For many for-profit companies, the starting point for setting a product’s price is to first determine how much it will cost to get the product to their customers. Obviously, whatever price customers pay must exceed the cost of producing a good or delivering a service otherwise the company will lose money.
When analyzing cost, the marketer will consider all costs needed to get the product to market including those associated with production, marketing, distribution and company administration (e.g., office expense). These costs can be divided into two main categories:
- Fixed Costs – Also referred to as overhead costs, these represent costs the marketing organization incurs that are not affected by level of production or sales. For example, for a manufacturer of writing instruments that has just built a new production facility, whether they produce one pen or one million they will still need to pay the monthly mortgage for the building. From the marketing side, fixed costs may also exist in the form of expenditure for fielding a sales force, carrying out an advertising campaign and paying a service to host the company’s website. These costs are fixed because there is a level of commitment to spending that is largely not affected by production or sales levels.
- Variable Costs – These costs are directly associated with the production and sales of products and, consequently, may change as the level of production or sales changes. Typically variable costs are evaluated on a per-unit basis since the cost is directly associated with individual items. Most variable costs involve costs of items that are either components of the product (e.g., parts, packaging) or are directly associated with creating the product (e.g., electricity to run an assembly line). However, there are also marketing variable costs such as coupons, which are likely to cost the company more as sales increase (i.e., customers using the coupon). Variable costs, especially for tangible products, tend to decline as more units are produced. This is due to the producing company’s ability to purchase product components for lower prices since component suppliers often provide discounted pricing for large quantity purchases.
Determining individual unit cost can be a complicated process. While variable costs are often determined on a per-unit basis, applying fixed costs to individual products is less straightforward. For example, if a company manufactures five different products in one manufacturing plant how would it distribute the plant’s fixed costs (e.g., mortgage, production workers’ cost) over the five products? In general, a company will assign fixed cost to individual products if the company can clearly associate the cost with the product, such as assigning the cost of operating production machines based on how much time it takes to produce each item. Alternatively, if it is too difficult to associate to specific products the company may simply divide the total fixed cost by production of each item and assign it on percentage basis.