In my last article, I looked at why you should be considering using a value-based pricing approach and I’m going to follow on from that by walking you through the calculations you’ll need to perform for this method.
Firstly, you need to know your business ratio. You do this by taking some key financial numbers from your last year’s performance and applying them to the chart below.
- Sales (S) – total sales for the year
- Materials and Outwork (M) – your total purchases
- Value-added (VA) – Sales less Purchases
- Wages (W) – your total wages
- Contribution (C) – Value-added less Wages
- Overheads – the rest of your company overheads go here
- Net profit – Contribution less Overheads
Let’s turn this into a percentage or ratio.
This table shows you the sums you need for assessing performance.
- To get your VA/S% just divide your Sales by your Value-added and multiply by 100.
- To work out your VA:W Ratio you’ll need to divide the total VA by your Wages and multiply it by 100. This calculates what value was brought back into the business for every £1 spent, and measures how efficiently you manufacture the products that you sell.
- To calculate your C/S%, just divide your Contribution total by your total Sales and multiply by 100.
These are the performance ratios that represent what your business is achieving across the full mix of products and activities.
Creating prices from these ratios
You’re now going to use these ratios to calculate three different prices:
Materials Price – This is what we call the VA price, and it gives you the value of a particular product in a particular sector. Rather than guessing what your customers are prepared to pay, you can use information that you already have to calculate this price using the following formula: M / (1 - (VA/S))
Productivity Price – This is where you use the Value-added:Wages ratio, which is an indication of productivity. So if you use this formula, it gives you the productivity price: W x (VA:W) + M
Contribution Price - The contribution price uses the Contribution / Sales% ratio while taking into account both materials and wages. The formula to calculate the contribution price is: (M +W) / (1 - (C/S))
Consider the following job to produce.
- Materials: £3,000
- Outwork: £525
- Wages (160hrs @ £20/hr): £3,200
Using our example above with the base ratios we calculated earlier, here’s the different prices we have to choose from:
- Materials Price: 3525 / (1-62%) = 9,276
- Productivity price: 3200 x 2.21 + 3525 = 10,597
- Contribution Price: (3525 + 3200) / (1-34%)) = 10,189
Which price to choose?
None of the above calculations are best. They are dependent on your company and what’s right for you. Typically, the productivity price is likely to be higher, and typically the materials price is likely to be lower. You should try calculating all three and decide which is best for your company.
Identifying customers who will pay more
If you really want to make the most out of this approach, you should carry out this analysis for all the different sectors you operate in, and the different types of products you manufacture. You can then plot them on a BCG matrix to analyze which ones are providing you with the most value. To find out how to do this, read my final article in this series.