What you will learn in this module
Understand the concepts of cost
Understand the importance of pricing in business
Learn different ways of pricing a product
Apply the concepts to decision making
SESSION PLAN |
||
Session 1 |
Costing: concept and practice |
1 hour 30 min |
Session 2 |
Pricing: concept and practice |
2 hours |
Rural women's cooperative groups often do not understand why they should calculate costs. It is important that they understand both the "why" and "how" of calculating costs.
Read the handout carefully and work out all the examples before you begin to teach.
Start the session with a discussion on the importance of calculating costs. Use the example given in the handout to emphasize the need for calculating costs. Proceed with teaching different cost concepts.
Divide members into groups and give them the case study for calculation of costs and break-even points. Allot at least one hour for group work.
Go around all the groups during the discussion and see that they are on track.
Convene the groups in a plenary to check whether each group understood the concepts.
If necessary, do the calculations yourself and explain to all participants.
End the session by emphasizing the practical use of calculating costs as in the break-even analysis.
If the women understand break-even analysis, they will be able to know the level of sales at which they can cover all their costs and begin to earn a profit.
Handout 1: costing concepts
Why calculate costs?
A women's group was earning a profit of 10 000 Baht a month after paying all members for their labour. They were very happy and did not calculate the cost of production. Their product was in demand, and as long as this was so, they did not have to spend time on any calculation. Do you think this attitude is right? Is it necessary for this group to know the cost of production?
The calculation of costs is important, regardless of whether a group is doing well or not. It is only when women know how much each product costs, that they can price the product well. It is important to calculate costs, because it is possible to cut costs only by attending to details.
Women's groups often forget several elements of costing. They tend to underestimate their own labour and, therefore, the profits they calculate may be overstated. It is important that groups recognize the voluntary contributions by members. When women begin to analyse costs, they also look into the details of the process and are able to find ways in which work can be reorganized to reduce costs.
A major cost is that of raw material. For instance, in one group, each woman buys the vegetables to make herbal sweets at home and brings them to the group for sale. In another group, each woman purchases the cotton or silk raw material, weaves on her loom at home and brings the items to the group for sale. These groups can save costs if they buy the raw material together. A group that makes artificial flowers buys all their raw material (paper, glue, metal, colour) together. The simplest way to reduce cost of raw material is by making bulk purchases. This results in individual saving and also enables lower pricing of the product, making it more competitive in the market.
Thus calculation of costs helps in:
Basic concepts of costing
Costs can be classified into two broad categories:
VARIABLE COSTS
and
FIXED COSTS
VARIABLE COSTS, as the name suggests, vary according to the number of units produced. For instance, the raw material used in the production of each piece of handcraft constitutes direct cost. The bananas used in the production of banana chips, the fish used in the production of fish sauce are examples of variable costs. Raw material and labour are variable costs. Examples of other costs that vary with production level are electricity and water.
FIXED COSTS remain the same for a certain level of production. For instance, in hiring a hall with an area of 1 000 sq.feet, which can accommodate 20 looms, the same rent must be paid even if between 10 to 15 looms are operating. Therefore, women often develop strategies to spread their fixed costs. In this case, they could try to improve their market and production and install the maximum capacity of 20 looms so that their fixed costs would be optimised.
Fixed costs include rent, salaries, tools and equipment.
Break-even point
Break-even point is that level of production at which a business unit makes no profit and no loss. The level of production and sales at which the income covers all variable and fixed costs of the business is termed the break-even point.
With good planning, it is possible to reduce both variable and fixed costs. Calculating the break-even point also helps in decision-making on the level of production and sales prices. If fixed costs i.e. overheads are reduced, break-even point will be reached faster and the business will become profitable at a lower volume of production/sale. Similarly, when price is increased the break-even point is realized at a lower volume.
Handout 2: case study on costing and break-even point
The Duang Mo cooperative group of 30 women makes handicrafts from water hyacinth. Their most popular product, a basket, is a fast moving item that is in demand throughout the year.
The following information is available about the cost of production:
members buy the processed raw material - water hyacinth fibre - from the group at 30 Baht per metre;
2.5 metre of the raw material is needed to make a basket;
a skilled woman can make two baskets per day;
each woman works for 20 days per month;
the group's total production is 1 200 baskets (30 women, 20 days, 2 baskets per day);
individual labour charge: 100 Baht per day;
all the baskets made by the women are sold immediately;
the group pays a monthly salary of 3 000 Baht each to an accountant and a marketing assistant;
it pays 300 Baht and 150 Baht respectively as monthly electricity and water charges. The monthly telephone bill is 450 Baht while transport to Bangkok and the district town costs 900 Baht per month.
Tips for adaptation This case study is on handicrafts. Examples of other products can be used depending upon the participants. The following products can be used for different credit sectors. Wood: Wooden mobile stand Food: Half-kilogram pack of Textile: One metre of cotton cloth. |
The group costs the product as follows:
Raw material |
75 Baht |
Labour charges (half a day) |
50 Baht |
Overheads and administration |
5 Baht |
Total cost |
130 Baht |
The price that the group charges per basket is |
150 Baht |
The product is sold for 250 Baht in Bangkok. The margin kept by most dealers is 10 percent, but the dealer pays a unit price of 150 Baht to this group, as this is the price that they asked for. The group believes that it is making a good profit at this sales price.
Calculate the cost of production of each basket and decide whether the group is making a good profit and a good pricing decision.
Calculating the cost
Variable cost of producing a basket in Baht
Raw material |
75 |
Labour charges |
50 |
Total variable cost |
125 |
Fixed costs of production of 1 200 units in Baht |
|
Salary of the accountant |
3 000 |
Salary of marketing assistant |
3 000 |
Electricity |
300 |
Water |
150 |
Telephone |
450 |
Transport |
900 |
Total fixed costs |
7 800 |
Fixed costs per basket |
(7 800 divided by 1 200) = 6.5 Baht |
Thus the total cost per basket is 131.5 Baht (i.e. variable cost plus fixed cost)
Q1. Has the group made a correct calculation of cost? Is the costing of overheads and administrative cost at 5 Baht accurate? Calculate the overhead cost of the group when the production level is 1 200 units. What is the price at which the group breaks even, if it makes 1 200 units?
Solution
NO. The group did not calculate the fixed costs and charged an ad hoc amount of 5 Baht. Their fixed costs are 6.5 Baht per unit. They should charge a unit price of at least 131.5 Baht to break even.
Q2. If the price is 150 Baht, what is the quantity at which the break-even point is achieved?
Solution
If price = 150
Then contribution to fixed cost |
= Price minus variable costs |
|
= 150 - 125 |
|
= 25 |
How many baskets need to be sold to cover fixed costs of 7 800 Baht?
7 800/25 = 312
When does the group break even, if the price is 150 Baht?
At break-even point, total revenue (TR) is equal to total cost (TC), thus
TR |
= |
TC |
TR |
= |
Price x Quantity |
|
= |
150 x Q |
TC |
= |
Fixed cost + Variable cost |
|
= |
7 800 + 125 x Q |
Therefore,
150 x Q = 7 800 + 125 x Q
or
(150 x Q) - (125 x Q) = 7 800
i.e. 25 x Q = 7 800
Therefore
Q = 7 800/25 = 312
Thus when the price is 150 Baht, break-even point is achieved at a quantity of 312 baskets.
Q3. If the price is 200 Baht, what is the quantity at which break-even is achieved?
Solution
If the price is increased to 200 Baht, the group will recover all its costs when it has sold only 104 baskets.
At break-even point, the total revenue should always be equal to total cost. Thus, if Q is number of baskets needed to be sold to recover total costs:
Total Revenue (Baht) |
= |
Total cost (Baht) |
200 x Q |
= |
Variable cost + Fixed cost |
200 x Q |
= |
125 x Q + 7 800 Baht |
(200 x Q) - (125 x Q) |
= |
7 800 |
75 x Q |
= |
7 800 |
Therefore Q |
= |
7 800/75 = 104 |
The group can, in fact, charge the dealer a much higher price. As the dealer sells the product at 250 Baht and expects a normal commission of 20 percent, (s)he would be willing to pay a price of 200 Baht to the group. Thus the market can bear a price of 200 Baht, while the group is only able to realize a price of 150 Baht.
Pricing is one of the most important decisions in a business. It is important that participants understand the simple concepts given in this session and are able to apply them.
Start by asking them the meaning of profit and how they can make a profit. After some participants have answered, write the key words on the board.
Profit = Total revenue - Total cost
Total Revenue = Price x Number of products
Emphasize the fact that price fixation is an important decision in a business.
Ask the women how they fix the price for their products. They may say that they put their mark up on the "cost plus". At this point, explain the first method of "cost plus" pricing as given in the handout.
Explain to them the next method of 'Price that a customer can bear'.
Tell them that they can deepen their understanding of pricing this way from the case study.
Divide the participants into groups of four each and tell them to work on the case study. Talk with every group during their work.
Convene the groups in a plenary after half an hour. When participants share their experiences during group work, ensure that all have understood the two ways of pricing.
Emphasize that members must be aware of marketing prices to take good pricing decisions.
Handout 1: concept of pricing
The primary motivation in starting a business is to make a profit. This is also true of a rural women's cooperative group starting a business. If the group makes a profit, it is successful in business. Whether the group makes a profit or not depends on the pricing of the product/service sold.
Therefore, one of the most important decisions that the group must take is about the pricing of the product. In order to be able to do so, members must first know the cost of the product/service. They must also know at what price the customers will be ready to buy their product/service.
Profit can be calculated using the formula below.
Profit = Total revenue minus Total costs
Profit margin = Total revenue minus Total costs of article
The price should be fixed such that it covers full costs, earns the group some profit and gives good value for money to the customers.
The following explains the concept of profit and the different ways of fixing prices.
Method 1: 'Cost Plus' pricing
The first method of fixing price, which is followed by many women's groups, is the 'cost plus' method. The women decide what profit margin they can add to the cost and fix the sales price. For instance, the cost of product is 150 Baht. They may decide to add a margin of 10 percent and fix the sales price at 165 Baht.
Total costs + Profit margin = Sales price
Method 2: Pricing at 'What the market can bear'
Another way of pricing is to price at what the market can bear.
Judging or understanding what the customer is willing to pay
+ profit margin
= sales price
Women must know the current sales price in the local market in order to calculate the price using this formula. Therefore, it is important that they know the prices prevailing in the local market. In fact, for good pricing decisions, they need to know the prices in urban markets as well.
Handout 2: case study on costing and pricing
The four-year-old Thumbole Mahardthai Women's Cooperative Group has 30 members and makes artificial flowers. The production cost of the flower made most by the group is calculated as follows:
The cost of producing 40 flowers is given in the table below:
Particulars |
Cost in Baht |
Labour cost at 100 Baht per day per person for five persons |
500 |
Raw material cost for 40 flowers |
530 |
Overheads and administration (Transport, electricity, phone bill, depreciation, packaging etc.) |
370 |
Total cost |
1 400 |
Cost of one flower = 1 400/40 = 35 Baht
This 35 Baht includes
Labour cost |
12.50 Baht |
Raw material cost |
13.25 Baht |
Administration costs |
9.25 Baht |
Total |
35 Baht |
Profit of margin |
115 Baht |
Selling price |
150 Baht |
Especially important for women to remember
Have you calculated and included the cost of your labour for production, management and marketing in the total cost of your product or service?
Have you priced your time at the current market value? Are you using this calculation as a means of determining the final price of your product?
What you have learnt in this module
Costing is important to ensure that all expenses are covered and the group fixes a price that ensures a profit.
The first and most important step is to identify ALL the costs of a business: production, sales, administrative, overheads, etc.
The next step is to classify costs into fixed and variable costs.
Break-even analysis helps with decisions regarding pricing and production levels.
Pricing can be done on the basis of 'Cost Plus' thinking and this ensures a minimum margin over costs.
Market considerations are important in pricing and are taken into account by pricing at 'What the market can bear'.
The price fixed lies within this range of possibilities. Therefore, it is important that groups calculate the costs and have an understanding of the final market for their products.
If the group depends on intermediaries such as agents, middlemen or traders, the latter's costs and profits must also be taken into account.
The services they provide include working capital advances, stocking, storage place, market information and linkages.
Marketing linkages and contacts are important to bring the group closer to its final customers.
Groups must assign at least two or three people for the marketing work so that they are constantly aware of the demand for their product, and its strengths and weaknesses.