How to Set Prices in a Service Business

This guide discusses costing and setting prices of services to assure that each job earns a reasonable profit. The figures used in the tables and examples do not reflect what your service costs, set prices, and profits actually would or should be. The figures are used to demonstrate costing and set prices and are rounded off for further simplicity. Because of the importance and sometimes complexity of costing and pricing, it is good business practice to consult your trade association and particularly your accountant to learn what are the best current practices, cost ratios, and profit margins in your service business.

Setting Prices Problems

Many businesses are not making a profit today because they do not know the basic concepts of costing and set prices. The situation is most serious in the service business because each service performed has a different cost. Frequently, the service business must bid for jobs by making a price quotation in competition with similar businesses. Can you calculate your costs for your service and quote a price that is competitive and returns a profit?

Without realizing what they are doing, some business owners set their selling price below their total cost. This may result in more business for the company, but a loss will be incurred on each sale. Occasionally, a business owner who lacks a knowledge of costing will try to compensate by setting prices very high. The end result is that the business is not price competitive and does not attract sufficient customers to survive. Frequently, a business earns a profit on some particular service and loses money on other services without knowing which services are earning a profit and which services are incurring a loss. The year-end income statement combines the profits and losses from the various services performed over the year. Therefore, it is impossible to determine the profitability of specific service jobs from a year-end income statement.

Use a simplified approach to cost accounting that reflects the needs of the business and reports the cost with a reasonable degree of accuracy. The total cost of producing any service is composed of three parts: 1) the material cost, 2) the labor cost, and 3) the overhead cost. Direct materials and direct labor + overhead = total cost of service.

Cost Determination

Direct Material Cost

The direct material cost is made up of the cost to you for parts and supplies that are used on specific jobs. Once the list of parts and supplies to be used is developed, a check with the supplier will give an up-to-date material cost. The shipping and other handling (storage etc.) costs for the parts should be included in the material cost.

Direct Labor Cost

The direct labor costs include those labor costs identified with a specific service job. The labor cost involved in providing a service is determined by multiplying the number of direct labor hours required by the cost per direct labor hour. It is very important to determine accurately the amount of direct labor hours involved to complete the service; therefore, you must use a time clock, worksheet, or a daily time card for each employee to determine the exact amount of labor time spent on each service job.

The hourly cost of direct labor can be figured (priced) two ways. One it can be the hourly wage only, with fringe benefits, Social Security, Workers' Compensation, etc., (all labor-related costs) allocated to overhead. Or two, the hourly direct labor cost can include the hourly wage plus the employer's contribution to Social Security, unemployment compensation, disability, holidays and vacations, hospitalization and other fringe benefits (payroll costs).

By this second method, the added payroll costs for vacations, holidays and benefits are expressed as percentages of direct hourly wages. For instance, if two weeks of vacation and ten holidays are given annually, this amounts to four weeks per year or 7.7% (i.e., four weeks off divided by fifty-two weeks 4 : 52 = 7.7%) of total labor cost was for time off. Thus, to determine the total direct labor cost per hour by this method, you must add the prorated cost of the payroll taxes, worker's compensation, holidays and vacation pay, hospitalization, etc., to the hourly wage paid. As a rule of thumb, the sum of the various payroll-benefit costs have generally been in the range of 20% to 30% of the hourly wages paid. It is more complicated to figure but more precise to use the higher labor cost (including labor related labor costs). The following table shows a sample calculation for figuring the total direct labor cost using this more exact method.

Overhead Cost

Overhead includes all job related costs other than direct materials and direct labor. Your overhead cost depends on which of the two ways you figured direct labor costs, with or without the labor-related payroll-benefits costs. If you did not include these expenses in direct labor, then you must include them in overhead. In our examples, however, these labor-related costs are included in direct labor and not in overhead. Either way the effect on the total job cost is the same, but your overhead cost varies accordingly.

Because they may not know how to allocate (or assign) overhead costs to the services performed, many business owner-managers miscalculate or avoid considering overhead costs.

Overhead is the indirect cost of the service and is made up of indirect materials, indirect labor, and other indirect costs related to particular services. Indirect materials are too minor to include as direct material costs. Incidental supplies and machine lubricants are examples. Indirect labor is the wages, salaries, and other payroll-benefit costs incurred by workers who do not perform the service but who support the main service function, such as, clerical, supply, and janitorial employees. Other costs, like taxes, depreciation, insurance, and transportation are also part of the overhead cost because the service cost includes a portion of all indirect costs (overhead). The following table projects total overhead for all services for one year. To figure the portion of overhead related to particular services or jobs, you allocate the various overhead costs by calculating the overhead rate.

 

Before opening your Company you Need to decide upon the general price Level you expect to keep. Will you appeal to people buying
in the large, moderate, or low price range? Your choice of location, look of your institution, quality of merchandise handled, and
services to be offered will depend on the customers you would like to attract, and so will your prices.

After establishing this general price level, You're ready to cost Individual products. In general, the price of an item has to
cover the price of the product, the other costs, plus a profit. Therefore, you will need to markup the thing by a certain amount
to cover costs and make a profit. In a business that sells few items, total costs can easily be allocated to each product and a
markup immediately determined. With a variety of items, allocating costs and determining markup might require an accountant. In
retail operations, goods are often marked up by 50 to 100 percent or more just to make a 5% to 10% gain!

Let us work through a markup example. Suppose your company sells 1 product, Product A. The supplier sells Product A to you for
$5.00 each. You and your accountant decide the costs entailed in selling Product A are $4.00 each item, and you also desire a $1
per item gain. What is your markup? The selling price is: $5 plus $4 plus $1 or $10; the markup therefore is $5. As a percentage,
it is 100%. So you need to markup Product A by 100% to produce a 10% profit!

Many small business managers are interested in knowing what Industry markup norms are for a variety of products. Wholesalers,
distributors, trade institutions and business research firms publish a huge assortment of these ratios and company statistics.
They're useful as guidelines. Another ratio (in addition to the markup percent ) important to small businesses is your Gross
Margin Percentage.

The GMP is comparable to your markup percentage but whereas markup Identifies the percentage above the price to you of each item
that you must set the selling cost so as to cover all other expenses and earn profits, the GMP indicates the relationship between
sales revenues minus the cost of the product, which can be your gross profit margin, along with your earnings earnings. Exactly
what the GMP is telling you is your markup bears a certain relationship to your sales revenues. The markup percentage along with
the GMP are basically the same formula, with the markup referring to individual product pricing and GMP referring to the item
costs times the number of items sold (quantity ).

Perhaps an example will clarify the point. Your firm sells Product Z. It costs you .70 each and you choose to sell it for $1 per
cent to cover costs and profit. Your markup is 43%. Now let up say you sold 10,000 Product Z's Last month thus producing $10,000
in revenues. Your price to purchase Product Z was $7000; your gross profit margin was $3,000 (revenues minus cost of goods sold).
This is also your gross mark for your month's volume. Your GMP will be 30 percent. Both of these percentages utilize the same
basic amounts, differing only in division. Both are utilized to establish a pricing method. And both are printed and may be used
as guidelines for smaller firms starting out. Often managers determine what Gross Margin Percentage they will need to earn a
profit and just visit some published Markup Table to find the percent markup which correlates with that margin requirement.

While this discussion of pricing may appear, in some respects, to Be directed only to the pricing of retail product it can be
applied to other types of businesses as well. For solutions the markup has to cover administrative and selling costs in addition
to the immediate cost of doing a particular service. If you're producing a product, the costs of direct labor, supplies and
materials, parts purchased from different issues, special equipment and tools, plant overhead, selling and administrative expenses
must be carefully anticipated. To compute a price per unit needs an estimate of the amount of components you plan to produce.
Before your factory gets too large it would be smart to consult an accountant about a cost accounting system.

Not all items are marked up from the average markup. Luxury articles Will require more, staples less. For instance, increased
sales volume from a lower-than-average markup on a specific item - a"loss leader" - may bring a higher gross profit unless the
price is lowered too much. Then the consequent increase in sales will not increase the entire gross profit enough to compensate
for the minimal price.

Sometimes you may wish to sell a certain item or service at a lower Markup so as to boost store traffic with the expectation of
increasing earnings of Regularly priced merchandise or creating a large number of new support contracts. Competitors' costs will
also regulate your prices. You Can't market a Product if your competition is greatly underselling you. These and other reasons Can
make you vary your markup one of items and solutions. There's no magic Formula which will work on every product or each service
all the time. However, You ought to keep in mind the general average markup that you need to generate a Gain.
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