Most vendors struggle with pricing their products. Their biggest error is asking too little for the work that they do. Pricing your products is a very difficult task. You want to get a fair price for your work but you also don’t want to undersell your work.
Fortunately there is a formula to use as a starting point.
Direct vs. Indirect Costs
First, we need to define some terms. These terms are direct costs and indirect costs. Direct costs are those costs that you incur that are spent solely on the cost of the specific product that you are making. Indirect costs are those costs that support the development of the product and not specific to the product.
For example, suppose you are a baker and you are making cupcakes for sale at your local farmer’s market. Making a batch of cupcakes involves getting all the ingredients for the cupcakes together, mixing it all in a bowl, pouring the batter into a cupcake pan, putting the pan in the oven and baking at the correct temperature for the right length of time.
The direct costs in this example are the costs of the ingredients of the cupcake. These costs may include:
- Baking soda
- Baking powder
- Cocoa powder
- Vanilla extract
- Optional cupcake paper
*Ingredients list taken from a recipe on AllRecipes.com
The indirect costs are the tools you use to make the cupcakes. Generally, if it can reused (to make another batch of cupcakes) then it is an indirect cost. These indirect costs may include:
- Mixing bowl
- Mixing spoon or electric beater
- Cupcake pan
- Kitchen you bake the cupcakes in
Determining Wholesale and Retail Pricing
The basic wholesale formula involves adding all your direct costs in the development of the product and then multiplying by 2.2. This is your WHOLESALE price. The wholesale price is the amount you would sell your cupcakes to a store that resells your cupcakes.
The retail price is calculated from the wholesale price. To calculate the RETAIL price, simply multiply the wholesale price by 2.2. This is the price you should sell your cupcakes for at the local market.
This calculation can be made easier by using a spreadsheet. If you don’t yet use spreadsheets, learn about them because they will become your life. Spreadsheets help to visualize the costs and help to find places to save money and either lower your prices or improve profitability (or both).
In our cupcake recipe from AllRecipes.com’s Chocolate Cupcakes recipe, it calls for the following:
- 1 1/3 cups all-purpose flour
- 1/4 teaspoon baking soda
- 2 teaspoons baking powder
- 3/4 cup unsweetened cocoa powder
- 1/8 teaspoon salt
- 3 tablespoons butter
- 1 1/2 cups white sugar
- 2 eggs
- 3/4 teaspoon vanilla extract
- 1 cup milk
The recipe says that it makes 16 servings. Lets assume that means 16 cupcakes.
From this list, we need to determine the cost of each of these ingredients. These ingredients can all be found at my local grocery store so I’m using their pricing in this example.
Here are the costs and sizes for our cupcake ingredients:
- 5 lbs All Purpose Flour – $2.69
- 16 oz Baking Soda – $.67
- 8.1 oz Baking Powder – $1.77
- 8 oz Baking Cocoa – $2.59
- 26 oz Iodized Salt – $.85
- 16 oz Salted Butter – $3.39
- 4 lb Granulated Sugar – $1.89
- 1 dozen Large Grade A Eggs – $.77
- 2 fl oz Pure Vanilla Extract – $6.29
- 1/2 gal 2% Milk – $1.47
The grand total of our trip to the store for our cupcake ingredients is $22.58! This doesn’t include the paper towels to clean up the mess or anything else.
Now we need to determine the cost of our cupcakes. This means converting the price we paid to the cost of the batch of ingredients in our cupcakes. To do this, some conversion is necessary to convert the size of what we purchased to the required amount in the recipe.
- 5 lbs of Flour = 20 cups = $.13/cup
- 16 oz Baking Soda = about 100 teaspoons = less than $.01 per teaspoon
- 8.1 oz Baking Powder = about 51 teaspoons = $.03 per teaspoon
- 8 oz Baking Cocoa = 2.5 cups = $1.04 per cup
- 26 oz Iodized Salt = about 175 teaspoons = less than $.01 per teaspoon
- 16 oz Salted Butter = 32 tablespoons = $.11 per tablespoon
- 4 lb Granulated Sugar = 9 cups = $.37 per cup
- 1 dozen Large Grade A Eggs = 12 eggs = $.06 per egg
- 2 fl oz Pure Vanilla Extract = about 12 teaspoons = $.52 per teaspoon
- 1/2 gal 2% Milk = 8 cups = $.18 per cup
Phew. That is a lot of work!
Note that I tried to make this accurate using Google to convert a weight measure to a volume measure. Your results will probably be different, but hopefully close to what I came up with.
Now that we have the cost per unit in our recipe, we can calculate the cost of the batch of cupcakes.
Our recipe from AllRecipes.com calls for the following:
- 1 1/3 cups all-purpose flour – cost $.17
- 1/4 teaspoon baking soda – cost is negligible ($0)
- 2 teaspoons baking powder – cost $.06
- 3/4 cup unsweetened cocoa powder – cost $.77
- 1/8 teaspoon salt – cost is negligible ($0)
- 3 tablespoons butter – cost $.33
- 1 1/2 cups white sugar – cost $.55
- 2 eggs – cost $.12
- 3/4 teaspoon vanilla extract – cost $.39
- 1 cup milk – cost $.18
Now we can calculate our total costs of ingredients for our batch of cupcakes to be $2.57 or just 16 cents per cupcake ($2.57 divided by 16 cupcakes)!
According to the wholesale and retail formula from the beginning of this post (remember that?), we should price our cupcakes accordingly:
Wholesale = $.16 * 2.2 = $.35
Retail = $.35 * 2.2 = $.77
Total Profit = $.61 per cupcake!
That’s right. We should sell our cupcakes at the Farmer’s Market for 77 cents each and we will make more than 4 times our original costs.
But wait. Something is missing.
Indirect Costs in Pricing
There are a few things that we didn’t account for in this example. First, we did not account for packaging and labeling of each cupcake. This was done on purpose because your packaging and labeling can easily exceed the cost of the actual product in this example. To apply this to your product, determine the cost of packaging and labeling in the cost formula then apply the wholesale and retail formulas.
Another thing that wasn’t included in this price is the indirect costs of producing the cupcakes. Using the profit of $.61 per cupcake, we would have to sell about a dozen cupcakes just to pay for the spoon and mixing bowl to make the cupcake. If you were selling a million cupcakes per year, this may be worthwhile, but you are probably selling fewer than that.
In order to recoup our expenses and still make a profit, we need to determine what the indirect costs are as well and include them in the formula. This isn’t necessarily done by a per batch of cupcake basis, but a yearly basis.
The indirect costs of making a batch of cupcakes may include the following:
- Kitchen facilities (including the oven)
- Utilities (electricity and gas)
- Mixing Bowls
- Electric mixer
- Cupcake pans
Since you are starting a business or are already running a business, you should include all of these costs even if you are using the kitchen and equipment in your home. As you grow your business, you will need to replace or add equipment or move to larger facilities. You want to identify and include these costs in your pricing today to accommodate expansion later.
To determine these costs, identify what it costs you or WOULD cost you if you didn’t already have the equipment or facilities. Add that total together on a per year or per month basis. Identify how often you replace equipment. How many spoons do you break per year? How many cupcake pans to you throw out and replace a year?
Add all that together and identify your yearly cost. For an example, lets assume that you have recognized all of these indirect costs to be $12,000 per year. Note that this number is totally made up and may or may not be realistic. We account for this cost in our pricing by determining how many cupcakes we COULD make in that year, not how many we do make.
To continue with assumptions, lets assume that with the existing facilities we can reasonably bake 144 cupcakes per day or about 37,500 cupcakes per year. This excludes weekends when we are out selling cupcakes. However, it doesn’t take into account holidays or other disruptions in cupcake baking.
This means that our indirect costs are $.32 per cupcake. We need to add that to our production costs per cupcake. So since it costs us $.16 in direct costs per cupcake and $.32 in indirect costs, our total cost per cupcake is now $.48.
Using our formulas, we should wholesale our cupcakes for $1.05 and retail them for $2.32! We are about to make a fortune!
Including Labor in Pricing
So far we have been working for free with all of this baking and selling of cupcakes! Believe it or not, this is very common with small businesses like yours. We are so tempted to keep our prices low to beat our competition that we do not include the cost of our labor in our pricing. This temptation will keep you from growing your business.
To account for the cost of labor, start with the assumption that you are not doing the work, but you have hired someone to do the work. In our example, lets assume that we have hired a baker at $10 per hour. Yes, I know that you value your work at $100 per hour but that would make for some expensive cupcakes! And if that were really true, you would have included the cost of your labor in your pricing instead of working for free.
Now we need to determine how many cupcakes that baker can bake in an hour. Using the assumptions so far, we can bake 144 cupcakes in a working day of 8 hours. That means that the baker can bake 18 cupcakes per hour. Since we pay the baker $10 per hour, that means that we are paying the baker $.56 for each cupcake that they bake.
Now that we have determined that, we can see that the cost of manufacture for each cupcake is now at $1.04. Referring back to our formula, we should be selling our cupcakes at:
Wholesale: $2.29 each
Retail: $5.03 each
Yay! We finally know how much we should be selling our cupcakes for! See how a spreadsheet could make this SO much easier?
Ignore the Pricing Rules
Now that we know what the perfect pricing answer is, this formula is there as a guideline only. You can price your products or cupcakes at anything you want. There may be other factors that influence pricing, such as creative value or excessive competition.
Monica and I are flexible when it comes to pricing in our labor costs. I can only speak for me because I know that when I am making a product, I could be far more productive. I alternate between working and watching Netflix in the shop.
What we do instead is price our products based on the direct and indirect cost formulas and then only add our labor costs without the multiplier. This is because if I hired someone I would expect them to be more productive that I am!
For example, if we were making cupcakes, we would determine that the cost of our cupcakes would be $2.32 plus the cost of our labor. Since our favorite show might be on or we might get pulled away with other tasks, we can only make 48 cupcakes a day so our labor cost per cupcake might be $.50. We would retail our cupcakes at $3 each.
When it comes to pricing your products, there are some rules to it. However, depending on your specific situation, these rules are flexible. If you spend 2 hours using donated products to make a highly desirable and unique work of art, using this formula may mean you are underselling yourself. While these guidelines account for the value that you put into a product, you can do what works best in your specific situation.
Also remember that all my numbers in this example are totally made up so don’t use my numbers thinking that you can be an overnight gazillionaire making cupcakes!