Every week as SmallBizLady, I conduct interviews with experts on my Twitter talk show #SmallBizChat. The show takes place every Wednesday on Twitter from 8-9pm ET. This is excerpted from my recent interview with Nicole Fende @BizFinanceForum Nicole is President and Chief Numbers Whisperer of Small Business Finance Forum. Nicole is a credentialed actuary with experience as a Chief Financial Officer, Investment Banker, and successful entrepreneur. Her forthcoming book, How to be a Finance Rock Star, is an easy, practical guide to mastering small business finance.
SmallBizLady: What is the first step in pricing any product or service?
Nicole Fende: You need to set your profit goals. In other words, you need to determine how much money you want to earn in a given period. Think of profit and pricing like a road trip. First you need to know where you are going, then you can get directions. I recommend starting with your annual profit goal. Think of it as the salary you are paying yourself.
SmallBizLady: What is the difference between revenue and profit?
Nicole Fende: This distinction is crucial. Revenue is the total funds you bring in the door. Whether you are paid in person or online, by cash, check, credit or even barter, this is the total amount of money the business has received in a given period for providing goods or services. Profit is the money that is left after all your expenses are paid. It is the money you are able to take out of the business and deposit into your personal bank account. Think of it as the salary your business pays you. Would you rather have a business that generates a million dollars in revenue and $50,000 in profit, or a business that generates a half million dollars in revenue and $100,000 in profit?
SmallBizLady: Establishing a profit strategy sounds like a lot of work. Can you create one quickly and easily?
Nicole Fende: Actually creating a profit strategy is really easy! You only need to answer four questions:
1) How many hours a week do you want to work?
2) How many weeks in a year do you want to work?
3) What is your target income (i.e. your salary) for the year?
4) What percentage of your time is spent on revenue generating activities?
SmallBizLady: Once a business owner or entrepreneur has these four numbers, what do they do with them?
Nicole Fende: Simply plug them into one easy formula:
(Target Income) ÷ (Hours Per Week) ÷ (Weeks Per Year) ÷ (% Revenue Generating Activities)
Your answer is the minimum amount you need to earn for every hour you spend on revenue generating activities. Let’s do a quick example using 40 hours per week, 50 weeks per year, 50% of your time generates revenue and an income goal of $100,000.
The formula is ($100,000 ÷ 40 ÷ 50 ÷ 0.50) = $100. You need to earn, net of expenses, $100 per hour when you are engaged in a revenue generating activity.
SmallBizLady: Your methodology to create a profit strategy seems easy, almost too easy. What’s the catch?
Nicole Fende: Garbage in, garbage out. If your answers are not realistic, then the answer you get won’t be achievable. If you estimate you will only work 10 hours a week, is that realistic? Probably not. If you assume an 80 work week but only actually work 40hours a week you will only hit half your profit goal. That’s a big difference!
SmallBizLady: Once we have our profit strategy, what is the next step in profitable pricing?
Nicole Fende: Every profitable price is based three building blocks; time, expenses, and profit. Think of your price like a house. Every house includes a bathroom, a kitchen (or cooking area) and living space. Yes you could build a house without a bathroom, but who would buy it? How much time will your product take to create? Or will your service require to be completed? What expenses do you have? What business profit margin would you like to achieve (I recommend starting with 10% for this)?
SmallBizLady: What do we do with these numbers to calculate the price for a product or service?
Nicole Fende: If you are a Solopreneur who currently does all the work, and plans to continue to do all the work, the following equation would give you the minimum price to achieve your profit goals:
Number of Hours * Hourly Rate (Calculated Above) + Expenses = Solopreneur Price
However if you currently have employees, outsource or plan to do either in the future, you need to add in a business profit margin. If your profit margin is 10% (again my recommended default assumption), then you will need to do the additional calculation:
Solopreneur Price ÷ (1 — 0.10). Now you have the final price.
SmallBizLady: Why do I need to add an additional business profit margin?
Nicole Fende: When you employ others, or leverage outside resources, most if not all your hourly rate goes to pay that other person. If that is the case where is your profit? The additional margin ensures profit even when someone else does the work. Plus if you are able to find someone to do the work at lower price with the same level of quality it will generate even more profit for you!
SmallBizLady: What if I believe I can charge more than the price I calculated?
Nicole Fende: The price we have calculated is the minimum you need to charge to meet your income and profit goals. If you can successfully charge a higher price then you should do it! The only requirement is to deliver value to your customers. In fact I’ve seen a phenomenon where businesses get more clients when they raise prices.
SmallBizLady: What if the market simply won’t support the price I calculated?
Nicole Fende: First I would challenge that belief. In large corporations and start-ups alike I’ve seen people fall victim to the myth that being the lowest price is the only way to compete. If that were the case high end brands like Mercedes, Rolex and Tiffany’s would not exist.
However if you have tested the price and it is not viable you have two options. You can add additional benefits or resources that will not add substantial cost, thus supporting the higher price. A great example is to include a free eBook that you have already written. The other option is to look at what can be cut either in the services or expenses in delivering the item. You must cut something if you cut the price, otherwise you will not meet your profit goals.
SmallBizLady: Fact or Fiction: If I just sell enough I’ll generate a profit.
Nicole Fende: FICTION! While there are certain benefits from selling a large quantity of anything, that only applies to your fixed expenses. If your price doesn’t cover time, variable expenses, and a portion of fixed expenses you will never make money. In fact the more you sell, the more you will lose.
SmallBizLady: I have my price. Am I all done?
Nicole Fende: Nope. Now you need to track your experience against your assumptions. What if the product or service takes twice as long to complete as you originally assumed? What if your expenses are 20% higher than anticipated? You will need to change your price or you will not meet your profit goals.
If you found this interview helpful, join us on Wednesdays 8-9pm ET follow @SmallBizChat on Twitter. Here’s how to participate in #SmallBizChat: http://bit.ly/S797e
For more tips on how start or grow your small business subscribe to Melinda Emerson’s blog http://www.succeedasyourownboss.com.
Melinda F. Emerson, known to many as SmallBizLady is one of America’s leading small business experts. As a seasoned entrepreneur, professional speaker, and small business coach, she develops audio, video and written content to fulfill her mission to end small business failure. As CEO of MFE Consulting LLC, Melinda educates entrepreneurs and Fortune 500 companies on subjects including small business start-up, business development and social media marketing. Forbes Magazine recently named her one of the Top 20 women for entrepreneurs to follow on Twitter. She hosts #SmallBizChat Wednesdays on Twitter 8-9pm ET for emerging entrepreneurs. She also publishes a resource blog www.succeedasyourownboss.com Melinda is also the author of the national bestseller Become Your Own Boss in 12 months; A Month-by-Month Guide to a Business That Works. (Adams Media 2010)
This is totally rocking information and great interview questions. Hats off to you both. Two of my favourite ladies.
hello
Melinda and Nicole:
This is awesome stuff. That’s saying a lot coming from a geeky b-school grad. This information offers a simple way for entrepreneurs to get their heads around what it will take to generate a profit. I especially like your advice on continuing to revisit pricing to make sure that margins remain healthy should costs increase.
In my work, I’ve seen many businesses fail because owners don’t understand basic cost accounting. Many types of costs are “hidden” or untracked, so it’s always helpful to document everything and thoroughly analyze where every penny goes in a business.
Your advice goes a long way to helping address this challenge.
Keep up the good work,
Justin
Justin,
Thanks for the feedback. Hey Geeky B-School Grads are cool! Almost as cool as geeky actuarial number lovers…
The whole inspiration for this article was getting at the basics, building a foundation to go forward. In danger of beating a dead horse, even after a house is built it still takes work, sometimes even a major overhaul like a new roof.
Nicole
Very useful tips just awesome
Keep it up
thanks a lot
Ravi Dharkhan
In regards of the formula for the solopreneur price, what will the no. of hr be? This may be a stupid question to others but would be appreciated if somebody can help me to understand this.
Hi Mimi,
There is no such thing as a stupid question!
The number of hours should reflect the number of hours you plan to spend on your business in a week. I often use 40 because in the US people use that as the benchmark. The reality is many solopreneurs work far more than 40 hours a week.
I hope that helps, if not let me know.
Nicole
Using profit goal to determine price doesn’t make a lot of sense to me. You need a bottom-up approach, not a top-down one.
Prices are set by the market. A good marketer should know what price the market will bear and offer his or her goods or services at or near that price. Great branding or other competitive advantages help command higher prices than substitute products.
When you do as you suggest — start from profit goals — you are in effect setting a limit as to how much revenue you can generate.
What if I want to earn $100k and I do as you suggest? I am creating a business model that leads to the generation of $100k. If $1 million could have been earned, I’ll never know. If $100k is too optimistic, I won’t know that either.
Profit goals are subjective, but there is only one optimum answer to the question of pricing a product or service.
This is one of the common misconceptions about marketing a product or service. Pricing is dictated by the market, not by you. Your job as an entrepreneur is to always be increasing your margins and top line, not choosing arbitrary limits and reverse engineering your day to day activities.
Long term goals are important, but not used this way. They are to be heights we hope to surpass, not a fixed equation from which a pricing strategy is derived.
Hi Jay,
First thanks for your input. I love discussion, it lets me know people are paying attention.
As someone who has priced products top down, bottom up and every other way you can imagine for companies large and small (multi-national corporations to start-up solopreneurs) I realize there is not a silver bullet.
The idea is to give people a foundation, a starting place from which they can build. I had hoped to make clear that the answer here is the minimum you need to charge, not a cap. If people will pay more by all means charge more!
If people see value they will pay. I can’t imagine Steve Jobs wondered if people would send $100’s on the original iPhone. He focused on delivering his vision and convincing people it was worth it.
Thanks again for sharing your thoughts.
Nicole
Thanks for the reply, Nicole.
I think we still have a fundamental disagreement as to how to approach this. I think your suggestions leave out some critical factors and essentially put the last step first. The result is going to be less profit and competitiveness than could otherwise be achieved.
I’m going to post a blog tomorrow that outlines my own approach in some detail. Hard to discuss this when I haven’t yet suggested my solution. So far I’m just throwing stones, which isn’t really fair. I’ll send you a link when it’s online.
Thanks for the stimulating discussion and debate.
Jay
I promised a more complete response. You’ll find it here:
http://bit.ly/oQEzyE
I may have missed something, but I checked out your link Jay and didn’t see your response…just a post about delegating.
Anyhooo….as a small biz consultant for nearly 10 years, I can tell you from experience that helping people understand pricing from the POV of what THEIR real goals are, is actually very helpful. Especially with those who may not be business savvy or who lack confidence around what they should charge (women, for example, tend to under charge customers, especially in the first 5 years of business). YES, pricing must take into consideration what the market will bear. But Nicole’s advice is a great starting point. Ultimately, pricing strategies can be as complex or as simple as we decide to make them. What works for one business, won’t always work for that same business in a different locale. We’re all unique. But what we do have in common is a need to develop a business that is profitable enough to get us off the ground. THEN we can look at building it bigger and better — IF that’s what we choose to do.
The question of pricing has plagued me for the last 2 years. LOL.
I own a business that provides a service in the homes of my customers. I cover my expenses and have been able to create “some” profit over the course of a year but a lot of my business is seasonal so some months are leaner than others.
Being the greedy capitalist that I am, I sometimes “think” I am not making enough money.
However, I have done some research and the rates I charge for my services are comparable to others in my industry (higher than some, lower than others).
There’s a flaw with the formula: it’s based entirely on an hourly billing model. I’m a freelance writer, so some of my work probably always be billed by the hour or in some way closely related to hours (like retainer or project fees.) But ultimately I need something more: a plan for selling reprints, some royalty-producing work, and some packaged product(s) or program. If I write a workbook, market it to existing clients, and take in $4,000 per year in sales, it makes no sense to account for the revenue in terms of X-per-hour.