When your company sells a service, the revenues derived from service sales will directly affect the success of your business. Though pricing strategy and computations can be complex, the basic rules of pricing are straightforward.
- Prices must cover all costs. See SCORE Brief 4.05, Profit and Loss (P&L) Statement.
- The most effective way to retain or improve the profit margin is to reduce fixed and variable costs, and adjust price as necessary
- Prices may need to be increased or decreased to assure that they reflect changes of costs, market demand, and competition.
- Competitive prices must be established to assure sales. Benchmark pricing against your competitors, but price to sell. Pricing of some products may be lower than cost (known as a loss leader) to create demand for products that can be priced at the desired profit margin.
- Product utility, longevity, maintenance, and end use must be judged continually, and target prices adjusted accordingly.
- Prices must be set to preserve order in the marketplace. If you raise your prices because you want a higher profit or a bigger marketing budget, but the competition doesn’t follow suit, your price will not be consistent with the market.
How should you set the price for your service? Procedures vary with the business, but the same three elements must be considered in every situation:
- Labor and material costs
These factors must be considered not only during your start-up phase, but also when you decide to increase the level of service revenue from your business.
Labor and materials
Labor costs include the wages and benefits you pay your employees and/or sub-contractors who perform, supervise, or manage your service business. Labor costs are usually expressed as an hourly wage. For example:
Labor Cost (2 workers total 24 hours) at $12.00/hr. = $ 288.00
Supervision (4 hours at $18.00/hr) = $ 72.00
Materials Cost $75.00
Total Labor and Material cost is: $435.00
Overhead refers to all the indirect expenses required to operate your business. These expenses include management , insurance, legal and accounting fees, telephone, advertising, vehicle maintenance, etc.
Overhead can vary substantially from one business to another depending on the way you operate. To calculate, simply total all of your expenses for one year (estimate for a new business), excluding labor and materials. Divide this number by your total costs of labor and materials to determine your overhead rate. Be careful not to assume that the number of billable labor hours is the same as the number of available hours in a year. In a service business, the number of billable hours in a year for an established business can vary from a low of about 1200 hours (for a consultant) to a higher number of hours for other services. The difference between the available hours per year and the billable hours per year results from the time needed to perform the many management duties such as sales, accounting, training, travel time and other administrative work.
For example, suppose your costs and expenses for a one-year period were as follows:
Overhead Expenses: $ 31,000
Labor & Material Costs: $ 52,000
Overhead Rate: (31,000/ 52,000) = 0.60 = 60%
Apply this overhead rate to a job quote as follows:
Labor and Material Costs: $ 435.00
Overhead ( 60% of 435): $ 261.00
Total Job Operating Costs: $ 696.00
Profit is the amount of income earned after all costs for providing the service have been met. When calculating the price of a service, profit is applied in the same manner as markup on the costs of a product. For instance, if you plan to net 20 percent before taxes on your gross sales, you need to apply a profit factor to your operating expenses to achieve that target.
Operating costs:$ 696.00
Profit (20% of $ 696): $140.00
Price to Quote Customer:$ 836.00
Margin, also referred to as gross profit (GP) margin, is the difference between your total sales and the cost of sales (variable cost); it equals the fixed costs plus profit. It can be expressed as a percentage or a dollar amount. As a percentage, the GP margin is always stated as a percentage of net sales. It represents a percentage of the seller’s price.
(Total sales-Cost of sales) / Net sales = Gross profit margin.
$5,000-$3,000 = $2,000 = 0.40 = 40 percent margin
Markup represents a percentage of the sellers’ variable cost of sales. It is expressed as follows:
(Total sales – Cost of sales) / Cost of sales = Markup.
$5,000 - $3,000 = $2,000 = 0. 66 = 66 percent markup.
Break-even (Refer to SCORE Brief 4.13)
Break-even analysis is a method that indicates when revenues equal total cost. Your break-even point represents the point at which you neither make nor lose money in producing your product. It is expressed as follows:
Breakeven sales = (Fixed cost x Unit selling price)
(Unit selling price- Unit variable cost)
It is highly recommended that you get advice from your SCORE counselor or go to the library or search the internet (Google “Pricing”) to get as much information as possible on pricing. Pricing is not easy and can be very confusing if you are not familiar with pricing concepts and structure.
Just remember, with any business that you start, the key to pricing is to find the price that (1) Customers are willing to pay, (2) is competitive in the marketplace, and (3) will produce the desired profit for your business.
Do not forget a very important rule: “Cash is King”.
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