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) Ã· (Hours Per Week) Ã· (Weeks Per Year) Ã· (% 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 Ã· 40 Ã· 50 Ã· 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 Ã· (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.
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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)