Pricing Services Profitably

Successful business owners know that the greatest opportunity for success and growth comes through quality of service and customer satisfaction. However, the service must be priced properly or
there will be no profit.

Many small businesses do what they consider a good volume of business, but do not make any money. Why? Because of improperly priced services or products. Some make a profit on certain services, lose money on others and do not know which is which. Remember, the right to establish price is yours - 100 percent yours.

Types of Costs

For the purposes of this section, costs are defined as

Fixed costs - Costs that remain the same in any time period despite changes in business activity. These include rent, insurance, utilities, office supplies, salaries, depreciation, legal services, accounting. These expenses are usually called overhead.

Variable costs - Costs that usually vary in proportion with business activity. These include materials used in manufacturing, goods purchased for resale, labor and commissions. In a service business, labor may not be variable.

Calculating the Cost of a Service

A simple, easy-to-understand method of calculating the cost of a service is by basing the cost on billable hours. Because services must be provided by people, begin by determining the number of hours available for billing in a year. Then calculate the break-even point by dividing the overhead and labor charges by the billable hours and adding the cost of any materials used. Your desired profit is then added to the break-even point. Two examples are shown below.

Example 1

Two people experienced at bookkeeping open a business together. They estimate their overhead expenses as shown in Table 1.

The two entrepreneurs decide they each want a salary of $25,000. In this case, the salary is actually an overhead expense, but we will treat it separately because the principals decide they want to make a profit of 20 percent on their salaries but only a 10 percent profit on their overhead. These expenses are set out below in Table 2.

    Table 1 - Estimated overhead expenses
    -------------------------------------
    Expense       Amount per year
    -------------------------------------
    Rent              $9,600
    Utilities          1,800
    Telephone          1,200
    Office supplies    1,200
    Insurance            600
    Depreciation       2,500
    Advertising        2,000
    Miscellaneous      1,500
                     -------
      Total          $20,400
    -------------------------------------


    Table 2 - Estimated total revenues required
    -------------------------------------------
    Expense                    Amount per year
    -------------------------------------------
    Owners' salaries              $50,000
    Profit on salaries (20%)       10,000
    Overhead                       20,400
    Profit on overhead (10%)        2,040
                                  -------
      Total                       $82,440
    -------------------------------------------

The number of working days per year is 260 (52 weeks x 5 days). Subtracting holidays, vacations and sick days, the actual number of work days total 230. Two people working 8 hours per day results in 3,680 hours (230 x 2 x 8 = 3,680). However, the bookkeepers estimate 20 percent of these hours (736) will not be spent working for clients. Therefore, the billable hours for this company total 2,944.

To determine what rate to charge, the bookkeepers divide the desired revenue ($82,440) by the number of billable hours (2,944), resulting in an hourly rate of $28.00. Profit is then calculated by subtracting total overhead and salaries from the proposed revenue ($82,440 - $70,400 = $12,040). This is the profit to be realized, assuming the billable hours figure is realistic for the first year of operation.

Example 2

DWA Repair Service employs ten repair technicians, who are paid $18,000 each. Social Security tax, unemployment tax, workers' compensation insurance, health insurance and retirement benefits cost an additional $5,400 each, for a total cost of $23,400. Because there are ten technicians, the yearly labor charge is $234,000.

DWA Repair Service's overhead expenses are listed in Table 3.


    Table 3  - DWA repair service's overhead expenses
    -------------------------------------------------
    Expense                       Amount per year
    -------------------------------------------------
    Salaries (including owner)       $60,000
    Payroll taxes and costs            3,700
    Insurance                         13,000
    Utilities                          2,600
    Rent                              10,000
    Telephone                          1,200
    Depreciation                       5,000
    Miscellaneous                      2,500
                                     ------- 
      Total                          $98,000
    -------------------------------------------------

To break even, DWA Repair must have a total revenue of $234,000 (labor) plus $98,000 (overhead) = $332,000. All of it must come from the income of the repair service based on the hourly rate
charged.

The owner of the business has calculated the billable hours as follows:

Work days per year = 52 weeks x 5 days = 260 days. Subtracting 15 vacation days,  7 sick days and 8 holidays leaves 230 work days.

Work hours = 230 work days x 8 hours = 1,840 per year for each repair technician.

However, from experience, the owner knows that he cannot keep his crew working eight hours per day as there is lost time between jobs. He deducts 10 percent of the hours as nonbillable, leaving 1,840 - 184 = 1,656 billable hours per technician. Because there are 10 technicians, the total billable hours = 1,656 x 10 = 16,560 per year.

To determine the hourly labor cost, the owner divides the labor cost per year ($234,000) by the billable hours (16,560). The result is $14.13 per hour.

To find total cost, overhead must be added. Total overhead per year is $98,000. When divided by billable labor hours of 16,560, overhead equals $5.92 per hour. Thus, the total hourly cost of labor plus overhead is $14.13 + $5.92 = $20.05.

The owner knows that if he charges only the hourly rate based on actual cost, he will merely break even. In order to make a profit so that he can reduce debts, buy new equipment, provide working capital and provide a return on investment, the owner decides to add 25 percent on his labor, and 30 percent on his overhead, as shown in Table 4.

    Table 4  - Calculation of final hourly rate
    -------------------------------------------
    Labor cost per hour              $14.13
    Profit on labor (25%)              3.53
    Overhead cost per hour             5.92
    Overhead profit (30%)              1.78
                                     ------
      Total                          $25.36
    -------------------------------------------

The owner decides to charge $25.50 per hour. This hourly rate, multiplied by the billable hours of 16,560, results in an income of $422,280.00 per year. Thus, the income ($422,280) minus the expenses ($332,000) equals profit of $90,280.

Each year this calculation must be repeated to include any changes in labor or overhead.

If any materials are used in the repairs, they must be figured into the cost per job. A profit percentage is also added to the materials charge.

Remember, the charge for a service equals materials plus labor plus overhead, with a profit built into each component.