One of the biggest challenges facing entrepreneurs is figuring out how much to charge customers for their products or services. If prices are set too high, you scare away customers. If rates are set too low, you get a line-up around the block, but end up losing money.
Many businesses base their pricing decisions on a combination of previous experience and a “gut” feeling for what the market will bear. However according to a BDC expert, developing a more formal approach and updating it regularly pays big dividends.
“A lot of small business owners are not reviewing their prices regularly to make sure that they remain current,” says Chuck Austin, a chartered accountant and BDC consultant. “When you accept an order, you want to drive your business towards its forecasted profits. To do that, you need an up-to-date pricing policy.”
According to Austin, most businesses price their products or services by charging for both the time their employees put into producing an order, at an hourly rate, and by placing a mark-up on the inputs they use in the goods they manufacture or re-sell. There are excellent software packages that will do these calculations for you once you have plugged in your labour and production costs and targeted profit margin.
Although businesses come in a variety of shapes and sizes, and operate in vastly different environments, there are several steps that most can take to help ensure their pricing is correct.
- Review hourly costs. It’s impossible to figure out what hourly labour rates to charge customers if you don’t know what your costs are. To get a good estimate, add up all employee salaries and benefits and then add overhead costs such as rent, heating and taxes. Then divide this amount by how many chargeable hours your employees work each year. This will give you your average cost for each chargeable hour. To this, of course, you must add your profit mark-up to come up with a basis for labour component of your price.
- Review industry mark-ups. One good way to gage how much you can mark-up employee costs and inputs, says Austin, is to find out what other businesses are charging. “Many rates are based on industry standards. While your particular situation may be different, knowing what the competition is doing will give you a good idea whether you are on the right track.”
- Review supply and input costs. Raw material costs fluctuate with economic cycles. During peak demand periods, some of your inputs may be hard to get. This will have an impact on how much you pay for them. Input costs and availability should influence product mark-ups and thus your eventual profit margins. Conducting periodic supplier surveys is a good way to stay up to date on material availability and costs.
- Large individual contracts. One tricky opportunity facing small businesses is when they are offered a particularly large order, in exchange for a substantial price discount. In such situations, Austin advises pulling out yearly forecasts and then plugging in the new potential order information, such as costs, selling prices, margins and so on, to see how landing the job would affect projected year-end profit.
The key to having a successful pricing strategy, Austin says, is getting the right information. “You need to know that if your bids are successful, that your sales will produce enough of a gross margin to cover your selling, general and administrative expenses and achieve your profitability goals,” he says. “If you are not sure of that, you are just running around like a chicken with its head cut off.”
Content in this section is provided in partnership with the Business Development Bank of Canada. BDC provides entrepreneurs with financing, venture capital and consulting services. To find out more go to BDC.ca.