want is as follows: [insert equation]