The Price Is Right
by Kyle Mackenzie, CPA
January 1, 2020
As a partner at my public practice firm, I see inside hundreds of businesses on a regular basis and this means I have insights into other businesses that many people don’t get. Because my business is other peoples’ business, it affords me opportunities to learn from those in the community around me. I’m able to shift and change my business based on what I see. This helps me be a good advisor to my clients. I get a scope of how those in our business community are doing and I get to see what success takes and identify the fatal errors that often result in failure.
Pricing is one of the fatal errors I see far too often. If you were to ask me what is the biggest mistake most business owners make, I’ll almost always tell you it has to do with pricing. This may not ring true for all businesses, but for most one owner or partner businesses (<$5 million in revenue), it is the case.
There are a few scenarios I typically see:
1) Undervaluing – This is the biggest one
2) Overvaluing – Not as common, but it happens, and
This article will focus mostly on services, as it’s where we see the most mistakes made. Let’s walk through the main points to consider when pricing your services.
Value is the biggest point when considering pricing in an established business. There is a lot of talk and buzz about value pricing, and first, lets define what value pricing is:
When setting prices or rates for services, value is the first thing one should consider. What is your service worth?
· Are you providing something in high demand?
· Are your services particularly specialized?
· Do you bring something to the table that’s harder to come by?
· Do you provide a benefit that your competitors don’t?
· Are you providing something that, without you, your customers wouldn’t get?
These questions all affect value. If you’re able to provide specific value to your customers, what is that worth to them? Value pricing is about framing your service in the context of your customer. If you can get them something that would be exponentially more difficult for them to acquire on their own, you’re providing a valuable service. The next step is to quantify what that value is worth. Let’s use an example:
Kevin is a management consultant who helps to improve efficiencies within technology firms. He’s able to speed up and create efficiencies within a client’s hiring process that cuts time required to bring on a new employee by 40%.
If a company hires 20-30 people every year, whereas the hiring process used to take 20 hours from start to finish before Kevin was brought on, it now takes 12. At an average rate of $40 per hour, Kevin is saving his client $6,000-10,000 every year. To implement the change, it takes Kevin about 20 hours on average. If Kevin charges a consulting rate of $85/hr, he’s walking away from each implementation with $1,700.00 – Kevin is leaving at least $5,000 in value on the table, every time he does this job.
If Kevin received 100 requests for his services in the year, he would be able to complete the work by himself, working 40 hours per week. But what happens when his business grows? When he has 200 requests per year? You would hire someone to help take on the extra work, and pay them for it, right? Wrong.
What kevin should be doing is adjusting his pricing so that there is a tradeoff of price and time. He needs to set his price so that the value he is providing is recognized and realized by both himself and his customers.
When I talk to clients who are successful, they’re not the ones who are working 60 hours a week and having the phone ring off the hook, trying to keep up with all the demand. Yes, there are some cases where that works; but it is not the norm. The clients we see with the most success have set their prices properly.
There are a few determining factors to setting your prices properly:
Competitive landscape: The questions to ask here are “what are my competitors charging for a same or similar service?” “by changing my prices, will I be driving away business to my competitors?” If you are continuously charging less than your competition, you’re not “smart” – you’re inspiring a race to the bottom. We see a few industries where this has become the norm. Every business tries to undercut the rest, and it’s a continuous cycle until it drives everyone out of business.
Internal constraint: What is your capacity? Do you have a limited number of hours you can spend to deliver one product or service? Do you have one specific service that provides better value than the others? You should be calculating your rates based on that constraint – The number of hours your business can contribute to your best service, as this is where you will see the most value as a shareholder. Remember, the point of a business, in most cases, is to drive value for the shareholder. If you’re working constantly to the bone but not getting ahead, it might be time to look at your prices.
Market expectations: What price are customers willing to pay for your services? Are you specialized? Do you deliver something different than the rest? If so, you will likely be able to charge more than the rest.
As a business owner, you have to consider all of these angles when setting your pricing. As a general rule of thumb, if you are selling 100% of your services on every job you quote, you are priced too low. You should have potential customers that don’t accept your quotes – The reason for this being that if you are always landing the deal, why is this? You are either the most affordable option, or simply the best. It may be both! If it is both, then there’s a second reason to update your pricing. When clients ask what percentage of jobs they should be landing, I tell them 75% is a realistic number.
Let’s put this into practice – There are a few steps to take.
1) Figure out what your total capacity is – This is useful to do on a monthly or annual basis. It could be the number of jobs you are able to complete, the number of hours you can contribute, etc. Each business is different.
2) Figure out what your fixed costs are – Rent, Salaries that can’t be avoided, other costs that you would have to pay no matter what your revenue is. This is your base revenue requirement. You need to make at least this much not to lose money in your business.
3) Figure out what your variable costs are – How much does it cost you to deliver your service? What does each job cost you? This may be a “by the job” or an hourly cost.
4) Multiply your capacity by your variable cost, and add this to your fixed costs from step 2.
5) What is this total summed number? Now, divide your this total sum by your total capacity – This is your breakeven rate – The amount you need to bring in in order not to lose money through your operations.
6) Your profit margin is any amount you charge above this breakeven rate – Now look at the external factors – What will the market allow? What do your competitors charge?
Let’s look at the formula:
Total Capacity = C
Fixed Costs = F
Variable Costs = V
Hourly Rate Addition = H
Total Costs at Capacity = $T
Breakeven Rate = $B
C (x) V = H
H + F = $T
$T/C = $B
Example – Let’s use Kevin again:
Kevin has rent of $2000 per month, and additional fixed costs of $4500 per month.
He has salaries to cover of $30,000 per year. He pays another employee $25 per hour. He also
has 2000 hours a year of capacity. He also spends about $12,000 per year on incidentals and other expenses.
C = 2000
F = (12x$2000) + $30,000 + $12,000 = $66,000
V = $25
$T = $66,000 + (2000*25) = $116,000
$B = $116,000/2000 = $58
Kevin MUST charge $58.00 per hour to break even on his costs. Any rate he charges higher than this results in profit.
If you go through these steps and find your breakeven rate is much more than you think you will be able to charge, then you need to fix your costs – you’re spending too much. If you are able to charge a rate higher than what you calculated, then congratulations, you have a viable business. Each dollar over your breakeven rate is profit.
If you would like some assistance with calculating your breakeven or variable costs, setting your pricing, or adjusting your costing, our team at Metrics are experts in business efficiency and advisory consulting.