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Whether you're a new business owner or an established one, developing an effective pricing strategy isn't easy. You want to charge enough money for your services to obtain a fair profit, but you don't want to run the risk of overcharging, which can send your clients directly into the arms of your competitors.

The solution is a robust pricing strategy that benefits you and your customers. The challenge is determining what that pricing strategy should look like.

There are multiple pricing strategies that business owners successfully employ. A few of the most common ones include cost-based, value-based, competitive, and dynamic. Our guide examines how to determine pricing for your services, including selecting the suitable method and applying it to your organization.

Understanding your costs and expenses

The first step of pricing services is carefully evaluating your costs and expenses. We'll go through the details below.

Identifying and calculating fixed and variable costs

There are two primary types of costs: fixed and variable.

Fixed costs consist of expenses that remain the same regardless of the number of sales you make. If you earn no revenue for the month, you'll still need to pay fixed expenses unless you actively remove the source of the cost. Examples include office rent, insurance premiums, employee salaries, and depreciation on assets such as your computer or vehicle.

Variable costs are directly related to sales and increase every time a client purchases a service. If your sales decline, so will your variable expenses. Examples include fees for direct labor or materials. For instance, if you rely on part-time work or an independent contractor to provide services to your customers, you'll pay them more when your orders rise. However, if sales fall, you'll likely cut their hours.

After classifying your costs into fixed and variable buckets, you must assign a dollar figure for each expense. For example, your monthly rent might be $1,500, and your direct labor might cost $25 hourly. Determining the exact amount of each expense will make figuring out how costs impact your profit margin easier.

A business checking account that integrates directly with your accounting software can help you easily separate your fixed and variable costs without complex spreadsheets. Novo's business checking solutions integrate with multiple software programs, are fully insured by the FDIC, and have no hidden fees or charges.

Understanding the impact of pricing on profit margins

Your profit margin is the percentage of revenue left over after deducting all costs. To calculate your profit margin, use the following formula:

Profit Margin = (Revenue - Total Expenses) / Revenue

Ideally, you'll calculate your profit margin over a specific timeframe, such as a month or quarter.

For example, consider a business with total monthly sales of $50,000. Expenses are $35,000. Applying the profit margin formula, you'll find that the company has a profit margin of 30%:

($50,000 - $35,000) / $50,000 = 30%

For every dollar in sales, the company earns $0.30 in profit.

However, another company may not experience the same level of success. Perhaps it earns $50,000 in monthly sales but has $60,000 in expenses. That company's profit margin would be equal to -20%, as calculated below:

($50,000 - $60,000) / $50,000 = -20%

For every dollar the company earns in sales, it loses $0.20.

Ineffective pricing strategies lead to lower profit margins. In the worst case, the company will lose money—which isn't sustainable long-term.

Determining the break-even point

The break-even point is where revenues equal total costs. Any sales that exceed your break-even point result in a profit. Conversely, you'll encounter losses if you don't earn sales to meet your break-even point.

To calculate the break-even point, use this formula:

Break-even Quantity = Fixed Costs / (Sales Price per Unit - Variable Cost Per Unit)

For example, consider a company that offers lawn mowing services for $75 each. The owner has fixed costs of $4,000 monthly and a variable cost of $25 per lawn. To break even, the company must mow 80 lawns monthly, as calculated below:

$4,000 / ($75 - $25) = 80 lawns

Establishing your break-even point can help determine whether your pricing strategy is reasonable. If your break-even point is too high, you may need to adjust prices upward to meet your profit goals.

Researching the market and competitors

After you've analyzed your costs and expenses, it's time to research your market and competitors. Performing market research enables you to determine whether you're pricing your services competitively or whether you need to change your strategy.

Analyzing competitors' pricing strategies

You likely have several competitors in your market sector. You'll want to compare your service offerings and prices to theirs. To start, create a spreadsheet listing your services, features, and prices. Next, create columns for each of your competitors offering similar services. Note the prices for their services and any attributes that differentiate your product from theirs.

The competitors you include in your analysis should serve a similar target market. Their services should be comparable, but you'll want to highlight any aspects that make their product more or less superior to your offerings. Differences in the quality of services can justify differences in prices.

You may need to adjust your pricing strategy if you notice significant discrepancies between your prices and your competitors'.

Understanding market demand and pricing trends

Market demand can impact your competitor's pricing (and yours). If customers are clamoring for services like yours, you'll likely have a lot of sales requests. You might find it prudent to increase your prices so you don't find yourself overbooked.

On the other hand, if there is little market demand for your services, you'll find it harder to make sales. You might need to reduce prices to encourage more customers to buy from your business.

Determining the value of your services

Determining the value you provide to your customers is part of evaluating your service prices. If you consistently offer high-quality services that go beyond what your competitors provide, customers will return whenever they need your help. However, customers will expect lower prices if your services don’t measure up to those of your competitors.

Experience and qualifications can impact your pricing strategy. For example, a bookkeeper will charge less for their services than a CPA simply because they don't have the same level of expertise.

Choosing a pricing strategy

After doing your research, you're ready to work on your pricing structure. There are four common types of pricing strategies that business owners use for their services.

Cost-plus pricing

Cost-plus pricing is a common strategy among retailers and manufacturers. However, depending on their market sector, some service organizations may also succeed with the cost-plus pricing model. In this approach, business owners add a fixed percentage to their unit costs for each service they offer. There is less focus on external factors, such as competitor pricing or market demand. Instead, the businesses seek to earn a specific profit for every unit they sell.

Add all of your labor, material, and overhead costs to calculate service prices under the cost-plus pricing strategy. Next, add the markup percentage you require. The total equals the price you set for your services.

For example, assume you sell household cleaning services. Your direct labor costs are $50 per house, materials are $10, and overhead is $5. You want a 25% markup, so your service price will be $81.25, or ($50 + $10 + $5) x (1 + 0.25). You'd quote customers a fee of $81.25 for every house your business cleans.

Value-based pricing

Value-based pricing involves setting your prices according to the perceived value you provide your customers rather than the costs you incur. In this strategy, you can charge much more for your services than they actually cost you. Companies that offer highly unique services or have a superb reputation in their market sector may benefit from value-based pricing. It is also standard when the demand for services is high, and there are few comparable competitors to provide them.

There is no specific formula for value-based pricing. You'll want to ensure that you charge enough to cover your costs, and you may need to invest more in marketing or advertising to demonstrate why your services are superior to those of your competitors. Over time, customers generally grow accustomed to the value pricing strategy and are willing to pay more for the perceived value they receive.

Competitive pricing

Competitive pricing is helpful for service-oriented companies that operate in a highly competitive environment. To price competitively, you'll need to closely examine your competitor's services and how they price them. Notice any unique features they provide that differentiate their offerings from yours and how that might justify price differences.

Typically, service businesses that use competitive pricing can follow one of three techniques: charge more, maintain average pricing, or underprice. Each method is appropriate in different situations:

  • Charging more than your competitors is appropriate when you have a strong reputation. You can command higher prices simply because customers know your organization and you deliver quality results.
  • Price matching is appropriate when you have a significant market share in your sector. Customers will perceive that you offer value and choose to purchase from you rather than moving to your competitors.
  • Undercutting market prices is beneficial for companies that are new to their market. When you're organization is relatively unknown, customers won't know what to expect from you. As you build your reputation, you can increase your pricing.

Dynamic pricing

Dynamic pricing is standard among service companies that experience heightened demand at certain times. When demand is high, companies increase their rates, and when it falls, they lower them. You've probably experienced dynamic pricing when placing an order on DoorDash or calling an Uber on a busy Saturday night.

To get the most out of dynamic pricing, you'll need a way to accurately gauge shifts in demand and adjust your prices accordingly. Market leaders often do well with dynamic pricing since they command a significant industry share.

Implementing and testing your pricing strategy

Once you decide on a pricing strategy, you must implement and test it.

Communicating pricing changes to customers

After deciding to update your service prices, you'll need to ensure current clients are aware of them. Update your website and marketing materials to include new fees, and notify clients of changes impacting their future purchases. For instance, if you have a contract with a client that allows you to adjust your prices if you provide notice within a specific timeframe, you'll want to let them know immediately. They can use the time to decide whether to continue receiving your services.

Update any legal contracts that contain your pricing information so they're ready to go when you accept a new client. If customers purchase your services through a website, ensure it correctly calculates new totals according to your updated pricing.

Measuring and analyzing pricing performance

Once your new pricing strategy goes into effect, you'll want to analyze its impact on sales and profit margin. Ideally, your profit margin should improve while maintaining most of your customer base. If sales drop dramatically due to pricing increases, you may want to reconsider your pricing changes. However, if you were significantly overbooked and increased your prices to manage your client flow better or establish your value, a drop in sales may not be as worrying.

It's best to review the results from your pricing strategy several months after implementing it. That should give you enough data to determine whether you're meeting your objectives or need to make adjustments.

Adjusting pricing strategy based on results

Your new pricing strategy isn't set in stone. You can always tweak it if you find that it's harming your organization or not delivering the results you're looking for. Pay careful attention to your profit margin and break-even point when determining whether you meet your objectives. If your profit margin drops, you're not meeting your sales goals. Customers may be purchasing from your competitors, or external conditions may impact your revenues.

If you aren't earning enough to meet your break-even point, you may need to decrease prices to reattract customers. However, ensure that you understand the reason for the decline in sales before changing your strategy.

The takeaway

Your pricing strategy can make or break your business. If you price your services too low, you may be bombarded with orders you can't keep up with while having little to show for your efforts. Companies that set their prices too high may find it difficult to attract clients. Establishing your pricing strategy strategically by considering internal and external elements can help ensure you strike the right balance. Once you implement your new approach, review your results and adjust as needed.

Novo Platform Inc. strives to provide accurate information but cannot guarantee that this content is correct, complete, or up-to-date. This page is for informational purposes only and is not financial or legal advice nor an endorsement of any third-party products or services. All products and services are presented without warranty. Novo Platform Inc. does not provide any financial or legal advice, and you should consult your own financial, legal, or tax advisors.

Novo is a fintech, not a bank. Banking services provided by Middlesex Federal Savings, F.A.: Member FDIC.

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