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:
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:
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:
Monitoring and Changing Your Price
In a service business, your biggest costs are usually your people costs -- salaries, benefits, etc. If you are having a hard time selling services at an acceptable profit, the problem may be that your employee costs are too high rather than the price is too low. You may want to also re-evaluate your overhead costs to determine whether there are other cuts you can make to bring your price down and your profit margin up. "Look at your expenses and see where you can cut," Toftoy advises.
Monitor profitability monthly
You need to understand the profitability of your company every month. By the 15th of every month, you ought to have your financial statements from the previous month. "If there is any mistake I see entrepreneurs make, it's that they don't spend enough time going over their financial statements," Osteryoung says. "In some cases, no one has ever shown them how to do that. I see their eyes glaze over." In addition to understanding your monthly profitability, you need to understand the profitability (or lack of profitability) of every service you sell. Make absolutely sure you know the degree to which every person or project you sell is contributing to your goal of making money each month.
Test the market for new services and prices
You should always be testing new prices, new offers, and new combinations of benefits and premiums to help you sell more of your services at a better and better price. Often the perfect time to do this is when quoting a price to a new customer. Raise the price and offer a new and unique bonus or special service for the customer. Measure the increase or decrease in the volume of services you sell and the total gross profit dollars you generate.
Be wise about raising your prices
It's a fact of life that you will have to raise prices from time to time as part of managing your business prudently. If you never raise your prices, you won't in business for long. You have to constantly monitor your price and your costs so that you are both competitive in the market and that you make the kind of money you deserve to make in your business. But there are risks to raising prices, particularly when your customers are going through tough financial times.
"You can price too high and sell yourself out," Toftoy says. "People don't forget that they felt like you gouged them for the quality of the service you were selling."
Here are some guidelines for when and how to raise prices:
The bottom line is: You owe it to yourself and to your business to be relentless in managing your pricing strategy. Remember, how you set the price of the services you sell could be the difference between the success -- or failure -- of your business.
The Price Is Right Setting prices has always been more art than science. New software aims to change that.
The Right Price
Too many new entrepreneurs harm their own prospects by underpricing their goods and services. But if those company owners just take the time to think, they can set their prices closer to fair market value.
Is It Time to Raise Prices?
Boost your bottom line by taking the guesswork out of pricing.
Flexing Your Pricing Muscles
Despite years of almost no inflation, you may have more pricing power than you think. Here's how to exercise it without bruising yourself in the process.
This page has some of the best business books and audio programs you can read. Most are focused on improving profitability and cash flow.
How to Sell at Margins Higher than Your Competitors: Winning Every Sale at Full Price
by Lawrence L. Steinmetz, and William T. Brooks
This is book discusses the importance of margins in setting prices. It is available at any online or traditional bookstore. The authors also conduct do seminars and have audio programs on the subject of selling at higher margins.
The Art of Pricing: How to Find Hidden Profits to Grow Your Business
By Rafi Mohammed
The author has a very interesting point about how to get out of the pricing 'Catch 22' by adopting a multi-price mindset.
SurvivalWare is a software tool that shines the light on your cash flow and profitability. Everything you do in setting prices must be measured by the degree to which it helps you make money and create cash flow. It is powerful, yet easy-to-use.
U.S. Small Business Administration's "Pricing Your Products and Services Profitably
This guide discusses how to price your products profitably, plus various pricing techniques and when to use them.
Risk Management Association's Annual Statement Studies
One of the few sources of benchmarking data from the financial statements of small and mid-sized businesses that are customers of RMA. Broken down by industry, this data can be used to help you set prices for your services.
ELIZABETH WASSERMAN is editor of Inc.'s technology website, IncTechnology.com. Based in the Washington, D.C. area, she has more than 15 years experience writing about business, technology, and politics for newspapers, magazines and websites. Her work has appeared in such publications as Congressional Quarterly, Business Week, Portfolio and Slate.