|Financial Management of a Small Handicraft Business (Oxfam, 1988, 43 p.)|
If costing is a fairly precise science, pricing is much less so. This is because the price obtainable for a product is that which the market is prepared to pay. It is of absolutely no use to complain to a customer that a product costs a certain amount to produce, if the customer perceives its value as less than that, and is not prepared to pay more.
This is not to devalue the costing exercise, which is a fundamental requirement for a production unit, and its relationship to pricing will be looked at. Nevertheless, it is necessary to separate the concept of cost from that of value. Price will ultimately be governed by the value of the product, not its cost. Where cost exceeds value, profitable selling cannot take place.
(i) Market knowledge
Value is related to cost, in so far as different production units in the same locality producing the same item will have similar costs, and sell the product at similar prices. Hence the market accepts that a particular product will be sold within a certain price range. Where selling overseas, the producer might well experience competition from handicrafts which are being produced in other countries at lower cost; this is a fundamental problem with exporting.
Value is also related very closely to utility, and in this respect handicrafts find themselves in competition with non-handicraft items. The introduction of machines, and synthetic fibres, have brought down production costs world wide, although the process has been balanced by much higher wages rates in industrialized economies. Thus handicrafts are caught in a dilemma: their own production costs are rising all the time, yet machine-made products serving a similar purpose are decreasing their value.
This trend is not reversible, so that in the long term market forces will reduce the scale of the handicrafts industry to well below what it is now. The immediate concern, though, is to maximize earning opportunities in the industry as it is at present. The point to consider is not the negative one about long-term trends, but the relevance of market forces in price determination. This is why it is useful to pause to consider the factors other than cost which determine price.
In order to analyze these effectively, it is absolutely necessary to refer to the market in which the product is being offered for sale. Two things need to be known:
· what level of acceptability will the products have in that market? Do people there want this type of item?
· which other products in competition with them are available in that market?
From answers to these can begin an understanding of the value of the products in the target market, and hence the price they will attract. It is quite normal that the same product will have a different value in different markets. For example, a heavily decorated woven basket produced only in one rural locality might fetch a low price in the local market because it is perceived only as a utility item, and many other similarly useful baskets are available. In the capital city, or overseas, it might be appreciated as an unusual and beautiful product, and accorded a high value for its decorative aspect. By contrast, many products may not be saleable outside of the production locality because other areas have access to similar products, or products performing the same function, at a lower price.
(ii) Increasing the value
Utility to the consumer, and competition from other products, are not the only factors influencing the market's perception of value. It is encouraging to note that while competition pushes prices down, other factors can push them up. Essentially, these can well be summed up under the heading presentation, and include labelling,packaging, display and promotion.
Production units should always look for opportunities to increase the value of their products. Often a small additional costan attractively printed label, eyecatching packagingcan increase value by a greater amount than the cost. Overseas markets are particularly responsive to packaging. There are examples of products sold in Europe and Americasuch as cosmeticswhere the packaging increases the value by many more times than its cost. Handicrafts producers can take advantage of this fact. For example, packaging spices or soap in small baskets, themselves costing very little, might immediately give the product acceptability in the gift market, as opposed to the self-purchase utility market, and thereby increase its value significantly.
Attractive display of productsin a bazaar, a shop, or a sales cataloguecan increase a product's value. Generally, the more sophisticated the market into which a business is selling, the more scope there might be for increasing value through presentation. Metropolitan consumers will have less knowledge than local ones about production costs, and more interest in how a product looks in its place of sale.
(iii) The artisan's income
One of the major difficulties faced by artisans the world over is lack of access to a market. The reality of their life is not how to turn market characteristics to their advantage, but how to survive on a hand to mouth basis. Lacking capital and knowledge about how to sell their products, they are often exploited by the local trader because of their desperate need for cash.
Organization of social production units can make a significant impact on an individual artisan's life. Aside from the important social benefits obtainable through participation in an income-generation activity, the artisan might derive vital financial advantages:
· access to credit at fair rates, or supplies of raw material of which the cost is offset against the remuneration for production, offer an alternative to a bank loan or to the money lender, at high rates of interest
· the possibility of regular work can remove the need to take a day off each week to sell what has been produced in the local market
· instead of depending on the local trader, the artisan can move one step forward in the distribution chain, selling through the unit to perhaps the same customer as the trader. The profit margin saved by removing a link from the distribution chain should to some extent be translated into higher prices for the artisan.
The unit cannot obtain higher prices than the value accorded to the products by the market in which it sells. For the artisans, though, this would represent a new market opportunity, through which the products would gain for them an increased value.
Consideration of market forces in price determination implies, first, that the business has access to such information, and, second, that there is a potential to raise prices to levels higher than the cost analysis would suggest. Both implications are often unrealistic for small handicrafts production units, who are therefore thrown back to costing as the basis of pricing.
From Figure 5, the total cost of the fibre mat was calculated to be 42.40, with small reductions on large volume production. To this, the production unit would add a modest profit margin to allow for accumulation of working capital and to cover contingencies. If we assume that to be 10%, the selling price of fibre mats would be:
· Per piece, 46.64 money units (probably rounded to
· Per 100 pcs, 45.32 money units (probably rounded to 45.25)
· Per 1000 pcs, 44.11 money units (probably rounded to 44.00)
This approach to pricing is called full cost pricing, or cost plus pricing, and it is the most commonly used method in the handicrafts industry, albeit often based on an inexact analysis of costs. It has two limitations. One is the lack of reference to market forces, as outlined. The other is the lack of distinction between fixed and variable costs.
The problem can be expressed in this way. Suppose a buyer came along and offered to buy 1000 mats, but insisted on a 10% discount on the price of 44.00. A quick calculation could suggest that the business should turn down the order. Total production cost is 40.10, and a 10% discount would mean a selling price of 40.0(). It would seem that a loss would be made by executing the order.
Or would it? The answer depends on whether there is spare production capacity. If there is, the business should accept the order, because in fact it is going to make not a profit, but a contribution to overheads. Where production capacity is available, a business should accept any order from which the revenue exceeds the variable costs of production, because it is thereby gaining income which will go towards meeting its fixed overheads (Figure 6).
Figure 6. Contribution Analysis of Sale of 1000 Fibre Mats
Unit selling price of mat
Direct and variable indirect costs of one mat
(as per Figure 5)
Total contribution to overheads on sale of 1 000 mats
Of course, it cannot operate in this way all the year round; its fixed overheads must be covered eventually. But in a lean period, keeping the distinction between variable and fixed costs in mind can assist in decision making about whether to offer discounts, reduce prices, or give a commission to a sales representative. contibutionwhich is revenue less variable costsshould be distinguished from profitwhich is revenue less variable and fixed costs. A business breaks even where the contribution equals the fixed costs.
Contribution analysis can be represented diagramatically, to reveal the break even level of production of either a single product or the whole production unit. It shows the costs and revenues at different levels of production.
Break Even Production Level
It is admittedly of limited usefulness in the handicrafts industry, because fixed costs are usually small. But it serves to emphasise that flexibility is an important element in pricing. An over-rigid application of a cost plus pricing policy might lead to under-achievement of sales. through disregarding opportunities for occasional special offers or discounts which will maximize employment potential without detriment to financial performance. If a particular product is a hot seller and yields sufficient return to cover all the fixed costs. then the other products in the range could be priced on the basis of covering the variable costs of producing them. Or. if a price is reduced to just above variable production costs, and a large increase in sales results, the overall contribution to overheads might be greater, as well of course as the employment benefit.
A standard mark-up is not necessarily the most helpful approach to pricing. It is usually worthwhile to experiment with price changes to test the relationship between price and demand.
Accurate costing is not just a basis for pricing individual products, but it can also provide the information necessary for deciding on the most advantageous type of product range development.