As you assess your business idea’s potential, one of the most important factors to consider—but one of the most often overlooked—is whether you can actually make money from it. New business owners often get so excited by their concept, they gloss over the math.
Just because people will buy your product doesn’t mean you will necessarily make a profit. To figure out if your business will be profitable, you need to set prices.
The first step in price-setting is figuring out your business’s overhead. Also called operating expenses, overhead refers to how much it costs to run your business, and includes both fixed and variable costs. Fixed costs don’t change from month to month; these include rent, loan payments and other financing costs, salaries and benefits, and insurance. You may have others. Variable costs usually change each month; these include marketing, sales, and promotional expenses; utilities; phone expenses; and mailing costs.
Pricing considerations differ depending on whether you sell a service or a product.
Pricing a Product
In addition to overhead, you need to know your cost of goods sold (also called cost of sales). This is how much it costs you to buy products from a manufacturer or to manufacture them yourself.
When you subtract your sales from the cost of sales, the result is your margin (also called gross profit margin). For instance, if it costs you $1,500 to sell $5,000 worth of products, your margin is $3,500 ($5,000 minus $1,500).
Gross profit margin can be expressed either as a dollar figure or as a percentage. As a percentage, the margin is: sales minus cost of sales divided by sales. In this case, that’s $5,000 minus $1,500 divided by $5,000 = 70 percent. Next, subtract your overhead from the gross profit margin, and what’s left is your net profit (before taxes).
Closely related to margin, and often confused with it, is markup. But while margin is a percentage of your product’s price, markup is a percentage of your cost. Markup is calculated this way: sales minus cost of sales divided by cost of sales. Using the example above, if you calculate $5,000 minus $1,500 divided by $1,500, the result is 233 percent. This is the markup (or price above your cost) that you need to charge to get a profit margin of 70 percent.
Confusing markup and margin can lead to big problems for your startup. If you mark up your product 70 percent thinking that will give you a margin of 70 percent, you’re in for an unpleasant surprise. The average markup in a product business can range from 5 to 100 percent or more, depending on your industry.
Pricing a Service
The concepts of markup and margin are the same for a service business as for a product business. What’s different is that your biggest variable cost is not inventory, rather it’s labor (your and your employees’ time). This can be harder to calculate. While it’s simple to get a price quote from a supplier for X number of widgets, it can be difficult to estimate how long a project will take you. Don’t forget to consider any material costs involved. By adding all your costs to your desired markup, you will arrive at a price. The average markup in service industries can range from 25 to 100 percent.
Fine-Tuning Your Prices
As a startup, pricing your products inevitably involves a certain amount of guesswork. To set prices as accurately as possible, research your industry thoroughly to get a good idea of costs. Get price quotes from suppliers or manufacturers. Find out how much the type of sales and marketing you plan to do will cost. Research the average hourly wage of the type of employees you’ll need to hire.
You must also research what the going rate is for your industry and how much customers will pay. As you evaluate your competition, gather data on their prices. Doing a focus group with potential customers will give you an idea of how much people are willing to pay.
If your calculations lead to a price that’s outrageously high or low, compared to others in your industry, you’ll need to recalculate. To bring the price down, you must lower your costs. An extremely low price most likely means you’ve underestimated costs; increase your estimate.
Pricing involves some trial-and-error at first. Remember, prices are not set in stone. Once you launch your business, constantly monitor your costs, and keep abreast of pricing trends in your region and industry. You may need to raise or lower prices to keep up with the competition, rising labor costs, or a changing economy.
Karen Axelton is Chief Content Officer at GrowBiz Media (www.growbizmedia.com), a content and consulting company that helps entrepreneurs start and grow their businesses.