Costing and Pricing - Basics
This section acts as introduction to some of the more important concepts associated with costing and pricing and attempts to set some parameters around the various technical elements we need to understand before we can move forward. If we don’t understand the building blocks it’s unlikely anything we produce will be stable.
Costing v Pricing
Our primary aim then is to understand our costs, and apply that knowledge when making decisions on pricing our services. Understanding your real-world costs is without doubt the most important element in the costing-pricing-funding equation. Understanding your costs for each deliverable service sets you up to make decisions on pricing (as well as allocating eventual funding). The two centre-pieces (costing and pricing) are not inexplicably linked however; certainly you can choose to price a service with only a partial reference to it costs. However, if you choose to price a service without any knowledge of its costs, well it’s likely you have a funding application due yesterday and it’s Friday at 9pm.
So, the real challenge for any organisation - for each program or service - is this: how can I possibly be sure my costing is accurate enough to use as a price guide?
The Cost-Price family
Part of the challenge us accountants face in our struggle with normal people is the terminology we use, so here’s an attempt to clarify a few definitions that we’ll be using in the rest of the document. These are not technical terms as such, and the list is certainly not exhaustive, they’re more designed to define the pieces of the puzzle.
Transaction: A distinct and unique transfer of funds between people or organisations in exchange for a good or service (e.g. purchase of office stationary, wages paid, receipt of grant etc). The basis of all our financial information is simply a big collection of lots of individual transactions we already know and love.
Account: The ‘tag’ used by an accounting system to categorise and group transactions by type - generally a combination of a number and name (e.g. 6-1000 Wages, 4-2000 Donations).
Accounts can be combined into Standard Account Groups, (i.e. summaries of Accounts) to assist consistency in applications, acquittals etc, across varying funders
Activity: The program or service the transaction is being undertaken to support (e.g. Program A, Campaign B, Service C). Activity-costing is the centrepiece of the methodology that follows.
Activities can also be grouped to assist reporting, however they are less likely to be standardised across the sector
Costing Model: A prediction of expenditure by Account for a particular Activity for a specified period, including associated logic and notes
Pricing Method: A pricing methodology used to predict or apply income to an Activity and its associated Costing Model, and provide a unit-price if required.
Budget: A summary of predicted income and expenditure by Account for a particular Activity or organisation, for a specified period.
Actuals: Historical summary of actual income and expenditure by Account for a particular Activity or organisation, for a specified period
Unfortunately it’s easy to get a bit technical, even when throwing together a few definitions just to help us communicate clearly. So rather than spend more time on the jargon, let’s move to how each part of the family could theoretically hang out together – the real-world stuff. Keep an eye on the above terms in italics as you read the following summary:
- We build a Costing Model for each Activity we feel is important or material enough to warrant one (more on Activity selection shortly)
- The Costing Model for each Activity is built by Account (or Standard Account Group depending on the level of complexity you wish to apply to the Costing Model).
- It is likely your Costing Model time period will be separated into months, then summarised by year(s). Again, this depends on the level of complexity you wish to apply. It is of course possible to build a Costing Model over any time period - week, fortnight, month or year.
- Associated with the Costing Model we may wish (or need) to add a Pricing Method, based on the same Activity and time period.
- We can then summarise both the Costing Model and Pricing Method into a Budget, either for an Activity or a whole organisation (simply the addition of all the organisation’s Activity budgets) for the specified time period.
- Depending on your funding contract documents, you may choose (or be required to) include all your modelling logic, just a price and/or a full budget.
The only orphan in the family above at this point is the Actuals. They’re included here because in the real-world they are often the only thing we have to give us a starting point to build our Costing Model. They tell us our current Account and Activity structures (if we currently use them), but more importantly they give us a nice summary of all our historical transactions, which in a lot of cases is a good indicator of the future.
Why all these fancy Models?
There is a huge risk in all this that we over-complicate the process and by doing so lose the very thing we’re trying to achieve: easy-to-understand, accurate financial information efficiently produced. It’s absolutely crucial as part of your own assessment of your responsibilities to funder(s) and other stakeholders that you apply a sensible level of complexity in predicting your costs, pricing your services and building budgets.
You should try and move through the detail until you’re comfortable with a level of complexity that is appropriate for your organisation and its resources. Here are a few tips:
- A solid, uncomplicated Budget, with sound logic that is used by all relevant people will beat a complex Costing/Pricing Model that no one can understand any day. However, in some instances, reasonable detail is the only way we can build good solid overall Budgets. If your organisation is of a size that you feel you can produce a solid Budget without having complex models, go with it. However, it’s unlikely that a solid overall Budget can be produced without a good understanding of your Activity structure (i.e. your individual programs and services) and without each Activity having its own Budget driven by reasonable logic.
- Don’t play with software you don’t understand, especially spreadsheets. Software should be seen as a tool, not unlike a calculator or the back-of-an-envelope. It’s frustrating to see people merrily throwing numbers at spreadsheets and waiting for an answer at bottom-right, without any idea of the formula structure and whether the logic is right. If you can’t replicate the logic in your head or on paper, the spreadsheet will only hinder, not help. Try it – get out your calculator and see if you can replicate the answer in a particular spreadsheet formula – if you can’t, stop the world until you can do so, or dump the spreadsheet. Robots don’t make good funding applications.
- Keep an eye on materiality. If your funding is 10% of your overall income – is it really necessary to build a complex Pricing Model just because you can? Similarly, if your funding is 90% of your overall income its obviously pretty important you’re comfortable with your numbers and the corresponding logic. Just applying some common sense is a good start.
Keep in mind that Models – as we’re using the term here – are a pre-cursor to budgets, they are the building blocks of a budget; they do not replace budgets. A Costing Model is a structured explanation of predicted costs. To more clearly interpret the way we’re using the terms above: Costing Models predict expenditure, Pricing Methods predict and apply income. Budgets are a summary of both expenditure and income, including a net financial result, over a specified period.
Can you have a Costing Model without a Budget – yes of course. Individual models often exist to assist an application for funding and might then be dumped if the funding doesn’t eventuate, never finding their way into a budget. Can you have budgets without Models – of course, just head straight to budgeting by each Activity, but you might just find that if you use Models you build yourself, they will serve you well in applying stronger logic to your budgets. This is because Budgets quickly become rows and columns of numbers, and as such they often don’t provide the logic commentary and source information you may need to refer to when fine-tuning your estimates as time goes by.
The primary message here is that you can build your own Models; they do not have to be an alien-looking spreadsheet emailed by Mr Smartypants up the corridor – although that will work too if you understand it. Your own notes, estimates, calculations etc that you compile yourself all form part of your Models. As we’ll find out later – it’s all about the logic behind the numbers – not the numbers themselves. Models should are less about spreadsheets and more about understanding and collating the assumptions that underpin our numbers.
Best have a nice lie down now, but before you do, there are a couple of other important points to make. As a professional (and clever) manager you already have a responsibility to have sound financial management in place, including solid budgeting processes. You shouldn’t see the above as doubling the workload – in fact if we all survive this, the structures and processes that evolve out of this new world can only help us to move our organisations forward.