One friend runs a successful professional service firm generating nearly $2 million a year in revenue.
The other started a micro business a while back and now generates about $50,000 in revenues.
The irony here: Though superficially, these two small businesses seem totally different, they suffer from the same problem. Bad pricing.
And another irony here? Both small business owners really know their respective industries and both work really hard.
Accordingly, I want to describe two, similar approaches that folks like my friends (and maybe you too) can use for pricing small business services profitably.
Selling a Cookie-cutter Service Profitably
Let me start with the smaller business because this firm is a one-person operation which sells, basically, a $50 cookie-cutter service.
We can use this simpler structure to illustrate most of the concepts of pricing for profitability.
Note: By “cookie-cutter,” I simply mean that each customer gets essentially the same service: the same one hour music lesson, the same haircut, the same shuttle to the airport, the same chimney sweeping and so on.
To provide some meat for discussion, suppose this small service business requires the owner to spend $15,000 a year in fixed costs. Perhaps that’s the annual lease costs on an expensive piece of equipment. Or the total cost to maintain a shop.
Further suppose the business sells 1,000 of these cookie-cutter services a year… a level that requires the business owner to work 2,000 hours a year.
Note: This is just a hunch, but I suspect my friend set his price to $50 because he spends about an hour with the client when he provides his service, and $50 seemed like about as much as he could charge. His customers, he thought, would think about the $50 as sort of equivalent to him earning $50 an hour.
In this case, the business owner’s annual profits look like what shows below if he sells his $50 service a 1000 times over the year and he pays $15,000 of fixed costs:
That $35,000 of profit equates to about $17 an hour in compensation–an amount that roughly equates to maybe a $15 an hour job. (I am thinking the $2 an hour difference between $17 an hour and $15 an hour goes for payroll taxes.)
But suppose the owner wants to price so he earns $50,000 in profits. Earning $50,000 in sole proprietorship profits, for example, probably roughly equates to a job that pays $40,000 in salary and provides some decent benefits.
In this very simple case, you can calculate the appropriate new price for the cookie-cutter service as $65 using this formula:
($15,000 of fixed costs + $50,000 of budgeted profits) / 1000 “Cookie-cutter” services a year = $65 a cookie-cutter service
With the new higher price–$65 instead of $50–this business owner’s annual profits look like this:
|Revenue (1,000 times $65)||$65,000|
|Less: Expenses (those fixed costs)||$15,000|
I know. You’re looking at this table and the formula that calculates that $65 price per service and thinking, “Come on… Steve… That’s embarrassingly obvious.”
And you’re right. It is obvious.
But can I point out three subtle things about this “pricing for profits” approach?
First, small business people often don’t price this way. Rather they sell time by the hour.
Second, small business people often don’t explicitly connect recovering the fixed costs of business from their customers.
Third, and related to the first thing I pointed out, small business owners often ignore that they need to get paid for both the time they provide services and the time they spend working in the business. (In this friend’s case, for example, he gets paid for the work time he spends with his customers but not the work time he spends away from customers.)
The end result with pricing at some hourly rate? A small service business prices way too low.
Profitably Selling Custom “Services”
Let me give you an example of how pricing for profits works for bigger operations with non-owner employees providing customized (or non-cookie-cutter) services.
Again, we need some meat for the discussion, so let’s assume the following:
- This firm generates $2,000,000 in revenues selling its average service 1,000 times a year at an average price of $2,000. Now note that $2,000 price is an average. Each time the service is provided, the actual invoice total depends on the time it takes to provide to the service. (The service in this case might be a complicated tax return or an electrical repair or a free-lance editing project…)
- Overhead (including office space, technology and administrative employees) runs $800,000 annually.
- The ten professionals providing the customized services each work 1,500 hours a year providing actual services at customer sites.
- Each professional employee earns (costs) $100,000 once salaries, payroll taxes and fringe benefits get tallied.
- The owner wants to price so she makes profit equal to 20% of the total revenues to pay for her time and as a return on the rather substantial capital invested in the business.
Initially, before re-pricing for profits, the situation described above means an annual profit and loss statement that looks like this:
|Revenue (1,000 “servicings” a year at average price of $2,000)||$2,000,000|
|Less: Overhead (rent, technology, admin employees, etc)||$800,000|
|Less: Salaries of professionals (folks who deliver the service)||$1,000,000|
To reprice for profits, however, the firm might use the following three formulas:
First, to recover the fixed costs, each “servicing” should include $800 for overhead, calculated as:
($800,000 of fixed costs / 1,000) = $800 of fixed cost per “servicing”
Second, to recover the variable employee cost, each “servicing” should cover the full hourly cost of $66.66 an hour calculated as:
($100,000 in total annual costs / 1,500 hours) = $66.66 per hour of service
Note: Someone who works full-time often gets paid for 40 hours a week for 52 weeks, or 2,080 hours a year. But commonly some of these hours are not working hours. Some hours represent holidays, vacation and sick leave for example. Further some hours go to training and administrative duties.
Third, and finally, when pricing a particular “servicing” the final total price needs to include not only the $800 in fixed costs and that $66.66 an hour in variable labor costs but also the 20% profit margin.
If someone buys a service from this firm which requires 20 hours of labor, the price should equal $2,250, for example–an amount which gets calculated like this:
($800 fixed cost “share” + 20 hours times $66.66 an hour employee cost)/(1-20% budgeted profit margin)
The “average” service delivers the following profit for example with the new pricing formula.
|Revenue for average service||$2,250|
|Less: Overhead charge||$800|
|Less: Cost of professional||$1,000|
The firm’s profit and loss statement below shows how this new pricing impacts the business profits over the course of a year:
Again note what’s going on with an approach like that describe here. The professional services firm isn’t selling consultants or whatever by the hour.
Further, the pricing specifically recovers the costs (both the fixed costs and the variable costs).
Finally, the pricing creates the profit margin the business owner needs to justify spending time and money in the venture.
Final Tips for Pricing Small Business Services Profitably
First, if you’re working hard but still failing to price services profitably, know that you’re not alone. Many folks find themselves in this predicament. Lots of accountants do–which is another great irony. (We’re supposed to be really good at cost accounting.)
Second, if you are busy but unprofitable and you can reprice your services to a level that recognizes fixed costs, variable costs and a desired return on your time and investment, your business will almost immediately become profitable if you retain most of your clients or customers.
Note: If retaining customers after a price bump seems unlikely, note that if your customers try to leave you for a cheaper price, they don’t just need to find a replacement… they need to find a replacement who also prices his or her services at a too-low, unprofitable level.
Third, if you’ve been pricing by the hour, you’re probably underpricing. Hourly rates by definition ignore your fixed costs, ignore your unbilled time, and ignore your opportunity cost.