In part 1 were provided all the non-financial influences for pricing in a small service business. In part 2, the financial aspect will be discussed starting with how to include costs in pricing.

Account for fixed/indirect costs

Within a company large enough to have overhead staff (i.e. administration, dispatching, accounting, etc.), a warehouse, and a fleet of service trucks, some costs will be fixed. Overhead staff salaries, rent, utilities, services, marketing, to name a few, are accounted for in fixed and indirect costs. These expenses will need to be included in how prices are assigned. This is one of the reasons why small service company prices tend to be higher than retail prices.

Of markups and margins

Ultimately, to understand if items are priced correctly, it is recommended to have visibility on individual items as well as overall margins. Overall margins can be separated into operational profit margins, gross profit margins, and net profit margins.

Individual items margins are essentially only the item price minus the item cost, divided by the item price. It is recommended to maintain individual item margins above 30%.

This differs from an item mark-up, which is basically the item profit on the item cost.

As an example, an item priced 12$ costing 8$ will have a markup of 50% while having a margin of only 33%.

The overall gross profit margin is essentially cost of sales subtracted from net sales, as a ratio over net sales, as per the formula below. This takes into consideration of course sales, and salary of the worker doing the work, cost of parts, and subcontracted work as the cost of goods sold (COGS). Once again, for a company with overhead, having a gross profit margin above 30% is recommended. If all individual items, as well as salary, are priced with a 30% individual margin, the gross margin should easily fall within the 30% criteria as well.

The operating profit margin is calculated using net sales, but cost is expanded. Cost now not only includes COGS but also any fixed and indirect costs. For small companies without alternate income or non-operating expenses, operating profit can be estimated with EBIT. It is obviously recommended to maintain the operating margin positive, and if possible, above 15% to allow for a small level of growth.

Finally, the net profit margin includes all income and all expenses. All expenses include all costs, both fixed and variable, as well as all interest payments and taxes. The net profit margin should at all times be maintained positive, and if possible, above 5%, to ensure a continued positive cashflow input. 

Takeaway

To conclude, pricing items can be either very simple or very labour-intensive. The best method to ensure business profitability and to correctly estimate the impact of prices on the net margin is to include all elements above when pricing items. And although this is difficult to do manually, having a digital solution for both accounting and maintaining price lists makes the exercise significantly easier and more accurate. Come back soon for more on Creating and Maintaining Price Lists.