The Challenges of Pricing a Service
By David Nelson from The Business Clinic
Unlike product-based pricing, we cannot always quantify all the costs that go into providing our service.
Please remember our time is finite, we cannot simply buy more to put on the shelf.
The costs, expenses and overheads that go into providing a service are harder to pin down than those that go into making or buying and reselling a product.
In a service-based business, finding our target profit margin is not as simple. We do not normally have an original price of the goods or materials to use as a starting point.
Instead, we need a pricing formula for our services that needs to account for the intangible features of running our business, such as time and our value.
To make pricing work for a service business we need a service pricing formula to work to.
Because there is not a perfect method for pricing services, there is some flexibility. But we need to create and follow some set rules to create a uniform process to price our service:
• Understand the time we are investing
• Review the market
• Know our clients
• Set our profit margin
• Calculate our overheads costs
• If charging an hourly rate or project rate, use the same core formula to price
Understand the time we are investing
Knowing our costs, competitors and business benefits should not be our only considerations when pricing services. The time we put into our business matters, it is finite.
Think about how much time we put in to (invest) in providing services. The longer we spend on a project, then obviously the more we should make.
We should keep track of the time going in to completing a service, this can be done manually or via apps or accounting solutions - it will not only help us come up with a fair price, but more importantly understand the time we are investing.
Also, consider our length of time in our industry. The more time we have clocked up, the higher the value of our experience and service we provide.
Review the market
What are our competitors charging for similar services? What is the demand in the market and is there under or over supply?
On its own, relying purely on market-based pricing generally is not a sustainable business model and it is the business that disrupts the status quo that keep ahead. We should not therefore base our pricing for services just on what competitors are doing. However, we should ensure we do know what other companies charge so our prices aren’t completely far of the mark.
Make sure we are comparing like for like, also look at associated things like payment terms, delivery terms (duration) etc. Be sure we are comparing like for like and not just taking a client’s word that the competition is charging a particular price. If we are completing our service in half the time with penalty clauses and providing 30-day payment terms, that is a very different value of service to a competitor providing a service with no penalty clauses, taking twice as long and working on 50% upfront and payment on completion.
Keeping an eye on our competitors’ pricing can help reveal what sets us apart. Our goal should be to charge more than our competition, not try to match or undercut, but at the same time show clients we are delivering higher value, otherwise it will always be a race to the bottom.
Know our clients ... what is our perceived value?
It is not what we charge that matters most, it is the benefit of our service to our clients that dictates the most. No matter how much you charge or how little, it matters not if our client is not willing to pay because the benefit to them does not match the price being charged.
We often spend too much time looking at the margin for us in a service delivery, rather than considering the benefits delivered to the client.
When providing a service, it is often saving our clients’ time. Remember to communicate how much valuable time we are saving our client.
Set our profit margin
Our profit margin is how much our business will be left with after taking the cost off. Having a target profit margin is essential, remember the incredibly old, but always true saying, “Turnover is vanity, profit is sanity”.
Like anything else important that we want to achieve, we should set a target - we cannot turn over a whole year’s turnover in one project (well, not in most normal businesses) so we should target this per project, so the annual target looks after itself.
Calculate our overheads costs
As a service-based business, our costs are going to be similar to a product-based business. We may not be stocking up goods on shelves or be manufacturing items, however we still spend money to operate/run our business.
Understanding the true cost of providing our services plays a major role in learning how to price our services.
Break down our costs into two categories - direct costs and indirect costs. Add together our direct costs and indirect costs to determine the total amount of money we must cover during a time period.
Knowing our costs is just a starting point for service pricing. Remember that we cover at least our costs to reach our break-even point.
Our direct costs are expenses that go directly into providing our services. Examples of direct expenses include:
• Direct materials – stationery, postage
• Direct labour - ours or an employee used on delivering the service
Our indirect costs are expenses that we need to run our business, but we cannot attach to a specific project or client.
Examples of indirect cost, overheads include:
• Indirect labour - bookkeeper, admin, receptionist etc
• Rent, rates and service charge
• Utilities: heat, light, power, telephones, internet
• Equipment and maintenance
• Marketing and advertising
If charging an hourly rate or project rate, use the same core formula to price.
Whether we should charge an hourly rate, a set retainer rate or a rate for the project can depend on many variables and sometimes this may be industry specific.
If working on a set rate, we cannot check if we are achieving the correct charge hourly and profit margin if we do not know how much time it takes us to deliver the service and the cost of those hours.
A pricing formula should follow these simple rules
A - Multiply 40 hours by the 52 weeks in a year = 2,080
B -Then deduct non-billable time - such as holiday periods, business development and administration time.
A-B = C - billable time
Then calculate direct costs and indirect costs = D - total costs
Now divide C by D = E (our billable time by our total costs)
E - This will provide us with our break-even hourly rate
Lastly, add the target profit margin (F) to our hourly rate to provide the correct hourly rate to charge for the service.
E + F = G – Client’s price per hour
Per project rate
To come up with a per-project rate you can:
Use our hourly rate as calculated above and estimate how long it will take to perform the service.
Add the target profit margin and then charge the fixed price for each service, and don’t forget to track if the estimate of how long it will take to perform the service is correct before using the per-project rate again.