Strategies and Formulas for Pricing Services at Your Small Business
Do you own a service business? If so, you know that figuring out how to price services isn’t always easy. To make sure your small business is profitable, try these tips for pricing services.
Why is pricing services so hard?
Many service-based businesses struggle to come up with a fair and profitable pricing strategy. Unlike product pricing, you can’t exactly quantify all the costs that go into providing a service.
The expenses that go into providing a service are more subjective than the expenses that go into making a product. How much you charge customers doesn’t always directly correlate with the amount you pay to perform services.
If you own a retail store, you buy goods at a certain price. To earn a profit, you need to sell the goods for more than what you paid. You determine how to price a product according to its cost.
In service industries, finding a target profit margin is not as simple. You don’t have an original price to reference. Instead, your pricing formula for services should account for the intangible aspects of running your business, such as time and value.
In short, pricing services is tricky business. Tony Mastri, Digital Marketing Manager at MARION Marketing, says:
As a service-based business, it’s difficult to price services because we need a model that is scalable yet flexible enough to solve our customers’ problems. Offering a scalable, one-size-fits-all price can turn potential customers off because their needs are typically not like those of your countless other customers. At the same time, offering 100% custom pricing can limit growth because of the time required to quote every facet of your services.”
So, how can you make strategic pricing work for your service business? You need the right service pricing strategy.
How to price services: Your 6-step guide
Because there is not a set-in-stone method for pricing services, you have some flexibility. Use the following six steps to learn how to price a service:
1. Calculate your costs
2. Look at the market
3. Know your customers
4. Consider time invested
5. Come up with a fair profit margin
6. Charge an hourly or per-project rate
1. Calculate your costs
If you want to avoid shortchanging your business, you need to know how much it costs to provide your services. To do so, use cost-based pricing.
Cost-based pricing is when businesses add up the costs that go into making a product or providing a service and mark up their prices from there.
As a service-based business, your costs are going to be a little different than that of a product-based business. You may not be stocking up on inventory, but you still spend money to operate your business.
Understanding the true cost of providing your services plays a big part in learning how to price your services.
You can break down your costs into two categories: direct costs and indirect costs. Add together your direct costs and indirect costs to determine the total amount of money you must cover during a time period.
Pro tip: Knowing your costs is just a starting point for service pricing. Remember that you must make at least your costs to reach your break-even point.
Direct costs
Your direct costs are expenses that go directly into providing your services. Examples of direct expenses include:
· Direct materials
· Direct labor
· Manufacturing supplies
Indirect costs
Your indirect costs are expenses that you need to run your business but can’t pinpoint to a specific project.
Pay special attention to your overhead expenses, which are a type of indirect cost. Examples of overhead include:
· Rent
· Utilities
· Equipment and maintenance
· Insurance
· Indirect labor (e.g., receptionist)
· Marketing and advertising
2. Look at the market
What are your competitors charging for similar services? How’s the market itself holding up?
Under market-based pricing, businesses look at what competitors are charging for similar products or services.
On its own, using market-based pricing generally isn’t sustainable. You shouldn’t base your pricing for services solely on what competitors are doing. But, be aware of what other companies charge so your prices aren’t completely off base.
Your competitors are playing in the same arena. Ignoring their strategies for pricing services doesn’t help you break the mold in your industry. Instead, it leaves you ignorant about what’s happening in your market. And, you need to know how the market is doing before setting a price that nobody can afford.
Pro tip: Keeping an eye on competitor pricing reveals what sets you apart. If you charge more than your competition, show customers the value of the unique experience your company offers.
3. Know your customers … and your perceived value
No matter how much you charge, you won’t make money if customers are not willing to pay. You need to understand how customers perceive your business.
And to do that, you need to know your customers.
Use a market study to collect information about your target customers. Find out how much your potential customers are willing to pay. Look at things like their needs, income, family status, occupation, etc.
You can also distribute surveys and conduct focus groups to find out how much customers would be willing to pay for your services.
Learning more information about your target customers is part of a value-based pricing strategy. Under a value-based pricing strategy, a business bases its product or service prices on how much consumers value the offerings.
Pro tip: Get to know your customers to determine just how valuable your services are in their eyes.
4. Consider time invested
Looking at your costs, competitors, and business value aren’t your only considerations when pricing services. The time you put into your business matters, too.
Think about how much time you invest in providing services. The longer you spend on a project, the more you should earn. Track how long it takes you to complete a project to help you come up with a fair price.
Also, consider how long you’ve been in the industry. The more time you have under your belt, the more value you add to your company and thus the offerings you provide. Generally, you can charge more as an experienced, trusted, and reputable individual in your industry.
Pro tip: You pouring time into providing a service usually translates to the customer saving their time. Don’t forget to consider your valuable time when coming up with a strategy—and marketing how much valuable time you’ll save your customers.
5. Come up with a fair profit margin
Your profit margin is how much your business will bring in after subtracting the cost of goods sold (COGS). Coming up with a fair margin is key to turning a profit.
First, decide what percentage you want the profit margin to be. Profit margins generally vary by industry. But, a 10% profit margin is typically average.
If you want to know how to determine pricing for a service, add together your total costs and multiply it by your desired profit margin percentage. Then, add that amount to your costs.
Pro tip: Consider your costs, the market, your perceived value, and time invested to come up with a fair profit margin.
6. Charge an hourly or per-project rate
Finally, decide whether you’ll charge customers an hourly or per project rate.
You might consider charging customers by the project if you’re confident in the amount of time you think it’ll take you. Or, you might charge hourly if you don’t know how much time it takes you to perform the service.
Whether you charge customers per hour or project may depend on your industry. For example, a psychologist may charge per hour whereas a lawn service may charge per project.
Learn how to price your services for both hourly and per project models below.
Hourly rate
Billing customers at an hourly rate is a popular strategy for pricing your services. To do so, find out the number of hours you will log during the year.
For example, if you plan to work 40 hours per week, multiply 40 hours by the 52 weeks in a year. If you work 40 hours per week all year long, you’ll work 2,080 hours. Don’t forget to consider vacation, holiday, and sick time you may need to plan for. Subtract non-work hours from 2,080 to find the actual amount of hours you will work.
Once you determine the total hours you plan on working for the year, find your billable hours. Subtract non-billable time from your total hours.
Non-billable hours include tasks that do not directly generate revenue, like sourcing clients, marketing, and filling out paperwork. The number of hours you devote to non-billable tasks depends on your business.
Finally, divide your expenses by your billable hours to find out how much you need to charge per hour to cover your expenses.
Use this formula to find the hourly rate you need to charge to break even:
Hourly Rate to Break Even: Total Annual Costs / (Billable Hours – Non-billable Hours)
Now, factor in your profit margin. Multiply the profit margin by how much you need to make per hour to cover expenses.
Check out the formula below:
Hourly Service Pricing = Hourly Rate to Break Even X Profit Margin
Want to see these formulas in action? Check out our example below!
Hourly rate example
Let’s say your business’s annual costs add up to $75,000. This year, you plan on working 1,920 hours. You determine that you’ll need to devote about 20% of your time to non-billable work. You decide that a 15% profit margin is fair.
1. First, multiply your total hours by 20% to find your non-billable hours:
1,920 (Total Hours) X 0.20 = 384 (Non-billable Hours)
Non-billable Hours = 384
2. Now, subtract your non-billable hours from your total hours to get your billable hours:
1,920 (Total Hours) – 384 (Non-billable Hours) = 1,536
3. Divide your total annual costs by your billable hours to find your hourly rate:
$75,000 / 1,536 (Billable Hours) = $48.82 Hourly Rate to Cover
4. Multiply your hourly rate by your desired profit margin of 15%.
$48.82 (Hourly Rate to Break Even) X 0.15 (Profit Margin Percentage) = $7.32
5. Lastly, add your profit margin amount to your hourly rate to get your hourly service price:
$7.32 (Margin) + $48.82 = $56.14
You would charge your customers $56.14 per service hour.
Per project rate
As a service business, you may opt for charging your customers by the project rather than by the hour. To come up with a per-project rate, you can:
Use your hourly rate and estimate how long it will take to perform the service
Charge a fixed price for each service
If you decide to use your hourly rate to determine your per-project rate, multiply the time you think it’ll take you by your hourly rate.
To charge a fixed price for each service, factor in your costs, the market, your value, time, and profit margin before coming up with the rate.
Per project—using hourly rate—example
Using your hourly rate of $56.14 from the “Hourly rate example,” find out how much you should charge to complete a 50-hour project.
To find your project rate, multiply the number of hours by your hourly rate:
50 hours X $56.14 = $2,807
What’s your fair price?
There isn’t one way to approach the pricing of services. It’s up to you to decide what your offerings are worth and how they fit into the market you serve.
If you’re calculating prices for the first time, you might think the amount is too high. But, it’s important to know how to calculate profitability accurately so your business can thrive. If you do a good job and take care of customers, you shouldn’t have a problem with your fees.
Deciding on a target profit margin is a careful balance. You want to mark your prices high enough to earn a good profit margin. But, you also must avoid getting a reputation for overcharging.
Consumers are smart. Most are willing to pay a fair price for a good service. But, it doesn’t take long for customers to figure out they’re getting ripped off. Know your worth and choose a service pricing strategy that matches the value of your offerings.