Fixed costs

Fixed costs are expenses that do not change regardless of the level of production or sales. Examples of fixed costs include cost items such as rent, salaries, and insurance. These costs must be paid regardless of the success of the business, and are not directly tied to the production of a specific product. Fixed costs have a direct impact on a company’s pricing strategy because they represent a base level of expenses that must be covered in order to remain in business.

Example on fixed costs

Consider a manufacturing company that rents a factory for $10,000 per month. This $10,000 is a fixed cost that the company must pay regardless of how many products it produces or how many sales it generates. In order to remain profitable, the company must factor this fixed cost into its pricing strategy by setting prices that are high enough to cover its expenses. In many cases the fixed costs are the essential ground to setup your overall generic pricing strategy. In case you can work with smaller fixed costs than your competitors, you are able to be the cost-leader in your industry. Otherwise you have to consider other types of pricing strategies, if your fixed costs are higher than you competitors. 

How to price your products (3 simple steps)

Understanding variable costs

The first step in setting a purchase price for a product is to determine the cost of production.

This includes all costs (COGS = Cost of Goods Sold) associated with creating and delivering the product, such as materials, labor, and overhead expenses. Once the cost of production has been determined, businesses can then add in a markup to cover expenses such as marketing, sales, and distribution (fixed costs).

If a business is producing a product at a high volume, the variable costs per unit may be lower, which means that the business can afford to set a lower purchase price for the product and still make a profit. On the other hand, if the business is producing a product at a low volume, the variable costs per unit may be higher, which means that the business may need to set a higher purchase price for the product in order to make a profit.

Let’s see an example of pricing a candle. The variable costs are the following:

• The cost of raw materials (such as wax, wicks, and fragrance oils) for each candle is $2.
• The cost of packaging materials (such as labels and boxes) for each candle is $0.10.
• The cost of direct labor (the time it takes to make the candle) is $15 per hour, and it takes 0.5 hour to make a candle.

Determining the total cost per candle:

• Variable costs: $2 (raw materials) + $0.10 (packaging) + $7.5 (labor) = $9.60 per candle

The role of fixed costs in pricing

By including fixed costs in the calculation, a business can ensure that they are able to cover these expenses and still make a profit. If fixed costs are not considered when setting a purchase price, the business may end up selling its products at a loss, even if the variable costs are covered.

Let’s say;

• The cost of rent for the workshop is $500 per month.
• The cost of equipment (such as a wax melting pot and molds) is $3,000.
• The cost of marketing and advertising expenses is $300 per month.

Determining the total fixed cost per month:

• Fixed costs: $500 (rent) + $3,000 (equipment) + $300 (marketing) = $4,800 per month.

If the company produces 1000 candles per month, the fixed cost per candle is $4,800 / 1000 = $4.8 per candle

• The total cost per candle is $9.60 (variable costs) + $4.8 (fixed costs) = $14.40

You can also allocate fixed costs depending on your product’s relative contribution to the total sales revenue when you sell multiple products. Here’s an example:

Product A: $5000 in sales revenue
Product B: $3000 in sales revenue
Product C: $2000 in sales revenue
Total sales revenue: $10000

Allocation of fixed costs to each product:

Product A: $4800 * ($5000/$10000) = $2400
Product B: $4800 * ($3000/$10000) = $1440
Product C: $4800 * ($2000/$10000) = $960

Alternatively, you could allocate the fixed costs based on the number of units sold of each product, or some other measure of activity. The key is to choose a method that best reflects the relationship between the fixed costs and the products being sold.

Profit margin

Now, in order to make sure you have a purchase price that allows you to make profit out of your products, you need to add a profit margin.

Let’s say you want to make a profit of 25% on each candle.

To achieve this profit margin, the retail price per candle would be $14.40 (total cost) / (1 – 0.25) = $19.2.

Note, that you may want to choose your profit margin before your costs, if as a business you prioritize maximizing profits over covering your expenses. You may need to experiment with different approaches to find the one that works best for your business. It’s also important to regularly review your pricing strategy to make sure it remains effective over time.