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Home-Based & Micro Businesses in Mississippi - FAQ 2

How do I figure out what to charge for my product or service?

Pricing products and services is a challenging process for most new home-based business owners. Often entrepreneurs will underestimate the value of their time and expertise and find it difficult to believe that customers will actually pay the price they need to charge to make a profit. The bottom line of any business is profit. If a business is going to be successful and maximize profits, accurate pricing is critical. Prices must be high enough to cover costs and earn a reasonable return, yet attractive enough so customers will purchase the product or service.

Many factors must be considered when developing a pricing strategy for a home-based business. Pricing decisions should be based on an orderly analysis rather than on an educated guess. By taking a systematic, step-by-step approach, you can make pricing a simple task.

Costs

The prevailing element when setting prices is costs. An accurate accounting of all the costs that go into a business is necessary. In a business, the total costs to be considered include three factors: direct costs, labor, and overhead expenses.

These are the three basic or minimum factors that should be used for setting prices. The more exact the figures used for setting prices, the greater the chance for success.

Direct Costs -- Include all the materials, parts, and supplies that go into the actual production of the product or service. Direct costs should be exact, figured to the penny.

Labor -- Includes all wages paid to employees. Many times, new business owners make the mistake of not paying themselves. Be careful not to fall into this trap. Labor costs are calculated by multiplying the number of hours worked by the hourly wage. Be sure to include fringe benefits either in the hourly wage calculation or in overhead expenses. Fringe benefits can range from 15 percent on up, depending on the benefits included.

Overhead Expenses -- Include all the business costs not directly related to the actual production of the product or service. Overhead expenses include taxes, advertising, rent, office supplies/equipment, business-related travel, insurance, business permits, maintenance and repair of equipment, utilities (electricity, telephone, etc.), professional assistance (accountant, attorney, etc.), and any other costs related to the overall operation of the business.

Overhead expenses can be determined as a percentage of direct costs plus labor. To determine the overhead percentage for the business, add up the total overhead expenses for a year. Next, divide the total amount of direct costs + labor for the year into the first figure.

For example, if direct costs plus labor for a year added up to $10,000 and overhead expenses for the year added up to $2,000, that would be $2,000 divided by $10,000 for an overhead of 20%. Once you determine the overhead percentage for the business, you can use it in calculating prices for the business. The overhead percentage should be re-evaluated on an annual basis.

A key concept to remember is that it is impossible to stay in business if prices are set lower than the "cost of doing business." Direct costs, labor, and overhead expenses are the bare minimum that must be reflected in the pricing strategy of any business.

Profit

Profit is the income left after all direct costs, labor, and overhead expenses have been paid. For there to be money left over, a profit factor or profit margin must be calculated in initial pricing. After the total costs are calculated, the profit factor is added to get the final price.

Generally, adding a 10 to 20 percent, or more, profit margin is standard for most home-based businesses. An initial mistake many home-based business owners make is not adding in a profit margin to their pricing strategy. If this is not done, there will be no money for growth or expansion of the business.

While the basic principles for pricing a product or a service are essentially the same, there are some differences that should be considered when you are wholesaling a product to a retailer. Up to this point, when pricing a product the pricing formula results in the wholesale price. To arrive at the retail price for a product, a retail margin must be added, which is usually two to three times the wholesale price.

The percentage a retailer adds to the wholesale price it pays for an item is called the markup. For example, a product that is wholesaled for $10 (Direct costs + Labor + Overhead Expenses + Profit = $10), will be marked up at least 100 percent or two times to a retail price of $20 (Wholesale Price x Retail Margin or $10 x 2 = $20). A retailer will mark up items using the best pricing strategy developed for that business.

A wholesaler also may cross over and be a retailer at times. When this happens, the wholesaler must be careful not to compete with or undercut his or her wholesale customers. An example is an artisan who wholesales pottery to gift shops and also sells pottery directly to customers at art shows or craft fairs must be careful when it comes to pricing. The artisan should sell the pottery at retail prices at the art shows and craft fairs --- the same prices the gift shops charge. If the artisan retails directly to customers at a substantially lower price than the gift shops, the artisan will lose the wholesale accounts.

A word of caution to small home-based businesses that are wholesaling to retailers or selling to retailers through a distributor or "sales rep." Many times a retailer will ask for discounts when buying in bulk and distributors will ask for a percentage of what they sell. Both of these are overhead "costs" that must be incorporated into the original pricing formula.

Breakeven Analysis

Prices charged must exceed total costs or there is no reason to be in business. A method business owners use to look at the big picture for pricing is breakeven analysis.

Defined in its simplest form, the breakeven point is the point at which sales (revenues) are exactly equal to costs (expenses). At this point, zero profit is made and zero losses are incurred. This approach is helpful in determining the number of units of a product or the dollar amount of sales necessary to cover all costs. This makes it possible to determine how much of a product must be sold to cover costs.

The basic equation used for determining the breakeven point is:

Since profit is defined as zero at the break-even point, sales must, by definition, be equal to total expenses. For example, let X represent the number of units to be sold to break even (zero profit). Suppose the cost per unit of X is $.45, the selling price per unit is $1.00, and there is a fixed cost of $275 to manufacture product X. How many units of X must be sold to break even? Going back to the equation and listing the known values results in:

In this case 500 units of X must be sold to cover all costs. In dollar terms, the breakeven point is $500 in sales of product X (500 units @ $1.00 per unit).

Using the same example, suppose you want a profit of 20 percent of sales. What effect would this have on the breakeven volume? Since profit is defined as a percentage of sale, the initial equation changes to include the profit calculation:

where .20(1.00X) is the profit term, since profit is defined as 20 percent of sales (1.00 per unit times the number of units). The equation then becomes:

To cover all costs associated with product X and to make a 20 percent profit on sales, 786 units must be sold. Total sales volume in this case will now be $786 ($1.00 times 786).

Going back to the example used earlier, where the selling price per unit was $30, and the cost per unit was $25, and the fixed cost was $5 --- and inserting these values into the equation --- you can see the formula works as intended:

Breakeven analysis permits the business owner to look at the pricing strategy using different combinations and variations of variables to determine necessary productions levels, unit pricing, costs, and desired profit.

Other Pricing Strategy Considerations

Competition -- Determine what the competition is charging for its product or service. The prices charged may be lower, higher, or about the same. If customers question a price by drawing comparisons to the competition, point out the quality of the work, the uniqueness of the product or service, and other features or selling points. Do not let customers change prices that are based on sound pricing strategy.

Discounts/Markdowns -- Discount prices only when necessary to generate business to increase cash flow. Limit discounts for family and friends.

Estimates -- Provide the customer with a written estimate to help avoid possible misunderstandings later. The estimate should reflect the maximum charges. Final charges to the customer may be less but should not be more unless there are circumstances explained to and accepted by the customer.

Exclusivity -- Custom, original, or one-of-a-kind products or services can command higher prices. Customers are willing to pay more for items or services that are limited in availability and less for items and services that are readily available.

Expertise -- In general, the higher the skill level or level of expertise, the more willing customers are to pay higher prices. Those with better skills can often produce more or provide more services in less time without sacrificing quality, and time is money.

Inflation -- Prices must adjust as the cost of doing business rises. It is best to anticipate rising costs when setting prices so that frequent price changes are not necessary.

Itemizing -- Sometimes, itemizing the final bill may help customers understand the amount charged. Frequently customers do not realize the amount of time involved and costs of materials.

Location -- Regional differences can affect prices. Generally, prices in urban, suburban, and high-income areas can be higher than prices in rural and low-income areas.

Odd Number -- Odd number refers to setting prices just below even dollars. For example, a price is set at $9.95 rather than $10.00. Customers often perceive they are getting the item for less.

Prestige -- Some customers are willing to pay above market prices for a product or service perceived to be of higher quality or with brand name prestige.

Professionalism -- Businesses that look and act professional are usually worth more to the customer.

Quality -- In most cases, the higher the quality, the more customers are willing to pay for a product or service. Top-of-the-line products and services can command top-of-the-line prices.

Seasonality -- Some products or services sell better at certain times of the year (for example, holiday items).

Volume -- Increased sales volume may or may not warrant lower prices. Sometimes it is more economically efficient to produce multiples of the same product. Any added savings gained through efficiency must be weighed against the expense of selling more items (for example, extra employees may be needed as volume increases).

What The Market Will Bear -- What the market will bear for price can be critical. In some cases, the cost of producing the product or service is too high. No matter how great it is, the market is not willing to pay the price a business needs to charge to make a profit. On the other hand, there are times when the market will pay a much higher price than the actual cost of producing the product or service. Understanding the market and what customers will or will not pay directly impacts pricing.

In summary, the primary purpose in operating a business is to make a profit. Prices should be established from an accurate accounting of direct costs, labor, overhead expenses, and profit margin. Wholesaling products to retailers adds another dimension to pricing that must be taken into consideration. In addition, careful thought of all factors that may have an impact on the business should be considered as a pricing strategy is established. Pricing is a skill that must be developed and continuously monitored in order for a business to be successful and profitable.

The following is a "short list" for additional and more in-depth information on the subject of pricing services and products for home-based businesses:

• Consumer Psychology Toward Price, Gregory Passewitz, Ohio State Extension Service, 1995.

• Homemade Money, Barbara Brabec, Cincinnati, Ohio: Betterway Publications, Inc., 1994.

• Home Office and Small Business Answer Book, Janet Attard, New York: Henry Holt & Co., 1992.

• Pricing for Profit, Barbara Rowe & Alma Owen, Purdue University, 1996.

• Pricing for Profit, Carol Thayer, Nebraska Cooperative Extension, 1992.

• The Complete Handbook for the Entrepreneur, Gary Brenner, Jowl Ewan, & Henry Custer, New Jersey: Prentiss Hall, 1990.

• Working From Home, Paul & Sarah Edwards, New York: G. P. Putnam's Sons, 1994.