A Smarthinking Article

How do you measure your firms profitability?

Smarthinking is a creative consultancy helping service-based businesses to find and keep new customers. If you want help to create a simple, effective and affordable marketing system, contact Steve Osborne on 03 9793 7816.

Pricing and profit for service-based businesses

Working out your actual costs is the single most important tool in setting fees for service-based businesses
Ever had a seemingly productive conversation come to a halt, due to a 'failure to compute'? It happened to me recently and came as a complete surprise. I was talking about marketing strategy with a dynamic and successful young service-based business owner. We were discussing the relative merits of positioning the firm's service offerings using pricing as a self-qualifying prospect attraction method. My particular interest was in what effect a price increase to one of the firm's service offerings would have on the market. What would the trade-off be between a higher price and lower volume? So I asked a simple question: "What's the profit margin for this particular service?' That's when the sudden lull in conversation occurred. With a slightly worried air, the business owner admitted she didn't know. Fortunately, she had a firm grasp on comparative pricing within the market and was comfortable with the firm's price structure. But without the margin figure, we could not calculate the higher price/lower volume trade-off. This inability to calculate the difference a subtle change to pricing has on overall margins is probably not uncommon for many firms that trade on services, rather than tangible products. Many service-based businesses use a very simple formula for calculating their prices: "Find out what the client will pay, then say that's what it will cost." This is also known as getting the "going", or market rate. It isn't a bad way to get business, but it's not a very good way to stay in business. The major problem with focusing only on the going rate is that it's just part of the story. You may have established what your prospect is prepared to pay, but it doesn't tell you whether you can make any money at that selling price. Ideally, the price of your services should match both factors. Simplistic tho' it may sound, if you intend to make money, you must first set a price that brings in more than you spend. So the first step in setting your price is working out your actual costs. This is the single most important tool in setting fees for service-based businesses. When you know your costs for providing a service, you've established your "base rate" the minimum below which you cannot go and still make money. At the other extreme, prices can reach a "ceiling" the point at which you've priced itself out of your market. It's vitally important the business knows where these points are at all times. To arrive at your "base rate," you have to calculate the true cost of an hour of your firm's time. Once that cost is clearly established, it should be reviewed periodically and adjusted (more likely, upward) to remain useful.

Pricing and profit for service-based businesses

HOW TO CALCULATE THE HOURLY RATE There is no universally accepted way to work out the hourly rate. It differs depending on a number of factors the type of business you have; the type of industry you're in. A realistic formula for your hourly fee is: Added to this should be all other costs associated with labour: taxes, benefits, workers comp, insurance, bonuses etc. General rule-of-thumb, add on about 20%, or $25,000. Total is now $145,000. Next, figure out how many chargeable hours the firm could charge actual and anticipated total annual salaries + actual and anticipated total in a year. Assume 8 hours a day, times 5 days a week, times 46 weeks, times 2 people. overheads + desired profit To illustrate how to apply the formula, we'll create a hypothetical resume writing firm in south-east Melbourne, called WGRW (World's Greatest Resume Writers). SALARIES The first step in determining WGRWs base rate is to add up the cost of all salaries, which typically represents the largest expense for a service-based business. For this illustration, let's give WGRW two employees: the principal, or owner, who is paid a salary of $65,000; and a writer/administration assistant, who is paid a salary of $55,000. Total combined salaries: $120,000. Note, 46 weeks, not 52 allows for public holidays, sick days and annual holidays. Total: 3680 hours. Now subtract an allowance for non-chargeable hours: time when both staff are cleaning up, filing, going over the books, doing research, attending training etc. Allow approx 25% for non-billable hours: 3680 minus 920 is 2760 hours. Now divide the number of chargeable hours (2760) into the annual cost of salaries ($145,000) to give the per-hour cost of labour. $145,000 2760 = $52.53. We'll round it to $52.50 per hour.

Pricing and profit for service-based businesses

Too many business owners operate on the short-sighted idea that anything left over after paying expenses is theirs to pocket
OVERHEAD Overhead represents what it costs to be in business, as opposed to labour, which is what it costs to do the work. Overhead for a servicebased business includes such things as rent, power, telephone, insurance, internet, postage, stationery, motor vehicle expenses, accounting fees and marketing. These expenses are passed on to the client indirectly by building an add-on percentage into chargeable time. For the sake of the illustration, WGRWs annual overheads are $38,000, which equals 26% of total salary cost. $38,000 $145,000 = 26% $52.50 per hour (labour cost) x 26% (overhead percentage) = $13.65 $52.50 + $13.65 = $66.15 $66.15 (rounded to $66) is the price per hour to recover the cost of salaries and overheads. This is the firm's base rate. PROFIT If WGRW sold every possible billable hour at this rate ($66) it would only be breaking even. It also needs to make a profit. Too many business owners operate on the short-sighted idea that anything left over after paying expenses is theirs to pocket. But the business needs profits too, just as the owner needs a return. Profits get the business through rainy days without having to lay off staff; they replace old equipment or buy new furniture; they provide the funds for bonuses and dividends; they can help secure a line of credit to finance growth. Profits make life easier for all so they can go about their jobs. Profits buy the freedom to say no and the freedom to say yes, at the appropriate moments. A minimum profit margin of 10% is desirable; 10 20% is preferable. To achieve a 20% profit margin, multiply by 25%. $66 x 25% = $16.50 $66 + $16.50 = $82.50 The hourly rate of $82.50 represents the minimum rate our resume writing firm can charge to cover its cost of labour and overhead, with a profit margin of 20%. This is the firm's charge-out rate. It can now use this charge-out rate to calculate its fee for its range of products, considering how long an average resume takes to produce. Apply this formula to your own situation, substituting your own figures to determine the base rate for an hour of your own firm's time. This figure becomes your basic tool for calculating all estimates.

Pricing and profit for service-based businesses

Clients buy services because they have a problem or need: their ultimate concern is for how well you solve their problem
TIME VERSUS VALUE The per-hour figure is not however, the last word on pricing. True, it represents costs and profit. It accurately reflects the time spent in producing a job. But it does not reflect value. Value is complex and not as easily reduced to a formula. It can be looked at from several different directions. Value is what the finished product means to your client's business. Clients buy services because they have a problem or need: their ultimate concern is for how well you solve their problem. In other words, they care about the end result, not about how you get there. It is critical that you define for your prospects the value your work will represent to them. Value is also what the finished product means to your business. It's your reputation for delivery to expectation and outstanding performance. What a service-based business sells, essentially, is its combined thinking, knowledge, training, experience and talent. The better the firm's track record for appropriate solutions and quality work, as well as the more experience it can draw on, the greater its potential value to the prospect/client. Value is the demand for your service, relative to the supply of competent competitors. If you're the only resume writer in town and the prospect is desperate, your value is higher than if heaps of writers are swarming all over the marketplace begging for scraps. The actual fee for your services is likely to be a combination of many complex factors. However it is calculated, it should reflect the base rate plus a weighting of the various components of value. As a rule, value is factored into the equation by adjusting your profit margin upward or downward. Hypothetically, WGRW considers itself to provide a higher than average level of experience and competence within its market. To compensate itself for this competitive advantage, it might want to factor in a Value margin of an additional 20%, doubling its desired profit margin to give it a charge-out rate of $100 per hour. It can now use this margin to choose the type and volume of new business it pursues. (Note that the new rate is not strictly a base rate, but for the purposes of calculating margins, it could be used in the PRICING examples below).

Pricing and profit for service-based businesses

BREAK EVEN For a business charging its services out based on an hourly rate, the following formula is used to determine the number of chargeable hours required to break even per week. Total Operating Expenses divided by Base Rate ($38,000 + $145,000) $183,000 $66 = 2772 chargeable hours per year Resume A (basic) takes 2hrs to compile. Using the first method, WGRW could provide Resume A for two times base rate (2hrs x $82.50) at $165. Next tier up is three hours times base rate (3hrs x $82.50) at $250. Top tier would be four hours times base rate (4hrs x $82.50) at $325.

Cover letters take 20 mins $30 and Selection Criteria take 40 mins Chargeable hours divided by Weeks In Year 2772 46 = 60 chargeable hours per week (30 per person) are required per point $50. to break even. Note, again 46 weeks allows for holidays etc. This method incorporates the desired profit margin of 20% into every hour of billable time. Even tho' there's a profit margin built into each of WGRW must sell almost $4000 of services per week to break even. the firm's services, WGRW does not actually start making a profit until it To meet that target, WGRW must sell (for example) an average of meets its $4000 break even target every week. 8 x Resume A, 8 x Resume B and 2 x Resume C. PRICING WGRW provides three levels of resume services for clients, plus several optional add-ons. Settling on a price structure for the services can be done in either of two ways. Firstly, simply multiply the charge-out rate, which includes a profit margin by the number of hours taken to perform the work. Or secondly, establish the market rate and factor in a Value margin, depending on your competitive position. In the second method, WGRW has upped its base rate to $100. The break even now looks like this: Total Operating Expenses divided by Base Rate ($38,000 + $145,000) $183,000 $100 = 1830 chargeable hours per year Chargeable hours divided by Weeks In Year 1830 46 = 40 chargeable hours per week (20 per person) are required to break even. The $4000 of services per week doesn't change, it's just a different way of looking at it.

Pricing and profit for service-based businesses

CHANGES TO PRICING But because there is a tendency to be more price sensitive at the lower end of the market and less at the top, WGRW might want to vary its pricing along the lines of market or competitive tolerances. In other words, how would lowering the price of basic Resume A to increase sales and increasing the price of Executive Resume C for higher margin affect overall profitability? For the sake of the exercise, we'll assume a lower price will attract more buyers. But in reality, you need to look very carefully at this assumption. Oftentimes, the lower price can lessen your perceived value and make your offering appear similar to your competitors. Subsequently, the strategy might backfire, resulting in fewer rather than more buyers. Nevertheless, let's look what happens when we adjust prices up or down. Reduction to price and costs stay the same WGRW reduces the price of its entry-level service by $15. Let's see what happens to the profit margin: Before Sales Costs Margin $ 165 132 33 % 100 80 20 After Sales Costs Margin $ 150 132 18 % 100 88 12

Reduction to costs and price stays the same WGRW reduces the time it takes to produce the service by .25hr ($20): Before Sales Costs Margin $ 165 132 33 % 100 80 20 After Sales Costs Margin $ 165 112 53 % 100 68 32

Increase to price and costs stay the same Because there is less price sensitivity at the top of the market, WGRW increases the price of its premium-level service by $50: Before Sales Costs Margin $ 325 264 61 % 100 82 18 After Sales Costs Margin $ 375 264 48 % 100 73 29

Note that in these exercises, the costs are calculated using the base rate of $66, which allows us to see how the profit margin is affected in each case.

Pricing and profit for service-based businesses

If you can't sell your services, it doesn't matter what the net profit margin is. You're not making money
NET PROFIT MARGIN The Net Profit Margin is commonly referred to as the business' "bottom line". The formula is: Net Income divided by Total Sales, expressed as a percentage. Net Income is Total Sales minus Total Operating Expenses. For our hypothetical WGRW, total sales for the year were $265,000. Total Operating Expenses were $183,000. ($265,000 $183,000) $82,000 $265,000 = 30% Net Profit Margin It is not necessary that a business have a very high net profit margin; in fact, in some industries it is better not to. With retailers such as electrical goods and supermarkets, it is important to move a massive amount of volume. To do this, these businesses must reduce their profit margins to as low as possible. Keep in mind that a high net profit margin does not necessarily mean large profits. If the business owners cannot sell their services, it doesn't matter what the net profit margin is, they are not making money. Basically, the net profit margin tells you how much markup, after all costs and expenses, there is in the firm's business model. It is perfectly acceptable to have a low profit margin with a very high turnover. High profit margin on very low turnover is nigh on impossible to sustain. SUMMARY For service-based business owners, knowing, maintaining and increasing your firm's profits should be high on your priority list. The profit margin measures the relationship between your profits and your sales. Knowing how you make your overall profit and how much you make per sale allows you to determine which business activities bring in the most money. You can then shift your marketing focus accordingly.