You’ve got customers. You’ve got sales. You’ve even got five-star reviews! Why, then, is your business STILL not making enough money? It might be your pricing.
Pricing is an art… an art that involves some math. Time and time again I see business owners pricing their products based on what they feel like the product should cost, rather than actual calculations.
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And most business owners feel like their prices should be lower than they actually need to be. Your prices don’t just cover the cost of what you’re selling, they also sustain your business AND sustain you as the owner. Which is why you need to be intentional about your pricing.
Here’s a step-by-step guide to pricing your products for ongoing profitability.
Free product pricing calculator for small business owners.
Step 1: Calculate your costs.
Cost of goods sold (or COGS—covered in more detail in my ultimate tax deductions list) refers to the costs of producing your products. This includes:
- The cost of raw materials to produce an item
- The cost of labor to make an item
- The cost of acquiring merchandise that you sell
COGS and overhead expenses are not the same thing.
COGS relate to the production or acquisition of what you sell—if you didn’t have these costs you wouldn’t have a product or service.
For example, if you make beaded bracelets, your COGS are:
- Labor for assembly
Without these costs, you wouldn’t have bracelets to sell!
Overhead costs, or operating expenses, are expenses that keep your business operational but have nothing to do with the production of the items you sell. While they may support the sale of your goods, your production is not dependant on these expenses. For example, if you make beaded bracelets, your operating expenses could be:
- Rent for your store
- Wages for a salesperson
- POS software
All of these expenses support the sale of your bracelets, but your POS system doesn’t impact the actual production of your bracelets.
The foundation of all your pricing is your COGS.
You, at the bare minimum, need your prices to cover the cost of whatever you’re selling. If your prices don’t, then your business loses money!
When pricing your products, you need to know your COGS for every single item that you sell. For example:
- If you own a retail shop and sell merchandise, your COGS will be the original price that you paid for the merchandise.
- If you manufacture products, for each item that you sell, you’ll need to add up all the costs involved.
Where this gets tricky is when one cost produces more than one product. In this case, you have to calculate the unit cost and how many units are used in each product.
Sound scary, I know. But it’s really not that bad. Here’s an example:
You buy a string of beads to make bracelets. Each string costs $10 and comes with 100 beads. Each bracelet uses 10 beads. You first calculate the cost per bead:
$10 / 100 = $0.10 per bead
Then you multiply the cost per bead by how many beads each bracelet uses:
10 x $0.10 = $1.00
Each bracelet uses $1.00 worth of beads. Here’s how it works when you have more than one cost per product:
|Description||Total Cost||Quantity||Cost per unit||Units needed per product||Cost per product|
|Bead #3||$1 each||1||$1/bead||1||$1.00|
|Thread||$5/spool||100 feet||$0.05 per foot||1.5 foot||$0.075|
|Assembly||$15/hour||6 bracelets assembled||$2.50||1||$2.50|
Total cost: $6.075 (rounded up to $6.08)
In this example, each bracelet costs $6.08 to make. That means, at the bare minimum, you must price the bracelet at $6.08 or higher.
You may be looking at this table thinking, “Seriously, Andi. You really expect me to do all this work?!”—and the answer is, I sure do! Too many business owners don’t know the cost of their products. They rely on guesswork and are shocked when they discover that their pricing just barely covers their costs.
Even if your guesses are off by a couple of dollars, over the course of a year, that adds up to A LOT of revenue lost.
Step 2: Determine your overhead percentage.
The next step is to calculate your overhead percentage, which is the percentage of money from your sales that goes toward paying your operating expenses.
Your prices need to not only cover your COGS, but also your business’s operating expenses. If they don’t, your business will not be profitable or sustainable.
To ensure that your prices also cover your operating expenses, you need to know your overhead percentage. Later, when we’re calculating your price, your overhead percentage will come into play.
There are two numbers you need to calculate your overhead percentage:
- Your annual gross sales
- Your annual operating expenses (remember, your costs are NOT included in your expenses—we’ve already accounted for that in Step 1)
The formula for overhead percentage is:
Expenses / Gross Sales = X
X * 100 = Overhead Percentage
Let’s go back to our jewelry maker. Their annual sales are $100,000 and their annual expenses are $30,000.
$30,000 / $100,000 = 0.30
0.30 x 100 = 30%
Their overhead percentage is 30 percent. In other words, 30 percent of the sale from each item goes into covering the operating costs of their business.
Step 3: Choose your markup.
Now that we’ve got all those pesky costs and expenses covered, the next step is to decide how much you want to mark up your products. Your markup is your profit, so it’s important that your markup is enough for you to make further investments in your business, pay yourself, pay off debt, and cover your taxes.
You can approach your markup one of two ways:
- Set a dollar amount for how much you want to earn on top of your costs for each product. If you make your products yourself, think of this as how much you earn to make the product.
- Use a markup percentage. Rather than using a fixed dollar amount to mark up your product, you can use a percentage. Your markup percentage is the difference between your product’s cost and the selling price. Using a markup percentage is helpful if you want to have a standard markup for products with different costs.
Choosing your markup is the subjective part of this process. There’s no right or wrong markup—it’s up to you and how much you want to earn from each product. This is the step that you’ll experiment with the most. Start with what you think you want to earn and adjust from there.
When choosing a markup, consider the following:
- Is there an industry standard for marking up the items that you sell?
- What costs do your profits cover? Add them up! Based on what you can produce, will this markup cover those costs?
- What’s your competition? Generally, in less competitive markets you can increase your markup, while in more competitive markets you will lower it.
Step 4: Calculate your price.
There are several steps to calculating your price. The first is to add your costs to your markup. If you’re using a set amount for your markup the formula is:
Costs + Markup Amount = Baseline Price
If you’re using a percentage, it will be:
Costs x Markup Percentage = Markup Amount
Markup Amount + Costs = Baseline Price
The next step is to multiply your baseline price by your overhead percentage to see how much you need to add into the price to cover overhead expenses:
Price x Overhead Percentage = Overhead Contribution
The last step is to add your overhead contribution to your baseline price:
Overhead Contribution + Baseline Price = Final Price
Let’s do an example with Super Awesome Bracelet from Step 1. In this example, we want to make $15 from each bracelet after costs and expenses. So our markup will be $15, which we add to our costs:
$6.08 + $15 = $21.08
In Step 3 we calculated our overhead percentage, which was 30 percent. Now it’s time to figure out our overhead contribution for Super Awesome Bracelet:
$21.08 x 0.30 = $6.32
Finally, we add our overhead contribution to our baseline price.
$21.08 + $6.32 = $27.40
The final price of the product will be $27.40, which could be rounded up to $28. Keep in mind, not all of this $28 is profit. Rather it looks like this:
|Overhead contribution||– $6.32|
|Cost of goods sold||– $6.08|
Let’s do the same example using a percentage markup instead of a dollar amount. In this example we want our markup to be 150 percent for all of our products, including Super Awesome Bracelet.
$6.08 x 1.5 = $9.12 (Markup amount)
$6.08 + $9.12 = $15.20 (Baseline Cost)
$15.20 x 0.30 = $4.56 (Overhead Contribution)
$15.20 + 4.56 = $19.76 (Price)
In this example, the price could be rounded up to $20.
Step 5: Adjust your price.
The very last step is adjusting your prices to meet the needs of the market and your business.
First, see if the price is realistic for your customers and is competitive in your market. For example, if you sell Super Awesome Bracelet for $20 and everyone else is selling a similar product for $12, then you’ll need to lower your prices.
That means that you’ll either adjust your markup or find ways to lower your costs and overhead expenses.
Next, ensure that your prices are sustainable for your business. Keep in mind that you not only live off of your profits, but your profits also allow you to grow your business. Just because you have some profit doesn’t mean you have enough profit.
For example, the profit for each Super Awesome Bracelet sold is $15.60. That means if you sell 100 bracelets a month, you’re projected profit is $1,560. But what if you need to pay yourself $3,000 a month? And what if you can’t produce more than 100 bracelets? Well, then you need to adjust your markup.
Adjusting your prices is a process of experimentation. Get in there and play with the numbers! Once you get over the fear of math, it’s actually super fun to figure out exactly how much to price your products. You’ll get excited about the possibilities and might even find yourself nerding out over a spreadsheet on a Friday night!
Got a service-based business? We got ya covered! The next article in this series will be all about the process for pricing your services so you can make what your time and skill are worth.