Small Business Series – Mistake 4:
A television show that I enjoyed during the earlier part of this decade was A&E’s Pawn Stars, which takes place in a Las Vegas pawn shop. Members of the public bring items that they personally own to see what the shop will pay them for their unique good. Invariably, the owners of the shop and the patrons haggle on price. Rick Harrison, one of the owners, will often justify his offer to buy being lower than the patron could get at an auction by talking about covering his overhead and how long he’ll need to hold the item until he gets a seller. Rick knows how to buy and how to price, but many businesses struggle in this area.
Continuing our series on mistakes that small businesses make, the prior installments were mostly related to approach and/or philosophy of business. However, this installment tackles one of the more glaring, practical reasons that limit many businesses from succeeding: not knowing how to buy inputs appropriately or price outputs accordingly.
Pricing business products or services is the one of the most important skills needed in order for a business to remain competitive and maintain existence. Without a proper pricing model, top-line revenue suffers, which leads directly to a reduced bottom line.
The ability to price properly should not be confused with a business who chooses to differentiate itself on price, as opposed to products or service. A differentiation on price is a tactical decision that businesses make whereby they lower the price to gain market share with the intent to still make a profit, often times by having less expensive inputs. Determining the price of products and services is more mechanical and requires consistent review, assessment and analysis.
Here are the steps to consider when determining how to price products and services.
Regardless of what industry a business is in, it must consider the costs of its inputs so that it knows what the price must be. It is crucial that this consideration is done in this order and not the other way around. If a price is set before a budget is established, the business will have an unintentional bias when it comes to their expense estimation and will not necessarily end up with the most accurate picture.
All costs of a business should be considered when determining pricing. The markup on the direct costs needs to be sufficient to cover overhead and generate a profit.
Procure Inputs Correctly
Perhaps more important than budgeting inputs is for a business to ensure it can obtain those inputs for the estimated costs. This is why a general contractor will solicit bids from subcontractors in conjunction with issuing a bid to a final customer. Businesses in the manufacturing sector, especially where they need to buy commodities, such as metals or food inputs, must be skilled in the art of knowing when to buy because the prices of the inputs can fluctuate dramatically. Some commodity buyers will enter into a pricing hedge, where they have a contract for a specific buying point.
Determine Reorder Points
Knowing when to reorder inputs is also vitally important. I knew a gentleman who owned a restaurant, and he struggled in the early going because he would run out of desserts, so he would send someone to the local grocery store to buy ready-made cakes, pies, etc. Of course, he was buying those desserts at a price that was already marked up by the grocery store instead of buying direct from a wholesaler or making the desserts in-house. When a business has to buy immediately, they do not have an opportunity to find the best price.
Establish Markup and or Selling Price
Once all inputs are determined, the selling price can be determined. In product sales, the price point is typically a direct calculation from the purchase price of the tangible good. For instance, a clothing store will often have a 100% markup on its wares. If they buy a shirt for $20, they will sell it for $40. That means that fixed costs -salaries and benefits, space costs, etc., must be less than 50% of the sales price in order to generate a profit.
In service businesses, the price can be determined by an hourly billing rate for employees and a markup on materials used. The billing rate for employees is essentially a markup on that employees’ wages. Knowing how many hours an employee will have on a particular job is crucial to setting a proper bid. When we see a construction company struggle with bidding, it is often because they are not conservative enough in their estimation of how much time it will take to complete the project. If I’m a painter, and I think I can do the job in 10 hours but it takes 15 hours instead, I have probably lost all profit on that job simply because I estimated time poorly.
In the example above, if unexpected circumstances arise that change the scope of a project, the business has to be willing to go to the customer and identify the issue and discuss the increased scope and the new price. For businesses that deal with commodities, they may have to continually be in communication with their customers about pricing changes.
Reasonable to Market
After all of these items have been determined, and a selling price is established, a business needs to make sure that their price is competitive in the marketplace. A business who offers the same service as its competitors for a significantly higher price without discernible differentiating factors will find generating revenue to be difficult. In this case, the costs of direct inputs or overhead must be reassessed to see where there can be cost savings to allow for a competitive price.
See previous installments in the Small Business Mistakes Series:
- Confusing Knowing a Trade with Knowing a Business
- Forgetting ‘Achievable’ When Setting SMART Goals for a Small Business
- Failure to Implement Proper Capitalization Planning & Equity Retention in Your Business
By Dan Massey, CPA, Manager
This installment is brought to you by Dan Massey. Dan is a Partner in the firm’s Assurance Division. He performs audit services for clients in many industries, focusing on construction, entertainment production, and not-for-profit entities.
Dan is both a member of the American Institute of Certified Public Accountants (AICPA) and the Pennsylvania Institute of Certified Public Accountants (PICPA). He is also chairman of the C.O.R.E. Task Force for the Keystone Chapter of Associated Builders and Contractors.
Connect with Dan on LinkedIn or contact our office to get in touch.