Service based pricing
Unlike businesses that manufacture physical products, service based businesses have no ability to build up stock, and this can have an impact on their pricing strategies.
For example, a company that manufactures cups can produce them and then store them if there’s not a ready market to sell them to today. They can store these cups for busier times in the year, or they can actively seek new markets to release this stored inventory.
A service based business can’t do that.
If there are three advisers in your business and they are not busy, their time for this week cannot be stored up and used at a later date when things pick up. A week with no work means a week of no production, and you can’t get that time back.
Sometimes service businesses vary their pricing based on their current workload. For example, in a particularly quiet week, you may decide to price a job more cheaply so that you can use the spare capacity the business has (knowing that if you don’t use it now, it is lost forever). Conversely, when you are operating at full capacity you wouldn’t want to discount.
Understanding fixed and variable costs
Over the course of a month or a year your pricing must cover all costs; fixed and variable, which can be measured by looking at your Profit & Loss Statement and asking did we make a profit?
In quiet periods it may make sense to charge a price that simply covers your variable costs. This concept is known as the contribution margin.
Contribution Margin = Price – Variable Costs
Your fixed costs are fixed. That is, they will be incurred regardless of trading or not (for example, if you are locked into a lease for your premises). The money you make, on any job, in excess of the variable costs helps to pay off some of your fixed costs for the month or year.
Premium restaurants use this concept for low volume trading times (lunchtime or early evening). At lunchtime in a top quality restaurant you can usually get a meal that costs less than a similar meal at a peak time (like dinner on a Friday or Saturday night). They do this because even though the price does not necessarily cover all costs (fixed and variable) it is better to take some money in excess of the variable costs, as this makes a ‘contribution’ toward paying off some of the fixed costs.
At busy times pricing more accurately reflects what they need to charge to be profitable.
Hotels do the same thing with their late room specials. Having sold enough rooms to cover fixed and variable costs for the month they can sell the remaining rooms more cheaply, as any money made in excess of variable costs just adds to their contribution margin for the month. This is better than having the rooms empty (where no contribution margin would be received).
Even if the hotel has not sold enough rooms for the month (in a quiet time of year) they can still use this concept to minimise losses in a difficult trading period. Obviously, over the medium to longer term, pricing must cover all costs and leave a profit otherwise the business will fail.
Think about situations in your own business where:
You have taken on too much work at one time and caused chaos in your team as they try to process it.
You employed your standard pricing strategy during a low trading period and lost work that you may have gained by flexing your pricing downwards.
In the first situation, could you have flexed your pricing up as the work was building? By pricing harder as the workload increases, some jobs will not proceed whilst the ones that do will do so at higher margin. This can keep you profitable whilst not letting things get out of control.
In the second situation, you might be under utilising your business assets (advisers and staff) and could address it with some greater focus on your pricing approach.
Can you see how some of the exceptions I’ve covered in previous weeks could now be accommodated with a more flexible pricing approach?
Understanding contribution margins can give you flexibility you may not think you have with pricing. [click to tweet]
Take some time to think about your current pricing strategy in light of this information.
Remember, you are a service based business so flexing from time to time on pricing will almost certainly occur.
You will still have to overlay other soft criteria when it comes to taking on a client; for example, how close to your ideal client are they? If you really want to secure a particular client this may drive your pricing approach and override some of the considerations I’ve outlined here.
You must be careful not to price too low (even when you are consciously discounting), lest you wake up 3 weeks later and think “I wish I’d never taken on this job”.
It is imperative that over the course of a month, quarter, or year you are covering all your costs (fixed and variable) and making a healthy profit margin.
This type of pricing approach may or may not fit your business, but it certainly starts to provide you with more pricing options for different client segments, or at different times of the year when the business is busier or quieter than is desirable.
By Brett Davidson