Whether you’re selling goods or providing services, setting your prices at a point where you’re able to compete with other businesses and make sufficient profit to sustain your business and yourself is key being successful in business.
Although mastering pricing is crucial to business success, few new entrepreneurs grasp the concept of setting prices that are both competitive and capable of sustaining business.
Service based businesses
If you’re running a service-related business, two major concepts you’ll need to master are how to set prices and how to bill your clients. Having reasonable, well-thought out rates is important to getting jobs and making sure you turn a profit from them. Knowing the right way to bill your customers is also important, as it helps to ensure both the profitability of your venture and your professional reputation. Amateurish billing can result in lost profits, and lost confidence from clients and a less than stellar reputation in your business community.
Service-based entrepreneurs or freelancers can have a difficult time determining what rates to use when they bill for work, as assigning value to time is more abstract that assigning value to an actual item or product. When setting rates, you should remember that these rates need to be sufficient to cover your overhead and yeild profits. Market pressure from competition can also exercise an upward or downward influence on your pricing.
Setting hourly rates
Many sole proprietor service businesses work out a billable hours formula to help them set hourly rates. The formula essentially takes the business owner’s target annual salary or profits, adds overhead costs and desired profit to the target and divides the total by the number of billable hours the owner feels he or she will work during the year. The result is the hourly rate. A modified version of this can also be used to determine a billable hours rate for businesses with multiple employees.
When determining your hourly rate, you’ll need to make a realistic assumption of how many hours you will be able to work during the year. For example, if you’re running a part-time consulting business and expect to put in about 20 billable working hours per week on your business, you’d end up with 1,040 billable hours per year. Remember, that not all of the hours you put into your business will be billable, as some time will have to be spent on administrative or marketing work.
Here’s a basic example of how a small business owner may use the billable hours model to determine his or her hourly rate:
John has started a home repair consulting service and wants to determine an hourly rate. John wants to make $40,000 per year from his work and expects to have annual overhead costs of about $15,000. John also wants to make a 10 percent profit. This necessitates John making $66,000 per year. John’s doing his work full-time, so there’s potentially 2,080 billable hours. However, John estimates he’ll spend about 20 percent of his time on marketing and administration, leaving him with 1,664. To make his goal, John will need to charge $39.66 per hour for his work.
Just because you’ve decided that you want to charge $39.66 per hour for your services doesn’t mean that you’ll receive $39.66 per hour for your services. The health of the local economy, as well as industry standards and competitors rates can exercise influence on your rates.
When starting your business, try to do a little research into what the industry standard is, and how much your local competitors are charging. When you’re just getting off the ground, you may want to charge slightly less than the industry standard or local rate to entice customers. Don’t drop the rate too low, however, or you may give the impression of low quality to potential customers.
When billing customers for a service, you can use three main options, flat fees, hourly billing and retainer arrangements.
Under a flat fee agreement, you and your client will agree to a set price for a specific project. Regardless of how many hours the project takes, the agreed upon fee is the compensation you will get, barring certain circumstances that may be agreed upon in the service arrangement between you and the client.
When setting a flat fee, it’s important to estimate the time necessary to compelte the project and also consider your billable hours estimate as discussed above. Contractors typically discount their hourly rate somewhat for large projects.
The flat fee arrangement can be beneficial for clients and contractors. Clients get to know the full cost of the service up front, and contractors are freed from the administrative task of having to keep up with hours worked in order to bill the client. Also, with flat fee billing, working efficiently is encouraged, spurring the contractor to find ways to make the project as quick and efficient as possible.
Small business owners can come out on the short end of the stick through flat fee billing if they’re way off the mark on estimating the time necessary to complete the project or if the scope is vague and the client continually asks for changes or expansions of the project. When setting a flat fee for a project, you need to make your estimate of the amount of work involved as accurate as possible, and you also need to nail down the scope of the project with the employer and make provisions for billing for work outside the scope to avoid getting caught in a project that ends up being unprofitable because of scope creep and schedule overruns.
Hourly billing is pretty straightforward. You quote the client an hourly rate. You do the work and keep up with the time involved and then present the client with a bill. Billing by the hour can prevent you from getting shafted on a project that isn’t well-defined and ends up taking longer than you thought it would. However, if the client is presented with an unexpectedly large bill at the end of a project, or if the client doesn’t feel that he or she has gotten value for the hours worked, conflicts may arise.
In a retainer billing arrangement, the customer will pay an ongoing fee, most likely on a monthly basis, to retain the service provider to perform certain services. Services that go beyond the agreed upon retainer arrangement may be billed for separately. A retainer arrangement is good for customers who will likely need services on a regular or semi-regular basis. For example, an accounting company may choose to retain the services of an IT contractor to maintain its web site and computers or a real estate rental company may retain a pest service to perform regular work at its properties.
When devising a retainer agreement, estimate how many hours you believe you’ll need to spend on the client’s project and also include your overhead expenses, such as supplies and parts. Don’t be afraid to ask your client questions about the amount of time their in-house staff or previous contractor spent on their needs and other questions that may help you come up with a realistic idea of how much time and materials the job will consume. The more accurate your estimate is, the more profitable the job is likely to be.
Few business owners come into business with an instinctual knowledge of what prices to set and how much to bill. For most it’s a skill that comes with experience as they complete jobs and learn more about the work and materials that go into differing jobs. However, by keeping the lessons above about pricing and billing in mind, you can reduce your learning curve and get to the point where you’re able to make accurate – and profitable – prices and billing.