Does the market decide the price? No. Your cost structure does
Theory and practice
Let’s continue our journey through informed business management.
There is one thing we often hear business owners say: “I can’t earn as much as I should.” Then we analyse the numbers… and discover that the problem is not the market but the method used to set the selling price.
Very often the price stems from assumptions, habits or - worse - from a percentage added “by feel” to the cost of raw materials. The real crux is this: people do not know how to allocate costs to the product correctly. The issue is not technical expertise but the fact that building a costing system requires method and a management mindset.
The solution is not necessarily a complex and costly cost accounting system (hardly sustainable for many SMEs), because there is a simpler, more practical way: the industrial analysis of the profit and loss account.
The objective is clear: to determine specific rates and costs to apply to quotations in order to arrive at a selling price that is consistent and profitable.
This is where direct costing comes in, a method that assigns to the product:
- variable costs (raw materials and direct labour);
- all specific production costs.
And beware: specific costs also include items that many people forget: depreciation of machinery (taken at replacement value); electricity consumption; indirect labour; consumables; maintenance.
They are fixed or semi-fixed costs, of course. But if they are needed for production, they must be included in the product cost.
It’s a different story with full costing, which also allocates a share of general overheads. However, it can give rise to cross-subsidisation, where high-volume products end up absorbing most of the overheads.
The result? Distorted decisions. Prices that look correct… but skewed margins. That is why building a clear, consistent costing system is not a technical exercise but an essential condition for making decisions that are truly sustainable over time, protecting the company’s profitability.
What about cost centres?
If the goal is only to determine the manufacturing cost of a product, they can often be avoided. They are useful for spending budgets or organisational analysis, but in direct costing many items are already allocated analytically.
The central point is a different one: to build a genuine industrial profit and loss account you need a final trial balance that is solid and consistent with the accounts. Without correct figures, any price will be nothing more than an assumption. And a business owner cannot afford to work on assumptions.
So the question is simple (and a little provocative): are you setting your prices… or hoping they work?