When questioning your business's prices – especially in a service business – it can be easy to undercut your value in fear of upsetting clients, losing them to the competition or worse, going out of business.
Perhaps you're adding new services to your business offerings and are looking to optimize your pricing structure or maybe your profit margins have started to shrivel after rapid growth and you need to raise prices to solve perpetual cash flow problems. No matter the reason your company needs to re-evaluate its pricing model, the task can be quite daunting.
You need not fear changing prices; price adjustments are a normal part of every business's lifecycle. Customers expect adjustments from time to time, and as long as you price your services fairly (for the wellbeing of both your business and your customers), you should not run into too many unexpected challenges.
Now that your worries about raising or changing prices are at ease, you have to figure out how much you should charge and how to determine an optimized pricing model for your business.
Nailing Down True Costs in a Service Business with Time-Driven Activity-Based Costing (TDABC)
Your total costs and how these costs should be allocated to different revenue streams are the first considerations you must make when adjusting prices or determining how to price a new product or service offering.
You need a clear understanding of your total cost of doing business.
This includes the cost of materials and supplies, overhead costs and your labor costs. Once you know how much your company spends in total, you will need to determine the amount each job or client costs your company.
Calculating the cost of supplies and materials used for each job or client requires a simple accounting of receipts and expenses.
The first step is simple – but, do you know how much of your overhead expenses and labor costs should be allocated to each job or client? Should you allocate labor expenses for only the billable hours of individuals directly involved with the job or should you also consider the labor costs for individuals indirectly related to the work?
This is where job costing, the practice of allocating costs and measuring unit economics, on individual jobs and/or clients comes in. Job costing and time-driven activity-based job costing can help you determine your true costs with respect to your entire organization and on a job by job, client by client, or service by service basis.
Job costing will help you better understand each of your services as a product and determine the optimal price structure to generate revenue. Accurate job costing allows you to generate profit and loss statements for each client, job or service you offer to determine how to adjust pricing, renegotiate contracts and streamline operations.
Nailing down your true costs in a service business will ensure your current costs do not exceed revenue, preventing a loss. Business owners, however, should be wary of implementing pure cost-based or cost-plus pricing structures in their companies.
Even if you build a considerable profit margin into your price, using this type of pricing puts you at risk of missing out on charging extra for the added value you uniquely offer over the competition, in addition to the danger of cost increases (added employees or shifting labor and materials costs) precariously shrinking profit margins as your business grows.
4 Additional Considerations and Strategies for Optimizing Your Pricing
1. Competitor-Based Pricing
Basing your pricing model on your competition can be a useful guide. Be careful, however, because price matching your competition can be limiting. Simply following your competitors' decisions can lead you to underpricing or undervaluing your business's service model. You might also miss out on better pricing models or opportunities to add value to your offerings. While you probably should not be the lone wolf, charging an arm and a leg above the competition, you should ask for a fair price for the value of services you offer.
2. Value-Based Pricing
This pricing consideration is largely subjective and that can make it tricky to get right. With value-based pricing, you need to consider how your customer perceives the value of your services and the client experience you provide. In other words, you are not determining how much you need to be paid for your service, but how much customers are willing to pay. When you compare your current prices to the competition, also look at their service model and customer experience. Consider how your business adds additional value or novelty to the industry and what that added value might be worth in terms of dollars.
3. Alternative Pricing Models
Management accounting and job costing can help you determine the best pricing structure for your business model. Evaluate flat fees, hourly rates, and variable pricing to determine which will best suit your business going forward. Here are two examples of variable, alternative pricing models:
One alternative method, called price skimming, involves setting rates high during the introductory phase of new products or services, then lowering prices gradually as new competitor services appear on the market. This method is designed to help businesses maximize sales on new products and services for early adopters, before dropping prices to attract more price-sensitive consumers.
Price skimming creates the illusion of quality and exclusivity when products or services are first introduced to the marketplace. More importantly, this method can also help businesses recoup the development costs of the new service.
The primary objective of relationship pricing is to enhance the firm’s relationship with its targeted consumers.
There are two types of Relationship Pricing techniques: long-term contracts and price bundling.
Long-term contracts offer prospective customers incentives for dealing with the same provider over a number of years, such as price and non-price incentives.
The practice of bundling services has become more common since most service organizations provide more than one service. Price bundling could be defined as two or more services in a single package at a single price.
4. Listen to Customers
Asking customers outright or hypothetically what they would be willing to pay for your services will not always yield accurate information, but you can pick up accurate data and market opinions in other ways. Try split testing clients. This works especially well for web-based businesses.
If you do not have an effective way to split test your market, then pay attention to what customers say about the cost of your services (either at the time of service or in online reviews). Do customers frequently say your company is a bargain? Do you often lose business due to prices being too high? Or, do customers say they do not mind paying a little bit more for the quality you provide?
Although you cannot get away from your costs somewhat dictating your pricing, you do have leeway when it comes to charging more for a truly high-quality client experience.
Listening to your customers and not putting too much weight on following the lead of your competition will allow you to add value to your customer experience and charge what your client base is actually willing to pay.
Establish an Accounting System That Collects the Right Data
When it comes to pricing in a service business, there are a lot of options and methods to consider. Making the right decisions and getting paid what you deserve, however, requires you to collect essential financial data and to track your business's operations.
The information gathered in your company's bookkeeping and accounting department can unlock the keys to pricing for profitability in your business.
With the right financial systems and integrated technology tools in place, you can efficiently and accurately track vital key performance indicators and collect the data which will allow you to optimize your pricing. You will be able to locate your most profitable revenue streams, eliminate service models or products which do not generate revenue or drive business and also ensure you charge the right amount for the value of services you provide.
Our financial experts can help you establish and implement the management accounting tools that will empower your business to optimize and drive profits while also improving value and offering competitive pricing to your clients.