Business Administration - Basic Skills Guide (SKAT, 1994, 162 p.) Module 4: Costing and Pricing Introduction Goal Purpose Types of Costs Definition Material Costs Labour Costs Depreciation (introduction...) Calculation Inflation Format Summary Format Credit Costs Other Costs Costing Purpose Variable Costs Fixed Costs Calculating the Production Costs Format Variable Costs Fixed Costs Total Costs Pricing Purpose Pricing Factors (introduction...) Costs Market Price - Quantity Reducing Costs Conclusion Appendix A: Exercise in Costing 1. Depreciation Calculation 2. Costs Calculation

Business Administration - Basic Skills Guide (SKAT, 1994, 162 p.)

Module 4: Costing and Pricing

Introduction

Goal

This module explains, what costs are and how to calculate them. In addition, some hints are given on how to find the best selling price for your products.

Purpose

The main purpose of business is to make money, but it is not always easy to know whether you are making or losing money. If you spend more money producing goods than you get from selling them, you will lose money.

To avoid getting into this situation, it is important to know the production costs per piece. Only if you set a selling price that allows you at least to cover all your production costs, you will make a profit.

Types of Costs

Definition

Costs are all expenses which result from producing and selling goods. The main types of costs that you should know are described below.

Material Costs

To produce any goods you need the following types of material:

· Raw materials. These are the basic materials which are combined to make your goods. Examples are cement, sand, aggregate, colorants and wire to produce MCR-tiles.

· Consumables. Consumables are the materials that are used up - consumed - in the process of producing and selling goods. However, consumables do not make part of the final product. Examples are plastic sheets to produce MCR-tiles.

Labour Costs

You have to pay the employees of your business:

· Wages. These are payments made to the workers who are directly involved in producing goods. Wages are usually based on time or on volume of production.

· Salaries. Payments to staff who are not directly involved in the production process. These include foremen, administrators, salesmen and drivers. Normally salaries are based on time worked and are not related to the amount of goods produced.

· Social security. In many countries employers have to make social insurance payments for every worker. Social security can include payments into a pension plan and payments during illness or maternity leave.

· Holidays. In some countries workers are paid for a few weeks of holiday.

Depreciation

Depreciation is the special term used when referring to the costs to the business that results from investments losing their value over time.

Investments are all the items owned by the business that last a long time. Investments include production equipment such as machines, administrative equipment such as office furniture, storage cabinets, calculators, and land and buildings which belong to the business. With the exception of land, all investments lose their value over time. For example, an old building is worth much less than a new one.

Figure

This loss in value are costs. Therefore, depreciation must be included when calculating production costs.

Attention Depreciation falls under costs, but cash spent on investments does not! For this reason costs and cash spent on the business must be regarded as separate things.

Calculation

The yearly amount of depreciation is determined as follows:

Step 1

Estimate how many years an investment will last. This number of years is known as the lifetime.

Step 2

Divide the costs of the investment by the lifetime in years to get the yearly amount of depreciation.

In 1988 Mr. Garcia buys a vibrating table (machine to produce MCR-tiles) for LU 3’000. The estimated lifetime is 5 years. Therefore the yearly depreciation is: The yearly depreciation costs of the machine are LU 600. Or, to put it another way, an investment of LU 3’000 which lasts 5 years, costs the business LU 600 per year.

If a profit and loss statement (see Module 5) is made every month, the monthly depreciation must be calculated. A year has twelve months; therefore the monthly depreciation is one twelfth of the yearly depreciation. If the yearly depreciation is LU 600, the monthly depreciation is 600 divided by 12 = LU 50.

Inflation

If the rate of inflation is high, e.g., 100% per year, the LU 600.- do not reflect the actual loss in value after one year, because now the LU 600.- are only worth half. The higher the rate of inflation, the stronger is this effect. Therefore, in countries with a rate of inflation higher than 30%, the calculation of depreciation should be based on a hard currency such as US dollars.

Mr. Garcia makes an example with one of his vibration tables: 1. Price of a new machine is US$ 1’200 2. The lifetime of a new machine is estimated to be 5 years 3. Depreciation in $: 1’200 divided by 5 = $240 per year 4. Exchange rate: LU: $ = 2:1 5. Depreciation in LU: $ 240 × 2 = LU 480

The monthly depreciation is calculated in the same way. First calculate the monthly depreciation in dollars, then calculate the monthly depreciation in local currency.

Format

With the format shown below the yearly depreciation can be determined, even in a country with a high rate of inflation. In the upper part, the yearly depreciation amount is determined as shown above. In the lower part, the amounts of yearly depreciation in the local currency are determined.

The effect of a growing rate of inflation can be seen very well: The amount of depreciation in local currency is increasing all the time.

Figure

Summary Format

In the profit and loss statement (see module 5) the total amount of depreciation is needed. To determine this figure you may need the format “Depreciation Summary”.

Credit Costs

Most businesses need credit from time to time. Money borrowed from a bank or moneylender is not free. Interest charges and bank fees normally must be paid when a business borrows money.

Other Costs

There are many other types of costs such as

· Water and energy, including electricity, firewood, and fuel costs,
· Transports, including shipping costs,
· Maintenance, including repairs to buildings and equipment,
· Office expenses, including stationery, postage and telephone,
· Marketing, including advertising and selling costs,
· Taxes and fees,
· Education of your workers.

Costing

Purpose

The purpose of costing is to find the best selling price for your products. The costs of producing goods must be calculated before the selling price can be determined.

You must know which costs change as the quantity of goods produced changes and which costs remain the same even when the production volume increases or decreases. Thus, there are two major categories of costs: ‘variable costs’ and ‘fixed costs’.

Variable Costs

Variable costs are costs that are directly related to the volume of production. If the volume changes, variable costs will change proportionally. The following costs are variable costs:

· Raw materials,
· Wages and social security payments for production workers,
· Energy,
· Water,
· Transports.

Fixed Costs

Fixed costs are those costs that do not change - that is, they remain fixed - even when the volume of production increases or decreases. The following costs are fixed costs:

· Consumables,
· Salaries and social security payments for employees not directly involved in producing tiles,
· Depreciation,
· Interest charges and bank fees,
· Repairs and maintenance,
· Office and administrative expenses,
· Marketing expenses,
· Taxes and fees,
· Education.

Calculating the Production Costs

Format

The costs per piece are the total of all variable and fixed costs divided by the number of pieces produced. The following is an example of a cost calculation for FCR/MCR tiles:

Figure

Variable Costs

We need to know the costs per piece. Sometimes, it would however be rather difficult to calculate these costs per piece. For that reason, it may be advisable to base the calculation on a certain number of pieces.

Mr. Garcia finds it too difficult to calculate the grammes of cement and minutes of work used to produce one tile. But he knows that with his vibrating table he produces about 1’000 tiles per week. He also knows his raw materials and labour costs for one week. Therefore he bases his variable costs on the raw materials and labour needed to produce a lot of 1’000 tiles.

Step 1

Determine the total costs of the raw materials needed to produce a lot of goods. Please keep in mind: The same dimension of lot, for example 1’000 tiles, must be used for all variable cost calculations.

One bag of cement costs LU 380, and one m3 of sand costs LU 300. To produce 1’000 tiles Mr. Garcia needs:
·	15 bags of cement	LU	5’700
·	1 m3 of sand	LU	300
	Total costs for raw materials	LU	6’000

Step 2

Determine the total labour costs needed to produce the same lot of goods.

It takes one week to produce 1’000 tiles. In Mr. Garcia’s workshop there are three workers and one foreman; each of them work 50 hours per week. The workers are I paid LU 32 per hour; the foreman is paid LU 44 per hour.
·	Wages, foreman (50 × 44)	LU	2’200
·	Wages, workers (3 × 50 × 32)	LU	4’800
	Total labour costs for one week	LU	7’000

Step 3

Add the raw materials costs and the labour costs together to get the total variable costs of producing one lot of goods.

To produce 1’000 tiles Mr. Garcia needs:
·	Raw materials	LU	6’000
·	Labour costs	LU	7’000
	Total variable costs:	LU	13’000

Principally, the expenses for water, energy and transports would make part of the variable costs. However, these costs are small and it would be difficult to determine them even for a whole lot of goods.

For that reason in this example the costs for water, energy and transports are considered to be fixed costs.

Step 4

Divide the total variable costs of producing a whole lot by the number of pieces in a lot to get the total variable costs per piece.

The variable costs per tile are: LU 13’000 divided by 1’000 = LU 13

Fixed Costs

Total fixed costs do not depend on the quantity of goods produced. However, the fixed costs per piece do vary with the number of pieces produced. If you only produce and sell one piece per year, all the fixed costs have to be covered by this one piece and the fixed costs per piece would be very high. However, if you produce a great many pieces per year the fixed costs per piece are much smaller.

Let’s assume that the total fixed costs of Mr. Garcia’s workshop are LU 300’000 per year. · If he produces 20’000 tiles per year, the fixed costs per tile would be (300’000/20’000) = LU 15 and the total costs per tile would be (LU 13 + LU 15) = LU 28. · If he produces 60’000 tiles per year, the fixed costs per tile would be (300’000/60’000) = LU 5 and the total costs per tile would be (LU 13 + LU 5) = LU 18. In the second case, the total costs per tile are only 55% of the total costs per tile of the first case.

As this example clearly demonstrates, the selling price would have to be much higher if production is low - because at low levels of production the fixed costs per piece are high. This leads to the following conclusion:

1. The fixed costs per piece decrease as production increases, and increase as production decreases. 2. The calculation of fixed costs per piece must be based on a certain number of pieces produced in a certain period (normally one year).

The fixed costs per piece are calculated as follows:

Step 5

The time period and the number of pieces produced during the specified time period must be determined.

Mr. Garcia is preparing a costing. He thinks that he will self about 50’000 tiles next year. He decides to base his costing on a period of one year and a production volume of 50,000 tiles.

Step 6

Determine the total fixed costs. A common method of determining costs is to base them on the costs of previous years with some increase added to account for inflation and changes in sales volume.

Last year Mr. Garcia sold 40’000 tiles and had total fixed costs of LU 250’000. This year he plans to sell more tiles. He takes the figures from last year’s profit and loss I statement and adjusts them for Inflation and other anticipated increases. For example he knows that he has to pay more taxes and he plans to make an advertising campaign. He estimates that his fixed costs will increase to LU 300’000. To simplify the calculation, the expenses for water, energy and transports are considered to be fixed costs.

Step 7

Divide the total fixed costs by the number of pieces to be produced to get the fixed costs per piece.

Mr. Garcia makes the calculation: LU 300’000/50’000 = LU 6

Total Costs

The total costs per piece are the sum of the variable costs per piece and the fixed costs per piece.

Step 8

Add together the fixed costs per piece and the variable costs per piece.

In Mr. Garcia’s case the total costs per tile are: (13 + 6) = LU 19

In Appendix A, you will find a calculation exercise. You can use it for your practice.

Pricing

Purpose

It is very important that the selling price of your goods is correct. If the selling price is too high, nobody will buy your products, because people will buy from cheaper competitors. If the price is too low, you will make a loss, because you will not cover your production costs. The various factors which influence the price must be taken into consideration and then a price must be fixed which optimally fits the situation.

Pricing Factors

The price of a product is mainly determined by its cost and by the market situation:

Costs

The costs of production are the best basis for determining the selling price. The selling price should always be higher than the costs; the difference between costs and selling price is known as profit.

Figure

The higher the selling price, the higher the profit and the greater your gain.

Market

If, however, the selling price of your goods is too high, your customers will buy from your competitors. Or they may use other products. They will for example use rooting materials such as iron sheets or clay tiles.

In Mr. Garcia’s workshop the production costs of each tile are LU 19. He hopes to make a profit of LU 3 per tile. Therefore he sets the price per tile at LU 22 (LU 19 + LU 3 = LU 22). If the competitors sell their tiles for more than LU 22, he is in a good position. If the competitors’ selling prices are in the range of LU 19 to LU 22 he can lower his price and still make a profit. If, however, the competitors’ selling prices are below LU 19 he will be unable to compete with them - and still make a profit. If he sells his tiles for less than his production costs, he will make a loss.

Price - Quantity

The demand for goods might vary strongly with the price. Because of this, it is possible for a small price reduction to lead to a big increase in sales. It is often better to sell many pieces at a low price rather than to sell a few pieces at a high price. A cost calculation will quickly show which alternative is best.

The variable costs per tile are considered to be LU 13 and the total fixed costs are LU 300’000 per year. Now let’s analyse two cases: · Selling 30’000 tiles per year · The fixed costs per tile are 300’000/30’000 = LU 10 · Total costs per tile are 13 + 10 = LU 23 The selling price should thus be at least LU 23. · Selling 60’000 tiles per year · The fixed costs per tile are 300’000/60’000 = LU 5 · Total costs per tile are 13 + 5 = LU 18 The selling price has to be at least LU 18. If the market price is LU 21 per tile, Mr. Garcia would make a loss if he produced only 30’000 tiles. However, if he produces and sells 60’000 tiles at LU 20 each, he will make a profit. But this is only true, on condition that, he can sell all these 60’000 tiles.

In the ‘Financial Analysis’ section you will learn how to calculate the ‘breakeven point’. The ‘breakeven point’ is the exact level of production, at a given price, where you make no profit and no loss - that is the point at which the costs of production and the selling price are ‘even’.

Reducing Costs

When production costs are higher than the selling price, you have the following possibilities:

· Reduce costs. Can you find a supplier of raw materials who will give you a better price? Can you employ less workers or increase the productivity of your existing workers?

· Make different or additional products with a better cost - price relation. Can you for example change your tiles so that they are a special colour, unique shape or a different form? Do they have a better cost - price relation?

· Produce more. Can you produce and sell more goods and benefit from the lower fixed costs per piece?

Conclusion

Please never forget the following rule:

The selling price should be higher than the production costs, but low enough so that the price is attractive to your customers and competitive with other producers and other products.

Figure

Appendix A: Exercise in Costing

1. Depreciation Calculation

In January 1988, Mr. Garcia bought a new vibration table for LU 3’000. The lifetime of the table is estimated to be 5 years. The inflation is about 50% per year. For that reason, Mr. Garcia decides to calculate the depreciation in US$. The exchange rates to the US$ were the following:

·	1 Jan 88:	2.00
·	31 Dec 88:	3.00
·	31 Dec 89:	4.50
·	31 Dec 90:	7.00
·	31 Dec 91:	10.50
·	31 Dec 92:	16.00

Please determine the depreciation amount in local currency for the 31^st of December of the years 1988, 1989, 1990, 1991 and 1992. On the next page, you find the answer.

Figure

2. Costs Calculation

Calculate the production costs per tile, based on the following figures:

· All costs are given in LU (Local Units of currency). Variable costs calculations are based on the costs of producing 1’000 tiles. All figures are based on the period from the 1^st of January to the 31^st of December 1992.

· 20 bags of cement and 1 m³ of sand are needed to produce 1’000 tiles. One bag of cement costs LU 300. One m³ of sand costs LU 280.

· There are three workers and one foreman. They produce 1000 tiles in one week (40 working hours). The workers are paid LU 30 per hour. The foreman is paid LU 40. Social security costs, paid by the business, are an additional 10% of the wages.

· All fixed costs are based on estimates for one year. Mr. Garcia expects to produce 50’000 tiles per year.

· Mr. Garcia estimates that his yearly fixed costs will be:

· Water and energy: LU 1’000,

· Transports: LU 2’000,

· Mr. Garcia will pay himself a monthly salary of LU 5’000. In addition there will be social security costs of 10% of his salary,

· Mr. Garcia’s records give the following information needed to calculate depreciation:

- The buildings cost LU 150’000. They will last for ten years,
- Equipment costs LU 300’000. It will last for five years,

· Mr. Garcia has a bank loan of LU 100’000. The yearly interest rate is 18%,

· Maintenance: LU 20’000,

· Office expenses: LU 2’000,

· Marketing: LU 40’000,

· Fees: LU 16’000,

· Other fixed costs: LU 10’000.

The following page has a few hints to help you find the answer.

Hints

· Wages, salary and social security expenses

The social security expenses should be added to the hourly wage of the workers and the foreman.

10% of LU 30 = LU 3. Therefore, the total wage per hour is LU 30 + LU 3 = LU 33. Mr. Garcia bases his calculation of variable costs per tile on the costs of producing 1’000 tiles. It takes three workers one week or 3 × 40 = 120 hours to produce 1’000 tiles. Therefore, the weekly amount of wages is: 3 (number of workers) × 40 (hours per week) × LU 33 (wage per hour) × = LU 3’960

The social security expenses should be added to the monthly salary of Mr. Garcia.

10% of LU 5’000 = LU 500. Therefore, the total salary per month is: (LU 5’000 + LU 500) = LU 5’500

A monthly salary must be multiplied by 12 to get the yearly salary (because there are 12 months in a year).

· Depreciation

To determine the yearly depreciation, divide the costs of each investment by its lifetime.

The investment costs of Mr. Garcia’s building was LU 150’000. The building will last ten years. Therefore, the depreciation per year is the investment costs divided by the life of the investment: LU 150’000 (investment)/10 (lifetime in years) = LU 15’000 (depreciation per year)

To determine the total yearly depreciation for all investment items add together the yearly depreciation for each investment item.

· Financial Costs

The financial costs are the yearly loan interest.

In Mr. Garcia’s case the yearly interest is determined by multiplying the amount of the loan by interest rate: LU 100’000 (loan) × 0.18 (interest rate/100) = LU 18’000 (yearly interest)

Figure