How do you set a price for your service? We get this question a lot at a2advisers.com. Changing your price is one of the most impactful things you can do for your business.
A study by McKinsey & Company shows that a 1% increase in price leads to an 11% increase in net income.
The first thing to remember is that pricing is part science and part art. Setting a price entails understanding and calculating your costs, which is science.
It also involves knowing and communicating your value, which is art. This post will dive into calculating costs and ways to determine your value so you can correctly price your services.
Table of Contents:
Calculating Direct Costs
The science part behind calculating your costs is allocating direct costs and adding a margin. Direct costs are directly related to the production of your service, such as materials, supplies, labor, and software.
To calculate your direct costs, you first need to list each direct expense associated with your service. Then, determine a desired profit margin. This calculation should look like the following:
200 hours of labor at $100 per hour = $20,000
Material = $20,00
Subcontractors = $25,000
Total costs = $65,000
50% profit margin = $65,000
Total price = $130,000
Although this approach is not wrong, it leaves money on the table. In addition, only using direct costs neglects overhead, which impacts profitability. Your pricing structure must reflect all the costs your services consume.
Calculating Overhead
Understanding how to price your services involves the consideration of indirect costs. Calculating indirect expenses are all the costs behind the scenes of creating a service.
The best way to calculate these costs is to print out your income statement and ask yourself, “what are the necessary costs to produce the service not included in direct costs?” This exercise will help you determine what expenses to allocate and potential expenses you can cut completely.
Indirect costs commonly include employee benefits, insurance, tools, phones, technology, etc. However, there are no right or wrong answers. You are better off having more.
The allocation of overhead ("OH") is an art formed by science. To calculate the allocation percentage, consider all the expenses associated with people working on your services. Then, allocate them by person and/or estimated projects in a year.
You also need to factor in some capacity for your people. We recommend starting with 80% billable and 20% non-billable. This allows you to have enough sales before adding another person and prevents burning out your current employees. More on this in a future issue.
Here is an example of OH allocation by person:
Average employee salary = $70,000
Payroll taxes = $5,600
401(k) match = $2,100
Cell phone = $2,000
Average tool spend = $2,300
Software = $3,000
Office supplies = $1,000
"Free" beer = $1,500
Total OH = $17,500
OH Allocation = 25% = $17,500 / $70,000
In most cases, the overhead allocation percentage should be around 20% to 35% of an employee’s payroll. The result of a 25% overhead allocation from the example above would be the following:
200 hours of labor at $100 per hour = $20,000*25% OH = $25,000
Material = $20,00
Subcontractors = $25,000
Total costs = $70,000
50% profit margin = $70,000
Total price = $140,000
Adding 25% overhead requires a company to raise its price by almost 8% to achieve the same profit margin.
Know Your Value
We hear, “but my competitor only charges $xx, so I cannot increase my prices”, a lot. We challenge this way of thinking by asking, “what do you do that your competitor does not?”
The list of answers that comes from this question is exactly the value your company brings to your customers. Service differentiation is crucial to justify the prices you charge customers.
Being able to make this list relatable to your customers is key. For example, your company might use a specific piece of software that your competitor does not. In most cases, your customer could care less about what software you use.
The customer typically only cares about one thing. They care about how your service makes their life easier, better, safer, etc. This is why communicating your value can be tricky.
Understanding your value and communicating the value can be difficult and take time. One way to shortcut this process is to raise prices until you get too many “nos” from prospective clients. Or your backlog begins to slow up.
This approach is similar to Warren Buffett's 20-slot rule. Here is Warren's 20-slot rule applied to your business and pricing.
"I could improve your [business] by giving you a ticket with only 20 slots in it so that you had 20 punches — representing all the [clients] that you got to [take on in a year]. And once you’d punch through the card, you couldn’t [take on] any more [clients] at all.”
Warren's rule would change your pricing mindset. He would tell you, "under those rules, you’d really think carefully about what you did and you’d be forced to load up on [clients] you’d really thought about. So you’d do so much better.”
The take here is you need to be more strategic in pricing services in your business. Stop taking the easy way and pricing by the hour.
Goldilocks Pricing Strategy
Many business owners become uncertain about their value and are afraid of receiving rejections from customers. The Goldilocks Pricing Strategy solves this problem by establishing three different prices.
This gives the customer a choice and lets them see the difference in value between each tier. The three prices are the floor price, the just right price, and the go celebrate price. These pricing strategies entail:
Floor price - industry standard profit
Just the right price – above industry standard profit
Celebrate price – go out and pop bottles profit!
The first price is an anchor and should be the sum of indirect and direct costs plus your overhead allocation and minimum industry margin. You aren’t trying to get people to buy this package. It’s designed as a baseline to show that tiers 2 and 3 are more valuable.
You want to put all the value in the second and third tiers with the goal of getting customers to buy the middle package. Finding the right tier prices will take trial and error. We look at pricing as a dial that can be turned up and down based on future projects in the pipeline.
Understand Your Value
Now you need to dive deeper into understanding your value. This is done by interviewing top customers. Ask these individuals the following questions:
Why did you pick us?
What challenges did we solve for you?
What do we do better than the competition?
What value would you assign to that part?
What do you wish we did more?
If multiple customers place emphasis on a certain feature of your service, that aspect might be your main selling point. Place the most common answers in the top two tiers and build your price around that.
Communicate Your Value
Getting customers to purchase your service relies on effectively communicating your value. In order to obtain your top-tier prices, you need to highlight the value your service will give customers. Show a return on investment for your service, if possible. For example, our service saves clients xx hours of time to do the stuff they love. Or, our projects have no change orders compared to the industry average of $xx.
Communicating your value can be done by using customer testimonials. Showing customer testimonials build additional trust, especially if you can show customers that returned more than their investment in your service. Also, getting client testimonials can help you determine what aspects of your services they value the most to put in your top two tiers.
Next Steps
Effectively pricing your services is vital to achieving desired profitability, continuing to grow your business, and creating freedom for you. Calculating indirect and direct costs, knowing your value, considering the Goldilocks strategy, and understanding and communicating your value are important aspects of pricing your services. Here is what we at a2advisers.com recommend as the next steps:
Review your financials for indirect costs
Determine an overhead allocation percentage
Develop a Goldilocks pricing strategy
Interview customers
Develop your value proposition