I coach several business owners who initially come to me with personnel challenges within their company. They claim their employees aren’t loyal; they lack leadership ability or they just don’t take their job seriously. If they don’t have employee problems, they often have problems making money. They don’t pay themselves and still they struggle making enough money to pay off their ever-increasing credit card balances. In almost all cases, our conversation ends up at pricing. What I’ve found is that most small businesses under-price their services which then leads to problems with finding and keeping the right employees; and paying themselves. My blog post today will talk about how you quickly find out what you should be charging your customers.
In order to understand pricing, you should first need to understand a few accounting terms: 1) Revenue; 2) Direct Cost; 3) Gross Margin; 4) Expenses; and 5) Net Profit.
Revenue is the total amount of money you will earn from your customers in a single year before you subtract any other expenses or costs.
Direct Costs are also called Variable Costs and are the costs you pay that directly go up or down as your revenue goes up or down. Such things as technician labor, cost of goods, etc.
Gross Margin is the Revenue minus the Direct Costs.
Expenses are the costs you pay that cannot be directly associated with your revenue. Such things as rent, management labor, sales expenses, marketing expenses, and utilities.
Net profit is the Gross Margin minus Expenses. This is the amount of money you get to keep or reinvest as the business owner.
In order to better define these terms, let’s go through an example. Let’s say that a caramel-making business sells 400,000 caramels at $0.40 per caramel in a single year. They buy 10,000 lbs of caramel at $5.00 per lb in a single year. The small caramels are made by equipment leased at $20,000 per year. You pay a single person who is responsible for distributing the caramels to customers a salary of $45,000 per year and an additional $20,000 per year for rent of space.
In this scenario, your total revenue is $160,000 (400,000 X $0.40). The direct costs for your caramel making business is $70,000 (10,000 X $5.00 + $20,000). This means the gross margin is $90,000 ($160,000 – $70,000). The expenses of the caramel business is $65,000 ($45,000 + $20,000). The net profit for this business is $25,000 ($90,000 – $65,000).
Most new business owners don’t know how much profit is reasonable and so I’ll give you some guidelines. Most successful businesses will have a gross margin between 35% to 80%. The more administrative support, sales and marketing you need for your business, the higher the gross margin. The percentage of gross margin is the total Gross Margin divided by the total Revenue. In the example of our caramel business, the gross margin percentage is 56.2% ($90,000/$160,000). The net profit margin should be between 5% and 25%. Higher profit percentages are necessary to pay down large amounts of debt; while the lower percentages will work for high volume businesses with repeat customers.
How do You Set Your Price?
Price is primarily based on the capacity of your business. Most businesses will run into some constraints; and these constraints will usually dictate capacity. In our caramel making business, the capacity is the limit of the amount of caramels that can be made by the caramel-making equipment and the size of the facility. In our example, I arbitrarily set this constraint at 400,000 caramels. Let’s say that each caramel-making machine can make 600,000 caramels, and the space will hold two caramel-making machines. Once the factory is producing 100% of its capacity of 1,200,000 caramels, two additional distributors, plus a general manager will be hired at an additional cost of $170,000. The maximum revenue will be $480,000 (1,200,000 X $0.40) with direct costs of $190,000 (30,000 X $5.00 + 2 X $20,000) yielding a gross margin of $290,000 ($480,000 – $190,000) (60.4%). Expenses will climb to $235,000 ($170,000 + $65,000), yielding a net profit of $55,000 (11.5%).
What can and does happen to most businesses, is that they rarely run at 100% of their capacity. The business owner will hire all of the people and pay them to deliver the maximum capacity, but will sell only 80% of maximum capacity. In the caramel-making business, at 80% of capacity, revenue will drop to $384,000 (80% X 1,200,000 X $0.40); direct costs will drop to $160,000 (24,000 X $5.00 + 2 X $20,000) yielding a gross margin of $224,000 ($384,000 – $160,000) (58.3%). Expenses will remain at $235,000, giving you a net loss of $11,000 ($224,000 – $235,000).
In order to make a reasonable profit at 80% of capacity, one of two things needs to happen: 1) the price of the caramels must increase to $0.47; or 2) the expenses must be reduced by $61,000. Most business owners do neither and simply live with the financial loss, hoping they will get more business.
Customers will Stop Buying if Price is Increased!
When I go through the exercise I just illustrated with the caramel-making business with my business owner clients, they tell me they will lose customers, if they increase price. They back up their statement with clients who say, “I buy from you because I cannot afford the prices your competitors charge.” They sometimes tell me their competition is charging less than they are… so how can they increase their prices further?
Consumers are price-sensitive, as they should be. However, many business owners are surprised to learn that many consumers will not buy from you, if your price is too low.
The chart above shows how demand increases and decreases as the price increases. Most consumers are hesitant to buy something for a price that is too low, thinking they will get inferior product quality. This is especially important when purchasing the services of an expert; an engineer, a lawyer, or someone that can dramatically impact a large decision. For instance… if you need to hire an architect to design your $10,000,000 building, would you hire an architect for $500,000 or $600,000? When you believe the $600,000 architect may save you $1,000,000 in cost overruns, the decision may seem obvious.
Unfortunately, most business owners don’t know where their price is on this chart. If you are on the down-slope of the curve, raising prices will result in fewer customers. If you are on the up-slope of the curve, raising prices will increase customers. The optimum point of pricing is when you raise prices a little bit, and you lose only a few customers. At this point, you know that you are on the down-slope; and any further increases may negatively impact your business.
When it comes to pricing, I’ve heard all the excuses:
I’ll lose customers!
I don’t want to charge poor people too much!
I’m not in this for the money!
My competition will beat me!
Once you go through the pricing exercise I outlined above, you have to know that price is NOT an emotional decision…. it is mathematical. If your competitor is charging less, they have either found a way to be more efficient; or they will soon go out of business. Part of creating the Successful Business Mindset as a business owner, is always trying to find ways to keep costs reasonable; and increase the value you offer to customers. If you are doing this, you should target charging some of the highest prices in your industry… because you’d be worth it.
As a business coach, I help my business owner clients change their mindset in a way that allows them the freedom and profitability they have always hoped for. If you’d like to develop a Successful Business Mindset, I urge you to complete the free Business Wheel exercise below to see how you can grow yourself as a successful business owner.
As a long-time small business owner, I know how hard it is to create the business of your dreams while struggling with the financial realities of attracting prospects, converting those prospects into high-paying customers, and making money for you and your family. The biggest mistake in my past was not seeking the advice of wise counsel sooner than I did. I don’t want you to make the same mistake. I help my clients see exactly what they need to work on in their business by doing the Business Wheel exercise. If you’d like to try it out, sign up to the right. It’s completely FREE.