Product Costing and Pricing: How to Price for Real Margin

Ask most owner-managers what a unit costs to make and you get a number that is confidently wrong. Product costing and pricing is where the profit in a South African business is actually decided, and it is usually decided once, in a spreadsheet, by someone who has since left.

This guide sets out how to build a unit cost you can defend, how to allocate overhead without guessing, and how to convert that cost into a price that funds the business rather than one that matches the competitor down the road. If your management reporting is not yet giving you margin by product line, start with our guide to what management accounts should contain.

What true unit cost actually includes

A unit cost has three layers, and businesses typically capture the first, approximate the second and ignore the third.

• Direct cost: materials, components, packaging, direct labour and anything else that only exists because that unit was made or that job was done.
• Allocated overhead: the share of factory rent, supervision, machine depreciation, quality control, electricity and consumables that the unit consumed.
• Cost to serve: delivery, warranty and rework, credit terms, returns and the sales effort the customer required. This is the layer that quietly turns a profitable product into an unprofitable customer.

Direct costs: the part most businesses get right

Direct cost is traceable, so the arithmetic is rarely the problem. The problem is the inputs going stale. Bills of material are built once, then the supplier changes, the rand moves, the scrap rate creeps up, and nobody updates the sheet.

Allocating overhead without guessing

Overhead allocation is where costing earns its keep. Spreading total overhead evenly across units is fast and almost always wrong, because a low volume, labour intensive product consumes far more supervision and setup than a high volume automated one.

1. 1Pool the overhead by activity, not by department. Typical pools are machine running, setup and changeover, quality and inspection, materials handling, and facility cost.
2. 2Choose one driver per pool that genuinely causes the cost: machine hours, number of setups, inspection hours, number of pick lines, floor space occupied.
3. 3Measure the driver volume for a realistic period, not a theoretical one.
4. 4Calculate a rate per driver unit and apply it to each product using that product's actual driver consumption.
5. 5Reconcile back to the general ledger. Total overhead allocated must equal total overhead incurred, or the costing is telling you a story the accounts do not support.

That last step only works if the ledger is structured to support it. If your expense accounts are a long undifferentiated list, pooling is guesswork. Our guide to designing a chart of accounts covers how to set the structure up so costing and reporting draw on the same data.

Capacity is the number that breaks most costings

Here is the trap. You have fixed overhead of a known amount and a machine that could theoretically run every hour of every shift. Divide the overhead by theoretical hours and your rate per hour looks excellent. Sell only a portion of those hours and the unrecovered fixed cost has to come from somewhere, and it comes from your profit.

Allocate over practical capacity: theoretical hours less planned maintenance, changeovers, public holidays, the December shutdown and a realistic allowance for load shedding and downtime. The unrecovered cost of idle capacity is then visible as its own line, which is exactly where a business owner can act on it.

Pricing for margin instead of by gut feel

Once cost is defensible, pricing becomes a decision rather than a reflex. Three rules do most of the work.

• Work backwards from the margin you need, not forwards from a markup. Markup and margin are different numbers and mixing them up costs real money on every line.
• Price the constrained resource. If a single machine, a single skilled operator or working capital is the bottleneck, rank products by contribution per hour of that constraint, not by contribution per unit.
• Set the floor and the target separately. The floor is the price below which the job destroys value. The target is what the market will bear. Sales should know both.

Almost every pricing problem I am asked to look at turns out to be a costing problem. The business is not underpricing on purpose, it is pricing accurately off a cost that is two years out of date.

Rishen Narsing, CA(SA)

Reviewing costs before they drift

A costing model is a living thing. Build the rebuild into your calendar: a full rebuild annually, a driver rate refresh at half year, and a monthly comparison of actual gross margin per product line against the costed margin. When the two diverge by more than a couple of points, something in the model has broken and you want to know in week four, not in month eleven.

Margin also leaks through the balance sheet rather than the income statement. A product priced correctly but sold on terms nobody enforces earns less than the model says, so pair the costing review with the discipline in our guide to improving debtors days and cash collection.

How Synergy helps

We build costing models that reconcile to the ledger, set the overhead pools and drivers with your operations team, and hand back a price list you can defend to a customer. That work sits inside our finance PMO service, and the monthly margin reporting that keeps the model honest comes through our operational finance service. If you would rather see what a full outsourced finance function costs first, our pricing page sets out the tiers.