Do You Have a Good Method for Pricing Goods and Services?

Jean from Texas asks: Do You Have a Good Method for Pricing Goods and Services?

Thanks for asking this Jean, Pricing is one of my favorite topics. It is a topic that seems complex but it doesn’t have to be.

First let’s establish whether we need to price by the SKU or price by the UNIT. If your company makes a specific product or provides a specific service that always has the same scope of work then we need to price by the SKU. Other products and services however, need to be priced by the hour, minute, pound, foot, etc.

Whether pricing by SKU or UNIT the method used is the same, the difference is, one is a commodity with a “catalog” price, and the other usually requires you to provide estimates and/or quotes to your customer.

Next, let’s understand that pricing is a two-part calculation. The first part is calculating what your company can “afford” to sell the product or service for (see below). And the second is understanding what the market will pay for that product or service. When you have both numbers, you will then know if your business (or this product line) is viable. Obviously, if the first number is larger than the second the venture is not feasible, and conversely if it is less than the second you have opportunity.

The Method:

Most of you know how to estimate your time and materials to calculate your “raw cost”, I would encourage you to also add other variable expenses that can also be estimated on a per SKU/UNIT basis. Those might be products or services that consume large amounts of energy, sales commissions, online sales fees, employer’s share of taxes, benefits, etc.

Once we have established the “raw cost” we then need to add “burden” to that cost. In order to do that we will need to look at your Profit & Loss Statement and separate your fixed expenses (overhead) from your cost of goods or services (COGS) or variable expenses.

When we have the total cost of overhead (again those expenses that have nothing to do with producing the product or service) we need to divide that by the COGS to obtain the burden rate. YES, I said divide by COGS NOT total revenue. It is a common mistake to look at overhead as a percentage of revenue BUT we need to remember that we are working from raw cost toward the final price (revenue) so we need a rate that we can add to our cost of goods.

Let’s say for example that our percentage is 50% we would then multiply our raw cost by 1.50. This new number is what we could afford to sell our product/service for that would cover our costs and overhead.

Next, we need to answer how much profit margin we would like to make. This can be found by looking at industry averages or simply what you think is fair (and competitive).

Lastly (part 2), we need to compare this price against what our competitors are charging. You will want your price to be competitive, so you may want to adjust up (never down) accordingly.

A few things to beware of:

When adding your profit margin, we need to convert that number to “markup” as margin works from price to cost, markup works from cost to price. Example for a 10% profit margin here is the formula to convert to markup: (100*.10)/(100-(100*.10)) = 11.11%

Be careful with industry average margins as they are usually based on raw cost not fully burdened cost.

Overhead as a percent of COGS will vary as your business grows (or shrinks) and should be recalculated when revenue changes dramatically. This is also one of the hurdles that must be overcome in a start-up situation or product launch. When this happens, I recommend using projected costs. Project the costs to a reasonable point in time when sales are/will be a year from now.

As revenue grows and overhead remains the same, the cost to deliver your product or service go down and amplifies your bottom-line profit, giving you more ability to flex your muscles with your competition.

Pushing the price thresholds should be a consideration, but we can talk about that later when we talk about price increases.

Jean, as I complete this response to you, I am realizing that I may not have made this as simple as I had hoped. If you (or anyone reading with this) struggles to get pricing right please know that you are more than welcome to reach out for more clarification.