At first glance, operating an ecommerce business appears to be fairly straightforward—create a website, offer something of value to consumers, make sales, repeat. Although this will certainly be your core objective, you will quickly realize that there’s a lot more happening behind the scenes.
As the world of online commerce continues to steeply increase, you will encounter many opportunities to grow your digital brand. Whether you plan to kickstart an online shop or are currently trying to grow your pre-existing company, it’s important to understand the financial variables that drive growth. One of these vital variables is relevant pricing.
What Exactly Is Relevant Pricing?
To put simply, a relevant cost—which may also be referred to as a differential cost—is a term that's used in relation to the potential future cash cost of a specific decision.
Often categorized as a “future cost” (which will vary from decision to decision), or an “opportunity cost” (the cost of a lost opportunity based on the decision you make), understanding these terms will help you remain competitive.
In contrast, there are also what’s known as irrelevant costs, which are those that will not change based on a particular decision. In this case, there are:
- Sunk costs: These are costs that have already been paid and cannot be recovered. Since this cost has already been paid, it’s considered to be irrelevant. An example of this would be the cost of your current website.
- Committed costs: This is when you make an investment that cannot be recovered. In this case, the future cost is irrelevant because regardless of the decision made, it must be paid.
A Breakdown of Relevant Costs
Analyzing the associated costs in relation to the decisions you make is essentially the lifeline of an effective, productive management process.
For example, say you run an apparel business online. You have begun to gain traction, and a big-box retailer would like to a price quote for 2,000 t-shirts. Before you make your final decision, you need to crunch the numbers to better understand how this order will impact your business. Some of the variables you’ll need to consider are:
- The cost of materials: To produce the quality of shirts you typically offer, you would need to order 2,000 t-shirts, at a cost of $4/unit. However, if you were to order 5,000, your price per unit would drop to $3. This means that you would either pay $8,000 for 2,000 shirts or invest $15,000 for 5,000 shirts (in the hopes that you can push the remaining 3,000). So, 2,000 shirts would either cost you $8,000 or $6,000 for the order. Additional materials—such as ink and silkscreen material—would cost you $2,500.
- The labor required: What will it cost you in direct labor costs to produce 2,000 t-shirts? For this example, say it would be $5,000.
- The cost of equipment depreciation: For example, the estimated depreciation amount of your silkscreen press.
- Hydro used while completing the order: What will it cost you to keep the lights on for x-number of days during the production process? For this example, say it would be $600.
- Overhead costs: From accounting fees to rent, repairs to taxes, this will include all costs outside of direct materials, direct labor, and direct expenses.
Of these cost variables, those that are NOT relevant to your decision would be equipment depreciation (this is a non-cash expense and will not impact the cash flow of your business) and your overhead expenses (these are not incurred as a direct result of the requested order).
In contrast, the relevant costs would be the materials, labor, and the electricity required. After you tally the total of all relevant costs, adding a set profit margin (say 15%), you would then quote that price.
In this case, you would quote: $8,000 + $2,500 + $5,000 + $600 = $16,100 + (16,000 x 15) = $18,515. You then need to decide if this is the best option moving forward.
To do so, you will need to compare each possible alternative based only on the relevant costs. How will each decision impact your financial growth?
Please note: Although this is an ideal approach short-term, long-term financial decisions should be made based on total cost, not just the relevant cost.
Should I Purchase a Pre-existing Ecommerce Company?
If you have not yet started your ecommerce journey, you may be wondering if it would be more cost-effective to build a company or purchase an existing ecommerce business. When comparing these two options, you need to weigh the pros and cons.
For instance, a pre-existing site will have already proven itself profitable, established traffic and suppliers, and have some degree of customer traction. However, this will require a significant upfront payment, which could be a gamble in terms of your potential ROI.
Say you have already begun building an ecommerce company, but are beginning to think that it was not the right approach—in fact, it has turned into a money pit. Instead, you have your eye on a successful ecommerce site that is currently for sale. In this case, the relevant costs are those that can be eliminated by closing your current site, as well as the potential revenue lost.
Although you may lose x-amount per month in relation to your original site, you need to focus on what you will gain by investing in an ecommerce business that is already the complete package.
The Bottom Line
To be successful, you must always calculate opportunity and compare all of your options before making a decision. Let the numbers guide you. By applying relevant costs to each situation, you will be able to make more accurate financial decisions and, in turn, boost profitability.