The price of an item or service is the sum of material costs, labor costs, overhead costs, and profit allowance.
Price = Materials + Labor + Overhead + Profit
Failure to measure any component of the equation accurately will result in a price that is unfair to either the business or the client.
The carefully kept records described earlier are the key to accurate pricing. Without them, price calculation is impossible. Even with records, pricing requires continual monitoring.
Materials Horticultural materials are both perishable and nonperishable. Nonperishable items range from floral wire to wire fencing. Their costs to the horticulturist can be found by consulting a current catalogue or by calling the distributor. Some nonperishable materials are reworked into new forms by the horticulturist (for example, wire and tape in floral arrangements and bricks and stone in a patio). Other nonperishables, such as bags of fertilizer or bottles of chemical spray, are resold without change. They are merely purchased at a wholesale price and sold at a retail price. Many of the latter types of nonperishables carry a manufacturer’s suggested retail price on the packaging. The retailer is usually not obligated to sell the merchandise at that price, but usually does so for at least two reasons: competitors are using that price, and the suggested price has been carefully researched by the manufacturer to cover the average costs of handling, sales labor, overhead, and profit allowance of retailers nationally.
Perishable merchandise is much more subject to cost variation than nonperishable merchandise. This is due, in part, to seasonal supply and demand. For example, wholesale prices for red roses rise before Valentine’s Day and Christmas; grass seed is most costly in the early spring; and hardy bulbs cost most in the fall. In turn, retail prices vary seasonally, requiring frequent recalculation to maintain fairness and accuracy. The pricing of perishable merchandise must include costs common to nonperishables such as handling, sales labor, overhead, and profit allowance, as well as allowance for losses from the aging and death of plants (known as inventory shrinkage).
Labor Calculating the cost of labor is more complex than determining the cost of materials. Labor costs include the wages or salary being paid to employees plus the cost to the company of all associated costs. These costs are termed labor burden. They include the employee
benefits, such as paid insurance, retirement, and vacations, as well as the support expenditures mandated by state and federal governments, including social security contributions and workmen’s compensation coverage. Depending on the method of cost recovery used by particular companies, labor costs may also include the cost of supervision and/or the cost of operating the equipment used by the labor force.
Overhead The costs of providing a service or bringing a product to the consumer that are not directly related to materials or labor are termed overhead costs. They are costs that must be recovered through the pricing process. Overhead costs are of two types: fixed and variable. Fixed overhead costs are those that are incurred by a company whether there is a customer that day or not. They include such costs as administrative salaries, rent or mortgage payments, telephone and utility costs, equipment depreciation, accountant and attorney fees, subscriptions, memberships, insurance premiums, wire service expenses, postage, repair and maintenance costs, stationery, travel to conventions, and a host of other costs. Each customer must pay a portion of those fixed costs that enable the business to remain in operation. Variable overhead costs, sometimes called project overhead, are assigned to specific projects or customized products because they would not be incurred if that project or product had not happened. They are overhead expenses that must be recovered from the pricing for that specific client, rather than from the general customer base. They include costs such as temporary utilities needed while working at the project, portable toilets, rental of specialized equipment, site permits, or subcontractor expenses.
Fixed overhead expenses are generally consistent unless there is a dramatic change in the volume of business done, salaries paid, or other costs of keeping the doors open. Using the records from the previous year, fixed overhead costs can be determined easily.
Example: If the year’s fixed operational overhead costs for Andrew’s Landscaping total $132,000, a cost of $11,000 can be assigned to a single month of operation ($132,000 ^ 12 months = $11,000).
Other uses of financial records The past year’s records will also provide valuable data about the cost of materials. Material costs are variable (not fixed) and change in direct proportion to the amount of sales, market conditions, and wholesale prices. The closest estimate of material costs for the current year should be projected and a cost of materials percentage determined. This is expressed as a percentage of total sales. For example, if Andrew’s Landscaping had $40,000 in sales for the month, and the cost of materials needed to do that business was $10,000, the cost of materials percentage would be 25 percent.
Cost of materials for the period
Cost of materials percentage =————————————–
Total sales for the period
Cost of materials percentage = ——— = 25%
In small retail operations, the staff may all be salaried and their labor costs included in overhead. In larger operations, particularly nurseries, landscape firms, arborists, and lawn service firms, much of the labor is
provided by temporary seasonal workers who are paid an hourly wage and may receive additional benefits. From properly kept work records and time cards, the cost of labor (including wages and benefits) during a time period can be determined. Like the cost of materials, labor costs are variable and must be estimated as closely and realistically as possible using current data and the past year’s records for guidance. From that cost data, adjusted to reflect current conditions, a cost of labor percentage can be calculated, also as a percentage of total sales. Using the same example, if Andrew’s Landscaping did $40,000 in sales for the month, and the cost of labor was $7,200 (wages plus benefits), the cost of labor percentage would be 18 percent.
Cost of labor for the period
Cost of labor percentage =———————————–
Total sales for the period
Cost of labor percentage =———- = 18%
Breaking even The break-even point in the operation of a business occurs when total revenue equals total cost, and there is neither a profit nor a loss. In the example month of Andrew’s Landscaping, the firm’s total cost (materials, labor, and overhead) is $28,200 ($10,000 + 7,200 + 11,000). The company needs to sell that much in merchandise and/or services in order to break even.
Profit Only after all costs for materials, labor, and overhead are recovered can the profit be added to complete the price. It is the profit that enables the business to grow, so every item or service sold by a company should include some profit. Otherwise the business is regressing. It is the responsibility of the company to determine a profit that will make their prices competitive within their market while being fair to their customers and, at the same time, returning enough revenue to the company to enable it to meet its needs for growth and debt reduction.
Making a profit As the volume of business increases or decreases, the fixed overhead costs generally remain the same. If the volume of business increases above the break-even point and fixed costs do not, then a profit begins to be shown. If volume declines or fixed costs rise, a loss will be registered (Figure 25-2). As the chart illustrates, profits increase rapidly as the sales volume increases, assuming no rise in fixed costs. The only costs to Andrew’s firm are materials and labor which total 43 percent of sales (the cost of materials percentage and the cost of labor percentage, or 25 percent plus 18percent). Thus for every dollar grossed in sales beyond $28,200 (the break-even point), there will be a 57Ф profit.
Break-even point analysis illustrates a basic principle of business: Profits result from (1) increasing sales volume without increasing overhead costs and (2) raising prices of the product or service sold. There are two points of diminishing returns that must be avoided. These are the points where (1) new investments must be made in personnel or facilities to handle the increased volume of business or (2) the price increases cause sales to decline.
figure 25-2. Relationship between business volume, fixed costs, and profit (Delmar/Cengage Learning)
Unit Pricing Until the break-even point is reached, each unit of material or service sold must regain not only all of the material and labor costs needed to provide it, but also a portion of the fixed overhead costs. The 57Ф profit on every dollar of gross sales only begins after the breakeven point is reached and the overhead costs are recovered. In theory, the assignment of a portion of the overhead costs to each unit sold is simple. The overhead costs for a period (month, quarter, or year) can simply be divided by the total number of units produced in that period. The difficulty lies in deciding what constitutes a unit and in the many different units dealt with by most horticulturists. A sales unit might be a retail item such as a bag of fertilizer, a bottle of chemical spray, a dozen roses, a container, or a birdbath. It might also be a measure of time such as an hour of labor. It might be a measure of area or volume such as a square foot or a cubic yard. The selection of appropriate pricing units is determined by the type of business and by its methods of recordkeeping and accounting. There is no single correct way to set up the accounting program, and the accountant employed will usually have valuable suggestions about unit pricing for the firm.
In the example of Andrew’s Landscaping, the $11,000 monthly overhead might be assigned to hours of labor worked during the month, from which the $40,000 in gross sales resulted. If the company’s labor force worked a total of 1280 hours that month, each hour of labor charged to the customer could include a cost of $8.59 to cover fixed overhead expenses. For example:
Total overhead for the period
Per unit overhead expense =———————————————
Total number of measurement units
————- = $8.59 per hour
If, however, Andrew’s Landscaping also retailed bedding plants in six-plant market packs, there would be an additional unit of measurement: a market pack. Had the $40,000 gross sales for the month been
attained by $35,000 in landscape services requiring 1,000 hours of labor and $5,000 in sales of 2,000 market packs, the assignment of overhead costs would be divided among the two units in proportion to the volume of sales generated. The landscaping accounted for 88 percent of the sales ($35,000 ^ $40,000) and must accept 88 percent of the overhead costs for the month.
$11,000 X.88 = $9680 overhead costs
The market pack sales accounted for 12 percent of the sales ($5,000 ^ $40,000) and must accept 12 percent of the overhead costs for the month.
$11,000 X.12 = $1320 overhead costs
The per unit overhead costs for each area of operation can be then calculated as before.
Per hour landscaping overhead expense =———–
Per market pack overhead expense =————- = $0.66 per market pack
As the number of types of merchandise and services increases, the calculation of costs becomes more complex. Some firms consolidate a variety of different items under a few categories for the sake of recordkeeping convenience. For example, a flower shop may classify its design work as wedding work, funeral work, holiday work, and other. Landscape firms may classify their sales as plant sales, installation projects, and maintenance projects. A nursery may use categories such as plant sales and nonplant sales or plant sales—retail, plant sales— wholesale, and so on. Grouping merchandise and services into categories for calculation of overhead costs or determination of markup can reduce the precision of pricing, but is commonly done for expediency. Each unit or category of units must have records to show what percentage of total gross sales it accounted for and how many items, hours, or other units were sold in the process.
Categorizing the profit centers of the business permits the company to assign the responsibility for overhead cost recovery to the areas where its greatest revenues are generated. Accountants refer to this as multiple overhead recovery, meaning that different overhead percentages may be applied within the pricing system of a single company based on what is being sold. A garden center is selling mostly materials, not labor. It must recover most of its overhead costs by adding them to the price charged for every plant, container, bag of fertilizer, lawn ornament, and similar item of merchandise that is purchased. Labor is a small part of the cost of its operations. A lawn service firm is totally different. It is selling labor more than materials. It must recover most of its overhead costs by adding them to the price it charges for each hour of labor expended in mowing, pruning, edging or otherwise servicing a client’s property. A landscape contracting firm may be both labor intensive and handle large quantities of materials. In such a case, both labor and materials will need to recover overhead costs for the company, not necessarily
in equal percentages. Multiple overhead recovery allows a company to reclaim overhead costs from the sectors of the business that generated them in the first place.