How to Price Your Product or Service – Part II
In Part 1 of How to Price Your Product or Service we concentrated on specifically how to price a product. In Part 2 we will explore how to price your service so that you not only remain market competitive, but also pay yourself what your worth while making a nice profit.
Many small business owners provide a service of some kind to their customers. They don’t have a tangible product per se, but provide information or solutions to meet their customers needs. These services could be as varied as tax planning consultants to interior decorators, from web developers to landscape architects, but the conundrum remains what should you charge so you can attract and retain clients while still providing an adequate income for yourself?
Just because you are providing an intangible doesn’t mean you cannot systematically price your service, and we recommend the following three step approach.
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Pricing Your Service
Most businesses based on providing a service are billed on a per hour or per job approach, and we advocate knowing what per hour rate you will charge even if you are billing per job. Also we suggest you work through these steps in the order we present them (you’ll see why shortly).
For sake of example let’s say you own “No Audit Tax Planning Consulting Services” and you provide tax planning consulting services to small business (I’ll be giving you a call in a couple months to do my taxes!). How do you go about setting the rates for your tax consulting business?
Establish a Baseline Rate
First you’ll want to establish your baseline rate, which factors in your cost of doing business month in and month out regardless of how many clients you have. All of your overhead cost associated with your business should go into your baseline rate calculation.
Example: At “No Audit Tax Planning Consulting Services” you run a pretty lean operation, and have only a few recurring bills each month. When you add up your office expenses, phone bills, stationary, monthly advertising expenses, office space rent, and a few other miscellaneous expenses you find it cost you $2000 each month to run your business, and that’s before ever getting a paying client.
Take your monthly expenses and divide that by the maximum number of billable hours you will work in a month. You’ll be tempted to overestimate this amount, but try to be realistic, factor in days off, or time between clients. For our example we’ll say you can bill a maximum of 30 hours a week, or 120 hours a month.
From these two numbers you have your baseline rate. Take your overhead expenses and divide by your maximum billable hours.
So the baseline rate for “No Audit Tax Consulting Services” is $16.66/hr ($2000/120). That is the rate you absolutely have to charge in order to not loose money every month.
Gross Up Your Baseline Rate
The second step is to begin “grossing up” your baseline rate to include an adequate profit and to account for necessary expenses that would be paid by your employer if you were not working for yourself.
Example: You know your baseline rate is $16.66/hr. To this you want to add the cost of benefits you will need to pay yourself, and such things as transportation cost, or other soft cost that usually would be picked up by an employer. A good rule of thumb is to add 30% to your baseline cost to incorporate these expenses. After doing that you now have an hourly rate of $21.65/hr.
To this you will want to add a reasonable profit, usually in the neighborhood of 20-30% for consulting services. You choose to use 25%, and will add an additional 25% to the above rate bringing your new base rate too $27.06. or $27/hr. You now know with reasonable certainty that if you charge your clients $27/hr for tax consulting services you will be able to cover your monthly overhead, business expenses, and make a nice profit! Notice we do not factor in what it cost you to live each month, or whether or not $27/hr will be adequate to live a life you are accustomed to. This rate is purely a rate that pays your business expenses and gives you a nice return…if you want to live in a McMansion and buy a boat you will need to figure out how to pay for that, and has nothing to do with what a fair billable rate is. Your clients shouldn’t be penalized by a higher than average rate because you like to fly to Paris on the weekend.
Time to run out there and start getting the business right? Not so fast…
Competitor Analysis
The final step in the process is doing a full competitor analysis. You need to go out in the marketplace and find companies offering similar services to yours and see what they are charging. If they are comprable to your grossed up rate, then you are probably okay, if they are much higher or lower you will need to make some decisions.
Example: You find for tax planning service providers in your area a typical hourly rate is between $20-$30 dollars per hour. This means you are one of the more expensive providers in your area for similar services.
What to do?
You really have two choices at this point:
- Accept that you will be one of the more expensive providers and find ways to differentiate your service from your competitors that will justify the additional expense in your customers eyes.
- Find ways to trim your expenses so that you can lower your hourly rate.
Do not just lower your hourly rate to meet the competition! This will be tempting, but is rarely the right decision. You have already established a rate that you would comfortably meet your financial obligations with and you should try to stick with that rate, and this is the reason we have you go through the steps in the order we suggest.
If you are going to lower your rate to match the competition you need to find a way to cut expenses first. By just lowering your rate to meet competition you set yourself up for numerous potential problems (what if your competition lowers their rate under yours again?).
We suggest you stick with the hourly rate you calculated above and find ways to ad value your competitors don’t. You’d be surprised, it doesn’t need to be anything drastic to justify the cost, going a little above and beyond should do the trick.
What if you find your rate is significantly lower than the market rate?
Being significantly lower than the market rate is not a good thing either, but the solution is probably a little easier to stomach. Accurately assess if your service is providing the same value as your competitors, and if it is then decide how you want to price relative to them.
Example: You find for tax planning service providers in your area a typical hourly rate is between $50-$75 dollars per hour. This means you are the least expensive provider in your area for similar services.
What to do?
You really have one choice at this point:
- Raise your rate to align more closely with the market
Why not keep your rate the same and be the low cost provider?
- When selling a service you need to keep in mind your customers perception of value, and like a bottle of wine most will think more expensive is better, within reason.
- Being 5-10% less expensive than your competitors may not be a bad thing, but if you are 25-50% less expensive, your potential customers will see you as “cheap” and not a “value” as you had hoped.
What to do if You Provide a Product and Service?
Some businesses overlap between offering a product and a service, and more often than not the product is a consequence of the service they provide not the reason they are in business. Most often these business will bill per job, and coming up with a good quote really shouldn’t be a mystery.
- Calculate your hourly rate as you did above
- Add in the cost of materials used on the job (some will choose to build in profit with the sale of materials to compensate for the time it takes you to procure them)
- Calculate the hours you will spend on the job times your base rate, plus cost of materials…and presto you have a quote for providing product and a service.
Pricing your service needn’t be nerve racking or a shot in the dark. Follow the steps above and you will have a realistic idea of what you need to charge in order to cover your financial obligations, make a nice profit, and remain competitive with your competitors.
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