There are many factors affecting “market” price from a mathematical perspective; however, the following four relationships should be used or considered in pricing a service:
1.) Selling Price = SERVICE COST
100% – (Overhead % + Profit %)
2.) Service Cost = True or actual costs incurred for the service, not including burden for Overhead (Operating) Expenses or pre-planned profit.
3.) Overhead % = Overhead (Operating) Expenses as a percent of sales from the “historical” management income statement.
4.) Profit % = The Pre-Planned profit margin as a percent of sales.
For example, let’s assume that a service “cost” the Company $500.00 (for all direct costs). In addition, the Overhead is 22%. We want/desire a profit margin of 9% (pre-planned profit). Thus, the item our firm is selling should be priced as follows:
- Selling Price = 100% – (Overhead % + P %)
Selling Price = $500.00 / (100% – (22% + 9%)) = $500.00 / 69% = $724.64
From a budgetary control perspective, the Overhead % and Profit % will be defined fairly well. These numbers are calculated from the income statement, although the profit % can be determined from the forward-looking budget. (Note, a forward-looking budget incorporates the numbers as they need to be to drive the profit you seek.) Therefore, here “Cost” is the item giving us all the problems.
The above ratio and the application to pricing is the mathematical plan. Unit pricing must be an “average” and must be used as a guideline. The actual price should be determined as a matter of policy, incorporating the market forces of the market place in addition to the internal cost structure and desired profit margin.
Your pricing policy execution should be monitored through the monthly income statement by reviewing the costs of the inputs as a percent of sales.