So, you’re a small business owner and you think the best way to set price is to look at your competition, then decide what you will charge. While this is a component of setting price, it is a major mistake to use this as the only criteria. Why? Consider these things:
- does your competition have the same overhead as you? office space, insurance, staff components, capital investment, etc.?
- do they have employees with benefits or do they use contractors?
- do they have more things or less things in common with your business?
- do they serve the same type of customer, or are they very different from you?
Hopefully this opens your eyes and mind to using more than the competition as your guide. I will try to simplify it as best I can.
Let’s start with the Price Equation, which is Price = Direct Product Cost (DPC) + Overhead (OH) + Margin. You take this formula over the volume of sales to get to your official price. Breakeven should be the price that uses just DPC and OH added together, divided by sales volume. Keep in mind you need to consider this formula for every product or service you have in your business. When you take the sales volume times your price, you arrive at a revenue line projection on your income statement.
DPC are the costs directly related to the revenues they produce. This is often referred to as an expense line called Cost of Good Sold or COGS. For a computer manufacturer, this would include things like the mother board, hard drive, power supply, RAM, monitor, keyboard, mouse, etc. It would even include the labor on the assembly line that puts the unit together.
OH are the costs that are necessary for the business, but are not directly related to the production of the product or service. This would include expenses like rent for the office, insurances, employees in the marketing, administration or human resources departments.
Margin is a little trickier. Margin is what you keep, your money, the income produced from your products or services. If you make a mistake and exclude any expenses related to DPC or OH, it will impact margin. There are two ways to calculate margin…
- markup – which is simply calculated by taking the price and multiplying by 1 + the markup percentage. For example, if you wanted to markup a $50 item by 35%, you would take $50 x 1.35 to get $67.50. This would be a 35% markup.
- gross profit margin is calculated by taking (SALES minus COGS)/SALES. Using the same numbers as above, you would take (67.50-50.00)/67.50 which would return a value of 25.9%, which is significantly lower. The price necessary to achieve a 35% profit margin would be (cost/1-margin) or 50/1-.35 or 50/.65 = $76.92. That’s almost $10 more than markup, which means you make that much more money when you take your costs into account to arrive at price.
I hope this helps you get better at setting price and helps you send bigger numbers to your bottom line. Market Naturally.