Pricing for Profit
About the Author:
Paul Wilton (editor)
CA with degrees in commerce, accounting and information technology. Paul worked overseas in the “Big 4” accounting firms and served as a director at Audit New Zealand before setting up his own consultancy. Author of A-Z of New Zealand Business Law, Paul has over 20 years of experience as a business owner and consultant. He joined FBA in 2004 and is totally committed to providing excellence in quality and value to our subscribers.
Simply by adjusting the price of your service or products, you could end up with substantially more profits. Wouldn’t that be worth exploring?
The importance of price setting cannot be overstated. Get this wrong and your profits will invariably be lower than they should be. It could even lead to business failure. There are many ways to set the price for your product or service. If you choose one you are almost certain to get it wrong. Consider the following and aim for a best fit:
Price based on Cost: This is the minimum price that must be charged to cover costs and return an acceptable profit that justifies carrying the line.
Price based on Competition: This is the price range that the market will use as a benchmark to evaluate your prices against those of your competitors. Your pricing strategy will be very different depending upon the uniqueness of your product or service and the influence of your competition.
Price based on Market Positioning: Adjust your price depending on whether you are positioned at the top end of the market (Rolls Royce), the middle or bottom. This strategy could fall flat if you ignore the next point.
Price based on Value: Smart customers look beyond pricing when considering a purchase. They look to value that includes delivery times, guarantees, customer support and quality to name a few. Value can be related to a number of factors including the “snob appeal” of a fashion brand irrespective of quality. This emphasises how important it is to know your customers and what drives them.
Do your homework. Ensure that you understand your costs, competition and customers. The best price will take all of the above into account. Even if the price is right, there is no guarantee of success. However, if the price fails any of the above tests, it is fairly certain that you will not achieve the best results.
Although the principles are the same, pricing a business service is often more complex than product pricing because the associated costs may be harder to estimate and in some cases the competition may be more difficult to assess. We will use this in our discussion.
Service Costs and Pricing
Each service has different costs. Many small service businesses fail to analyse the costs involved in each service and therefore fail to price their services profitably. They may make a profit on certain services and lose money on others, not knowing which is which. By analysing the costs associated with each service, you can set prices to maximise profits and eliminate unprofitable services.
The most restrictive factor for many service based businesses is that they are limited to charging out on an hourly basis. Overcoming this problem can assist in boosting profits. Consider other ways to charge out your time such as packaged service costs (car service oil change at a fixed price) or percentage service costs (commission for sale of a house).
In contrast retail mark-up depends on the nature of the business. For instance, large turnover supermarket businesses work on low margins whereas niche market products often retail at twice their wholesale price and more.
Components of Costs for Services
As with products, the cost of producing any service is composed of three parts:
materials
labour
overheads
Materials cost
Materials cost is the cost of parts used directly in the final product, such as sparkplugs and gaskets in the repair of an engine. Consumables such as cleaning products are part of overhead, not materials costs. A materials cost list must always be used in quoting a job – and don’t forget to add shipping, handling or storage costs for materials, as these must be included in the total materials costs. Never on-sell materials at trade price. You will need a mark-up to cover your cost of ordering, credit, handling (offloading), storage, etc.
Many businesses on-sell materials installed at just below the full retail price.
Labour cost
Labour cost is the cost of work directly applied to a service, such as a mechanic's work. Work not directly applied to the service, such as cleaning up, is an overhead cost. Direct labour costs are derived by multiplying the cost of labour per hour by the number of hours required to complete the job. In calculating hourly costs don’t forget to include associated costs such as overtime rates, Holiday Pay, time for training, ACC and any other benefits such as insurance and retirement benefits.
Example:
Joe's Garage
Labour cost per hour (40 hour week)
44 working weeks used, i.e. 52 – 4 (hols) – 2 (stat) – 2 (sick) = 44 working weeks in a year
Hourly wages $18.00/hr per Employment Agreement
Revised rate for determination of costs:
Hourly wages 37,440.00
Allowances (per agreement) 1,100.00 (safety gear, clothing, etc)
Overtime 2,970.00 (44 x 3 x 18.00 x 1.25)
(Overtime estimated at 3 hours per week ave +25% over 44 working weeks)
Total Annual Pay 41,510.00 = $21.94/hr (44 wks x 43hrs/wk)
(assumes overtime can be charge to customer)
ACC Levy say 2.5% 1,037.75
Lost time allowance 1 week 798.27 (collecting items, deliveries)
KiwiSaver contr employer 4% 1,660.40
Gross paid per Year 45,006.42
Giving a net hourly rate of: $23.79
Overhead Cost
Overhead cost includes all costs other than direct materials and direct labour. Overhead is the indirect cost of the service. Usually there are people on a company's payroll who perform support services who are not charged to direct labour but must be included as a cost. Some examples of these services are clerical, payroll, legal, cleaners and supply. Insurance, rent, depreciation, accounting, advertising, office supplies, utilities and transportation are also part of the total overhead cost.
A reasonable amount of the overhead cost must be allocated to each service performed. The overhead rate can be expressed as a percentage or as an hourly rate. This will change depending on your turnover and needs to be reappraised on an ongoing basis.
In businesses using a range of skills with different rates of pay, overhead cost is more closely related to labour cost than to labour hours. In this situation, the overhead cost is allocated on the basis of direct labour cost and expressed as a percentage as follows:
Overhead rate = Total Overhead Cost / Total Direct Labour Cost
In businesses such as machine shops and vehicle repair shops where there is relatively little difference between the hourly wages for employees, or little relationship between worker skill and equipment used, the following hourly rate formula is used:
Overhead rate = Total Overhead Cost / Total Direct Labour Hours
The following examples show the two types of overhead rate calculation:
Joe's Garage
Calculation of overhead rate
Overhead rate (cost percentage) = Total Overhead Costs / Total Direct Labour Costs
= $70,000.00 / $135,000.00 = 0.52 or 52%
OR Overhead rate (hourly rate) = Total Overhead Costs / Total Direct Labour Hours
= $70,000.00 / 5,676 hours (44 x 43 x 3 staff) = $12.33 per direct labour hour
In calculating overhead costs it is important not to depend on historical costs! Charges must be updated to reflect current costs, including inflation and known price increases. It is best to project the costs for the current six-month period and include increased executive salaries as well as any other projected costs. This should be reviewed every 6 months at least.
Example of a Costing a single job
Joe’s Garage fixed Mr Field’s car. The job used $18 material and took 3 hours.
Material cost = material used + 15% handling
= $18.00 x 1.15
= $20.70
Labour cost = Direct Labour Cost Per Hour x Hours Required
= $23.79 per hour x 3 hours
= $71.37
Two types of overhead rate have been discussed. We will use both to calculate overhead cost for the example:
Overhead cost = Direct Labour Cost x Overhead Rate
= $71.37 x 52%
= $37.11
OR Overhead cost = Direct labour hours x overhead rate
= 3 hours x $12.33 per hour
= $36.99
Because Joe's Garage usually uses the percent of cost overhead rate, we will use the $37.11 figure instead of $36.99 as the overhead cost. The total cost of the repair is now detailed below.
Material cost = $20.70
Direct labour = $71.37
Overhead cost = $37.11
Total Cost = $129.18
Figuring Profit
Profit can be figured several ways. One way is to add a percentage to each of the cost factors, for example,
This equates to a percentage of 23.4% on $129.18 giving a total of $159.40 for the job.
Flat Percentage Add-on
Another way is to decide that you wish to make a 22.5% profit. Then you can simply add all of the costs plus 22.5% of the total:
Total charge = ($21.70 + $71.37 + $37.11) x 1.225 = $129.18 x 1.225 = $158.25
Your aim is to charge as much as you can and satisfy your customers. This can be achieved by differentiating your service and in almost all cases is defined by a better perceived service.
There may be times when you purchase materials at a lower price and can therefore add a higher percentage of profit.
So How Much to Adjust Your Price?
This depends how much your customers value your service. Because your overheads are fixed a 10% increase in rates may provide you with substantially more than 10% profit. Looking at the above example let’s increase our charge rate from $158.25 (flat percentage 22.5%) by 10% to $174.08.
This 10% increase in charge rate corresponds to margin = (174.08 – 129.18) / 129.18 = 34.8%,
a whopping 55% increase in margin!
A solid understanding of this process and understanding your costs is essential to good business management. Many businesses are in a position where costs are not fixed and they can increase costs marginally to determine the highest and best cost for return. This is demonstrated in the figure below.
This graph can be plotted before you commence sales and so you can adjust your prices and monitor the results of your sales “on-the-fly”. This will ensure that you maximise your return for a given product/service.
You may check your financial information monthly but are you doing enough? Do you create a cash flow chart? And have you established the cash flow goals for your business, both long and short term?