Overhead costs are not a factor of revenue, they are a factor of complexity. Too much complexity overhead increases your costs and reduces your profits. An alternate approach to determining product pricing starts with understanding your material margin.
By understanding the material margin, you can reduce pricing for high volume jobs in order to be more competitive in the marketplace. High volume jobs typically have less complexity, so applying overhead using traditional methods could overstate cost and price you out of the market. Conversely, you may be able to take on smaller more complex jobs if you have excess capacity (idle equipment, no additional labor, or expense outlay) as long as the material margin is high enough to cover fixed costs.
Material margin dollars are revenue less material costs. Dividing material margin dollars by revenue equals material margin %. Be careful not to include direct labor, overhead, or costs other than direct materials.
If you suffer from low material margins, there are only two options to make significant improvements to your bottom line: raise prices or lower material costs. One or both may not be viable which prevents competitive pricing.
The material margin analysis allows companies to approach to pricing from a different perspective which eliminates complexity that directly impacts bottom line profits.
Megan Johnson is a Partner and Client Manager at Redpath and Company, providing extensive business advisory expertise with a focus on strategic planning, tax planning, and management consulting. She specializes in financial and tax matters, business succession, and mergers and acquisitions with an industry focus on manufacturing and distribution. She has provided public accounting services since 1996. Megan can be reached at 651-407-5835 or firstname.lastname@example.org.More posts by Megan Johnson