Author: Stacey Adams
To achieve long-term profit growth and provide value to customers, organizations must adopt proactive pricing and quoting programs that consider market dynamics, competition, and customer behavior. However, one fundamental factor that significantly impacts profitability is the cost of the products and services being offered.
For manufacturing organizations, calculating costs accurately can be challenging due to various factors that affect the final result. From fluctuations in material prices to disruptions in the supply chain and inaccurate cost allocation methods, neglecting costs during the quoting and pricing process can lead to unprofitable deals and products.
So, What’s the Relationship Between Profit and Price?
Let's start with the basic profit equation: Profit = Revenue - Cost. Regardless of the industry, customer base, or sales channel, every organization generates revenue by selling products or services and incurs costs to make those products available. In the pricing equation, Price = Cost of One Unit + Expected Return or Markup, it is clear that the cost plays a crucial role. Without confidence in your cost calculations, you may find yourself either losing potential deals or leaving money on the table.
But what does it mean to truly know your costs? Calculating costs involves considering more than just direct material and labor expenses. Post-production, delivery, service, quality control, logistics, and other overhead costs all contribute to the final cost of a product. Additionally, costs are not static numbers; they can be influenced by market dynamics, competition, and customer behavior. Without a comprehensive understanding of the cost of each product you sell, you risk pricing yourself out of the market or missing out on potential profits.
Accurate cost data is essential for pricing professionals as it helps identify cost-saving opportunities, adjust pricing, and optimize production processes to maximize profitability. While you may not have full control over the cost of each unit, successful pricing and quoting professionals recognize the critical importance of cost in their decision-making.
Categorizing Costs and Identifying Key Drivers
Costs occur at every stage of your company's value chain. To effectively manage costs, organizations need to identify the true drivers behind them. For manufacturers, direct costs associated with production are significant, but there are many other cost considerations to take into account.
The Cost and Profitability Framework, developed by 3C Software, defines three areas of cost to help organizations understand how costs are generated and help teams understand their impact.
Cost to Source: This includes calculating the costs of materials and resources required to manufacture products. It involves determining the inbound landed costs of materials, subcontractor or vendor manufacturing costs, target costs, and should-cost estimates for new products.
Cost to Make: This encompasses the costs associated with manufacturing products, such as manufacturing product costs, bill of materials and routing costs, allocations, rate building, and inventory costs.
Cost to Deliver: This includes the costs associated with moving products and servicing customers. It encompasses post-manufacturing costs, supply chain expenses, outbound transportation and reverse logistics costs, and all the selling and support costs related to your products.
These different cost categories combined offer a comprehensive view of costs for the organization and the foundation for all types of analysis. One area quoting and pricing teams find interesting is cost-based quoting - the ability to calculate detailed cost estimates for customer quotes.
Cost-Based Quoting: Reducing the Risk of Inaccurate Quotes
For quoting teams in manufacturing, calculating costs is crucial. In scenarios where customers place custom orders, the cost-based quoting process becomes essential because each order is unique, and there are no existing bills-of-materials (BOMs), routings, or established processes.
The first stage of cost-based quoting involves inventing the product. This entails understanding the customer's specifications, creating BOMs and routings, and estimating direct costs. While this step may appear straightforward, it is actually quite intricate.
Customer specifications in spreadsheets, drawings, specifications, and other documents are reviewed, and relevant data is captured and shared with the product or cost engineering teams. The initial product specifications are then confirmed, and the process moves to the next stage.
The second stage focuses on calculating costs and determining prices. In most cases, three steps are involved in arriving at the final selling price communicated to the customer:
· Computation of material, production labor, and overhead costs.
· Summing and amortizing specific non-recurring costs, such as equipment, tooling, engineering, design, or other required expenses.
· Assigning freight and distribution costs, selling, general, and administrative expenses, royalties, required profit margins, and others to the product.
The final stage involves communicating pricing decisions to the customer and monitoring the ongoing performance of the quote.
One important factor to note is that cost-based quoting is not a linear process. Throughout the three stages, there is constant communication and collaboration among stakeholders, including customers, commercial teams, quoting teams, product and cost engineering teams, and procurement.
During negotiations, and even when the deal is complete, market changes can impact the costs of the quoted product. For example, commodity or raw material prices may change between accepting an order and producing it. With a cost-based quoting approach, you can evaluate the impact of those changes to ensure you meet your profit targets.
Similar situations can arise when creating new products or modifying existing product lines to maintain or gain market share. A deep understanding of the costs associated with ongoing production is critical for determining pricing.
How Cost Accounting Can Help
Cost accounting analysis has the potential to uncover areas where a company can reduce internal costs, thereby minimizing the necessity for substantial price increases for clients. This approach facilitates the discovery of common ground and the development of win-win solutions that benefit both parties.
Improved cost data can provide valuable insights for negotiations and broaden your pricing capabilities beyond mere price increases. For instance, your team could suggest alternative pricing models like volume discounts, usage-based tiered pricing, or longer-term contracts with fixed prices to address client concerns. In any situation, having access to precise cost information will only enhance your ability to maximize profits.
Collaboration & Transparency: The Profit Multipliers
The objective of strategic pricing is to maximize the amount that customers are willing to pay. While cost may become less significant from this perspective, its critical role in generating substantial profits should not be disregarded.
Collaboration among teams cultivates initiatives to save costs, unifies everyone towards common objectives, and enhances transparency in pricing decision-making. A comprehensive understanding of costs allows for shaping customers' perceptions of value, managing discounts to safeguard profitability, and effectively communicating price increases in response to market conditions.
Conclusion
Cost accounting provides invaluable insights to pricing professionals, supporting informed decision-making, and optimizing pricing strategies. Often overlooked, cost accounting provides accurate data to benchmark and analyze competitors, facilitate strategic planning and forecasting, justify pricing decisions to stakeholders, and enable data-driven decision-making.
In summary, effective pricing programs require a solid understanding of costs. By categorizing costs, identifying key drivers, and leveraging cost accounting insights, organizations can achieve profitable quoting and pricing strategies, maximize profitability, and succeed in the long run.
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