When setting the price of your product or service, you must do more than simply look at what your competitors are charging. One of the most critical and often underestimated factors is your own internal cost structure. Understanding how expenses and overheads affect pricing is essential to profitability, sustainability, and growth.
What Are Expenses and Overheads?
- Direct costs / cost of goods sold (COGS): These are costs directly tied to producing a specific product or delivering a service for example, raw materials, labor directly working on the product, components, packaging, etc.
- Overheads (indirect costs): These include costs not directly tied to any one unit, such as rent, utilities, depreciation, administrative salaries, insurance, marketing, accounting, and general office expenses.
Together, these form your cost base: everything you must cover before you can generate profit.
Why Pricing Must Incorporate Overheads?
If you price solely on direct costs (or even worse, “what the market seems to bear”), you may leave yourself exposed unable to pay rent, staff, or invest in future improvements. Overheads are real, recurring obligations. Ignoring them is a recipe for under-charging.
To illustrate, imagine you manufacture widgets:
- Direct cost per widget: £5
- You sell 100 widgets at £10 each → revenues £1,000
- Gross margin per widget: £5 → total gross margin £500
- But if your monthly overheads (rent, utilities, admin, marketing) are £600, you end the month £100 in the red.
You must factor in overheads to ensure your pricing covers both direct and indirect costs plus a margin.
Methods to Allocate Overheads into Pricing
Markup on cost method
You take your total cost (direct cost + allocated overhead) and add a markup percentage to get your selling price.
Price=Total cost×(1+markup %)\text{Price} = \text{Total cost} \times (1 + \text{markup \%})Price=Total cost×(1+markup %)
Absorption costing / full costing
Here, you allocate overheads to each product unit (based on a driver: labor hours, machine hours, etc.), so each unit “absorbs” its share of indirect cost. Then you add your desired profit margin.
Activity-based costing (ABC)
Overheads are traced more precisely based on activities (e.g. order processing, shipping, quality checks). Units that cause more of these costs are assigned more overhead. This gives more accurate unit costing, especially when your product lines are varied.
For deeper guidance on structuring these methods to suit startups and small businesses, resources such as www.ukstartupblog.co.uk provide practical frameworks and examples that can help entrepreneurs avoid common mistakes.
Practical Steps for Pricing Based on Overheads
List all overheads, fixed & variable
Don’t omit anything from subscriptions to repair reserves. Distinguish which overheads scale with volume (variable) and which don’t (fixed).
Choose allocation base
Pick a rational driver (units, labor hours, machine hours, revenue share) to spread overheads to product lines.
Compute cost per unit including allocated overhead
Direct cost + allocated overhead = full cost per unit.
Decide your margin / markup target
Based on industry norms, market sensitivity, and growth goals.
Test price against reality
Market may resist high markup. You may need to optimize cost, reduce overheads, or accept a lower margin in early stages.
Balancing Market Realities with Cost-Based Pricing
Even after you’ve derived a “cost-plus” price, you must cross-check it against:
- Competitor pricing: Are there players charging much less? Are their cost structures much lower?
- Customer willingness to pay: Does your product’s perceived value allow the price?
- Positioning strategy: Premium vs budget positioning might override pure cost logic.
If your cost‐based price is much higher than what the market expects, you must either reduce costs or find ways to justify premium value (branding, features, service). Conversely, if your calculated price is lower than what the market offers, you may have room to push margin upward.
Continuous Monitoring and Adjustments
Costs (especially overheads) change: rent increases, utilities fluctuate, wages rise, and you may add new expenses (marketing, tools). Pricing should not be static. Review your cost base periodically monthly or quarterly and revise allocations, cost interfaces, and pricing.
Also, growth or automation might increase fixed overhead but lower per-unit cost. As volume grows, your absorption of overhead per unit may shrink, giving you margin flexibility.
Conclusion
In summary, pricing without properly accounting for overheads is dangerous. You risk eroding all your profit margin and could even operate at a loss. The right approach involves:
- Identifying all direct and indirect costs
- Rationally allocating overheads to cost units
- Adding margins in a way consistent with market dynamics
- Continuously revisiting pricing as costs and volumes change
