Customers write your paychecks. Yet, they must be profitable for your company. Growing a customer base where you buy a product for a dollar and sell it for 95 cents is a recipe for disaster. Yet, businesses do this all the time. This article gives two real-life business pricing nightmares, how to price for profit, and a simple way to save cash from that profitable sale.
How Business Owners Don’t Understand Costs
Situation #1:
A business owner needed cash. He decided to give their customer base a special offer to entice them to buy. He promoted a 50% discount on the retail price of one of their products. So, if a customer bought by the deadline, the customer paid $49 instead of $99. Since the product cost the company about $40, they thought that we were still making $9 on the product.
They sold a lot of product and generated a lot of cash at what they thought was a $9 profit. It was a $9 gross profit. When overhead was taken into consideration, they lost $4 on every product they sold. By the time they paid for the product and the overhead, their bank balance was lower than before the promotion.
Situation #2:
“If my competition can sell it for that price, so can I”.
Maybe. Or maybe you will lose big.
“If my competition can sell it for that price, so can I” is one of the greatest myths of business.
You have no clue about your competitor’s costs. They don’t share their P&L and balance sheet with you. So, you don’t know if they are earning a profit at low prices.
Here is a rule of thumb: A large company with many more revenue generating personnel than your company probably has an overhead cost per hour lower than your company’s overhead cost per hour. This means they can have exactly the labor costs as you have but still give the customer a lower price than you can…and make a profit!
Smaller companies may have a lower total overhead but since they have fewer people or even one person to cover that overhead, their overhead cost per hour is usually higher.
Let’s assume:
Your competitor has an overhead cost per hour of $25 per hour.
Your overhead cost is $35 per hour.
For a 20-hour job, their overhead cost is $500. Your overhead cost is $700. That means they can sell the job for $200 less, all other things being equal.
To calculate overhead per hour, divide your total overhead for a month or a year by the number of billed hours for that month or year. More information can be found in The Courage to be Profitable: Get and Stay Profitable in Less than 30 Minutes a Month.
How to Price to Ensure You Are Earning a Profit
Start pricing by turning your profit and loss statement upside down.
Normally the profit and loss statement starts with sales and subtracts direct costs (costs of goods sold) to get gross profit. Then overhead is subtracted from gross profit to get net operating profit:
Sales
– Cost of Sales
Gross Profit
– Overhead
Net Operating Profit
Turn this process upside down. Determine your desired net profit. Then add your overhead cost to produce the product or provide the service. This is your gross profit. Add your direct costs to arrive at the selling price.
Example:
You estimate that it will take 40 hours to complete a proposed project.
You want to earn $50 net profit for each hour of labor on a project. The total profit you want to earn is $2,000.
You estimate the overhead cost for this project to be $1,000 (one quarter of your monthly overhead costs assuming there are 160 hours per month).
You pay the person producing the work $75 per hour. Total cost for this person is $3,000.
The proposed price is $6,000.
If your price is higher than your competition, figure out a way to increase the value of your work.
Most of the time business owners never know they are pricing incorrectly because they are managing by the amount of dollars in their checking account. As long as the dollars are growing, they have a false sense of security. That’s how they buy a product for $1 and sell it for 95 cents.
Once a business stops growing, the problems start: not being able to pay suppliers on time, payroll issues, and more.
Pricing including the profit you desire and overhead costs in addition to direct costs solves this issue.
Save Money from Every Sale
The final step is to put 1% of every dollar that you receive in a savings account. If you don’t want to take the 1% out of your existing product sales, then add 1% to the estimated price to the customer.
This 1% is your rainy day account and provides a safety net when that customer didn’t pay when expected or a big surprise cost hits your business. 1% isn’t much on a daily basis. However, over a year’s time that 1% builds up and becomes your own line of credit.
Price to include overhead and desired profit. Then save a small piece of the revenue.
