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Pricing for Profit

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How do you know how much to charge your customers for goods or services? In some cases, where manufacturers give recommended retail prices, or where your competitors are selling similar products, it’s easy enough to figure out what you can get away with. If you offer a specialised product or provide a unique service, however, it can be a bit more difficult to determine what the market will bear.

You can go the optimistic route: pluck a figure from the air and hope for the best. This turns pricing into a guessing game, and it’s not certain that the price you pick will be the right one for what you’re selling. Too low, and you’ll soon be out of business; too high and you’ll price yourself out of the market.

Pricing is never an exact science, but there is a simple, four-step process that reduces some of the uncertainty when deciding how much you are going to charge. It doesn’t require any complicated mathematics or modelling, and should also give you an idea of how much money you need to generate to keep your business going.

1. Household and personal costs
Unless you’re running a charity, you expect your business to keep you in the manner to which you are accustomed, maybe even better. So, start off by figuring out how much you cost. Tot up your bills, expenses, saving and tax contributions to reach the amount it takes to run your household for a year. Don’t underestimate anything, and try to be as thorough as possible. Congratulations! You’ve just calculated your salary.

2. Business overheads
Next you need to know how much your business costs to run. In addition to your salary, there’s be the costs of your premises and running your office, any staff wages, marketing and advertising costs, payments on loans or plant equipment, materials, and the fees you pay to you lawyer/accountant/shaman. If your business isn’t operating yet, you’ll have to estimate these costs, but you did all this when you were writing your business plan, didn’t you? Once again, add everything up and reach a figure for the year. This is the bare minimum that the business needs to be earning to keep going.

3. Cost per unit
Now that you know how much money your business needs to break even, you can begin experimenting with numbers. This is also useful when doing sensitivity analysis to test how robust your business concept is. How many sales do you hope to make in a typical year. If you want to be thorough, you can make estimates for worst-case, best-case and most likely scenarios; if you like to live dangerously, you can settle on just one figure that you feel is most realistic. Whatever you decide, divide your annual business overheads by the estimate(s) to reach the cost of each unit of whatever you’re selling. This is not the price, though: this is what it costs you to get your product or service to market.

4. Profit and price
This is (for me) the fun part. Taking your cost per unit, you can now start adding your profit on top. Once again, if you’re feeling reckless, you can settle on just one figure; the more cautious amongst you might prefer to choose a range of profit margins. Regardless, arriving at your price is simply a matter of multiplying the cost per unit by your desired percentage of profit: by 1.05 for a five percent profit, by 1.1 for a ten percent profit, and so on. Personally I like to start at five and work my way up in increments, using best and worst-case estimates to get a better feel for where my price-point should be. Given market conditions and the feasibility of your business plan, you should now have a clear idea of what you can and should be charging.

You don’t have to set your price at the exact number given by your calculations, but you now know what sorts of profits are possible with the overheads you have, and what level of sales you will need to maintain to keep your business ticking over. For those offering bespoke products or individually tailored services, the situation is a little more complicated, but crunching the numbers can still give you a useful baseline for the minimum you need to charge to stay afloat. While you do need to do your research carefully and to be realistic when estimated your figures, it is far better – for your business and yourself – to pick a price that bears some relation to reality, rather than one from the realms of fantasy.

[Image by TheTruthAbout]

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3 Comments

  1. poseyghosts says:

    Great Article!

    I run a martial arts school and have always struggled with the pricing component of my services. This is a handy guide for small businesses looking for a way to compete and profit in the market.

    I see so many businesses start because they think they can offer the same service but only better and cheaper than the competition. This sounds good in theory but often hard to implement in practice.

    This article outlines what small business owners need to think about before they price themselves into poverty.

    Jeff Barnes
    Community Martial Arts
    http://www.CommunityMartialArts.com

  2. Stephanie
    This is cost based pricing and is not a way to price for profit. Cost based pricing is wrong for at least two reasons, one cost allocation problem (like fixed cost and overhead allocation) and two it ignores the customer. Pricing should be based on the value you add to customers (and what they are willing to pay). Only if you can generate revenues that deliver higher profit than any other options available to you should you even get into the venture. A marketer’s costs do not matter to the customers, customers pay for value.

  3. Excellent – really useful step by step guide. I see we are thinking along the same lines :-) I’ve helped many small businesses who couldn’t udnerstand whey they were leaking money – because they didn’t know the true, true cost of sales. http://wp.me/pSkhO-2S

    http://dotherightthinguk.wordpress.com
    Chris @ Do the Right Thing turns business advice into profit

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