How to Price Business Services
Advice for small businesses on how to manage pricing strategies by calculating costs, considering different pricing models, and evaluating customer and competitor behavior.
The reason you went into business selling services to customers was to make a profit. If you were giving away your services for less than cost, or just breaking even, you'd be operating a non-profit venture – or a business that's likely to fail. There are a variety of components that factor into whether or not a business is profitable, including location, leadership, market demand, competition, and so on. But one of the most important decisions you need to make to determine whether you turn a profit or not is how to price your services.
Service businesses can range from a sole proprietorship consultancy to mid-sized businesses with several hundred employees, some of whom go out to customers and perform anything from cleaning homes to providing information technology expertise to large corporations. Get your pricing strategy for these services wrong and you will create a problem you may never overcome. Get it right and you will dramatically increase the likelihood of creating a business that perseveres and takes care of you financially.
"It can just destroy you if you don't do it right," says Charles Toftoy, an associate professor at the George Washington University School of Business and Public Management. Toftoy has helped counsel 1,500 small businesses along with his graduate students. "It doesn't matter whether you're putting out a novel you've written or providing a service through a pest control company or you're a veterinarian. The bottom line is that pricing is extraordinarily important."
The following pages will provide a guide to how to price your services, the benefits and risks of certain pricing structures, and how to monitor and change the pricing for your services without alienating customers.
Pricing Your Services
The good news is you have a great deal of flexibility in how you set your prices. The bad news is there is no surefire, formula-based approach you can pull off the shelf and apply in your business. Pricing services is more difficult than pricing products because you can often pinpoint the cost of making a physical product but it's more subjective to calculate the worth of your counsel, your staff's expertise, and the value of your time. You can, however, use some of the same underlying pricing guidelines to figure out your costs and operating expenses plus your target profit in setting your price for services.
Factors to consider in pricing
When pricing services, there is a bit more leeway than pricing products. "The price of a product is more objective. The price of a service is more subjective so that there is a gray area," Toftoy says. "Pricing is both an art and a science." Here are the factors that experts say you should consider when trying to determine what price to charge for a service:
- Cost-plus pricing. This standard method of pricing in business seeks to first determine the cost of making a product or, in this case, providing a service, and then add an additional amount to represent the desired profit. To determine cost, you need to figure out direct costs, indirect costs, and fixed costs. "With the cost-plus approach, the thing to remember is that if you're paying someone $11 an hour, you may think you should charge $11 an hour for the service they provide, but you have to factor in all your costs," says Jerome Osteryoung, a professor of Finance at Florida State University and outreach director of the Jim Moran Institute for Global Entrepreneurship. Those costs include a portion of your rent, utilities, administrative costs, and other general overhead costs. "When I make a deal to sell a service," he says, "I have to make sure to cover all my costs."
- Competitors' pricing. You need to be aware of what competitors are charging for similar services in the marketplace, Osteryoung says. This information could come from competitor websites, phone calls, talking to friends and associates who have used a competitor's services, published data, etc. "I don't think it's a good idea for any entrepreneur to compete on price if you can avoid it. Compete on service, ambiance, or other factors that set you apart," Osteryoung says. If you have to compete on price to win a customer, you may ask yourself whether that customer will be loyal to you if they find someone offering a service at a lower price. You want to establish long-term relationships in the marketplace. "You need to convince the customer that you are giving them tremendous value in terms of service and quality," Osteryoung says. "You just need to be aware of what the competition is charging."
- Perceived value to the customer. This is where a lot of the subjectivity comes in when setting a price for a service. When you have a product, you may decide to use keystone pricing, which generally takes the wholesale cost and doubles it to come up with a price to charge and account for your profit. With a service, you can't necessarily do that. To your customer, the important factor in determining how much they are willing to pay for a service may not be how much time you spent providing the service, but ultimately what the perceived value of that service and your expertise is to them, Osteryoung says. That is where pricing becomes more of an art form.
Calculating your costs
Before you set a price for the services your company will provide, you need to understand your costs of providing these services to customers. The U.S. Small Business Administration advises that the cost of producing any service is made up of the following three parts:
- Materials cost. These are the costs of goods you use in providing the service. A cleaning business would need to factor in costs of paper towels, cleaning solutions, rubber gloves, etc. An auto repair business would tally up the cost of supplies, such as brake pads or spark plug, which are being installed by service people. You may want to include the material list with your estimate in bidding for a job.
- Labor cost. This is the cost of direct labor you hire to provide a service. This would be the hourly wages of your cleaning crew and/or a portion of your mechanic's salary and benefits while they were providing the service for your customer. The SBA recommends using a time card and clock to keep tabs on the number of hours of labor involved in providing each service for a customer.
- Overhead costs. These are the indirect costs to your business in providing services to customers. Examples include labor for other people who run the firm, whether administrative assistants or human resources personnel. Other overhead costs include your monthly rent, taxes, insurance, depreciation, advertising, office supplies, utilities, mileage, etc. The SBA suggests that a reasonable amount of these overhead costs should be billed to each service performed, whether in an hourly rate or a percentage. One important thing to note: don't just depend on figures from last year to determine your overhead costs. You need to charge customers rates that cover your current costs, including higher salaries to employees, inflation, etc.
Determining a fair profit margin
Once you determine your costs, you need to mark up your services to ensure that you achieve a profit for your business. This is a delicate balance. You want to ensure that you achieve a desirable profit margin, but at the same time, particularly in a down economy, you want to make sure that your business doesn't get a reputation for overcharging for services. Osteryoung suggests that you look for resources in your industry, such as the annual statement studies on small and mid-sized business financial benchmarks from Risk Management Associates, to help you determine whether your profit margin is on target. "The net profit margin for a specific industry might be 5 percent, so if I'm sitting on 2 percent I need to come up a bit," Osteryoung says. "I need to sell services, give value, and make sure the firm runs a fair rate of return."
Different Pricing Models
Now that you understand what it costs you to provide a service, what your competitors are charging, and how customers perceive the value of your services, it's time to figure out whether to charge an hourly rate, a per-project rate, or try to negotiate a retainer for your services. This may be predetermined by your industry and the type of service pricing that predominates in your sector. For example, lawyers tend to charge hourly rates for their services, although those rates can vary. Many construction firms charge a project fee and require that one third be paid up front, another third be paid at the half-way point, and the remaining third be paid upon completion.
Here are some benefits and risks associated with the following pricing models:
