If you’re the small business owner who thinks carefully about pricing and NAILS IT from the get go, Congratulations! But you’re not the norm.
Most of us start a business and figure it out as we go, with pricing as an afterthought, usually loosely based around what our competition is offering, in an attempt to stay competitive. However, after running a business for a while, most of us will hit a point where we are not satisfied with our profit margins and/or growth and we’ll need to look at how we’re pricing goods and services.
This is by no means a comprehensive look at pricing, but rather three little tricks you can use to help analyze your pricing strategy. These will require you to pull out your P&L statement from last year and have a look at some data.
1. Product Multiplier
Take a look at your total end-of -year revenue and then divide by all of your direct product costs. This gives you a product multiplier. When you consider new products or services, this gives you a rough idea of how much you’ll need to charge. It also can give you an idea of what overall effect you’ll get with a price change, and can help you compare different products you sell to see where pricing might be disproportionate.
For example, if you currently sell embroidered hats for around $30, and you get the base hats at $10 each, your product multiplier is 3. If you want to introduce Polo’s with embroidered logos, and you’ve priced a supplier out at $12 each, you have a quick idea of what you’ll need to charge to still cover the harder-to-quantify costs. A price of $36 should keep you at the same margin as with the hats that you’ve been selling, using the same product multiplier of 3.
Now, you decide you aren’t quite operating at a high enough margin. Maybe someone suggested that a mild drop in price would increase volume. What impact would some pricing changes have? You know what your direct cost was, and you can quickly see how your prices and gross revenue change with a multiplier of 3.5 or 2.8.
The real world is much more complex. There are people doing the same thing. If you have niche products, you typically trade off larger ratios to make up for lower volume, but high-competition markets might force you to run lower ratios between product cost and sale price.
This might give you a good metric whereby you can quickly tell if selling a certain product is not working for you, or that your pricing is just not working. If most of your products sell around a product multiplier of 3, and you’re trying to compete in a labor intense segment where the competition won’t let you run a product multiplier higher than 1.5, you might need to re-evaluate your commitment to that segment.
2. Revenue Per Hour
Another easy number is revenue per hour. Take the gross yearly revenue and divide it by the number of hours worked in the year. This will give you a true gross “hourly rate” that you actually earned per hour, including those hours spent tracking down that impossible-to-find part.
This can help identify how valuable those 90-hour work weeks really were to the company, or whether your hourly service rate is actually too low. If you don’t charge hourly, it can give you feedback about how well you’ve priced your goods and services relative to the time it takes to fulfill orders.
How much time does each dollar cost you and your team? The numbers are still a little abstract, but they help reveal what a price change would do to the payout for the labor you put in. It doesn’t tell you what you have to overcome in costs before you’re actually making a profit (that’s the next one), but it does give you a number that you can make projections with.
3. Fully Loaded Labor Rate
This metric is similar to the last one but is used for a different reason. Take your total yearly expenses minus product costs and divide it by hours of billable (productive) work. This gives you a fully-loaded per hour labor cost. This will easily help you identify segments of your business that are unprofitable.
For example, if you have a lawn care business and your calculated fully loaded labor expenses are $70.00 per hour, but you charge $30.00 to mow a lawn that takes ½ hour to cut. This means you stand to lose $5.00 for cutting that lawn every time. This calculation is especially helpful for labor intensive businesses. Raise the price by $5, and no one will get hurt.
Setting pricing initially can be a guessing game, but once you have your first year’s financials, you no longer have an excuse. So, grab your calculator and jump on in there.