Do You Base Your Prices on a Minimum Gross Profit?
Setting a price for a product or service is often compared to an art form that requires intuition, experience, and skill.
Undoubtedly, guessing the market price or figuring out how much to increase your prices without losing customers is inherently inaccurate.
However, leaving these decisions only to intuition without considering your product costs, your company's overhead expenses, and your profits, from which you pay yourself, is a missed reality check.
Instead, I recommend a three-step process that aligns internal profit requirements with external market realities, a process that also gives you critical information about your business.
Step 1: Set a Minimum Gross Profit
The difference between your sell price and how much you pay your suppliers for the products you sell is called gross profit.
If the gross profit is high enough, it will cover your overhead expenses (operating expenses), leaving you with a net profit (net income) to pay yourself.
So, how high should your gross profit be?
To come up with this number, take a typical 3-month period (fiscal quarter) and add up all your overhead expenses, such as rent, electricity, and salaries for your employees. Then add your company's quarterly income taxes (if any) and your personal living expenses to that amount. Your minimum gross profit should at least cover the sum of your overhead expenses, your company's income taxes (if any), and your personal living expenses.
I include personal living expenses in the minimum gross margin calculation because small business owners such as sole proprietors or members of an LLC often have to live on their companies' net income. That does not necessarily apply to corporations as the owners typically receive a salary (part of overhead expenses).
Step 2: Define Your Product/Services Mix
With your minimum gross profit set, you have to find the right mix of products and services that would meet or exceed that gross profit level.
After listing all your products and services with their current sell prices and costs, multiply them by the amount (quantity) you believe you can sell and deliver.
I recommend working with a spreadsheet program, such as Google Sheets, Microsoft Excel, or Apple Numbers. These programs automatically update your gross margin when you change your inputs.
If your product mix doesn’t yield enough gross profit to meet your minimum gross profit threshold, adjust your mix towards products and services with higher gross profits. You can also increase the quantities by selling more or raise your prices.
It's perfectly okay to repeat this step a few times to get it right.
Step 3: Align Your Prices With the Market
Are the prices you used in your model in the second step realistic? Are they too high or too low? How many customers would you lose if you raised your prices?
While there isn't a straightforward, numerical answer to these questions, you probably already have a good idea of where roughly the market prices for each product and service are. However, I suggest considering three crucial questions with an open mind:
What is your market in terms of customers, competitors, and geography? Is your market local, national, or global? Suppose you sell online. Since any US customer could order your products, the US would consequently be your market. You would then compete with companies across the US, and the market price would reflect that geography.
Aside from price, what other factors do you use to differentiate your products? While customers consider the price of a product when deciding if they want to buy from you or your competitor, price is rarely the only factor. The quality of your product and its availability are also crucial factors, along with your reputation, purpose, and story.
How big should your price increases be? Since no one can predict how your customers will react to a price increase of, for example, 25% and whether they would switch to a competitor's product, I recommend playing it safe by increasing your prices only in small increments of under 10%.
The alignment of your prices with the market does not follow strict rules. In this regard, it is indeed more a matter of intuition, experience, and skill to get your pricing right. However, after going through this third step, you should have a little comfort that your prices are somewhat in line with reality.
Valuable Insights
This three-step process is designed to give you valuable insight into your business and the minimum gross profit it needs to generate to cover your living expenses.
If you captured all inputs in a spreadsheet, you also have a tool that you can regularly update before making important business decisions.
