Pricing For Profit

Have you ever wished that someone would tell you the secret to turning your business into a money-making enterprise? Well, the answer is simple-know your overhead and cover it! This may mean increasing your markup, but it is the only way to stay in business for the long term.

So, how do you price for profit? "Knowing your costs is the first major step to getting to profitability and knowing how to price properly," says David Cerami, CKBR, President of HomeTech Renovations, Inc. in Fort Washington, PA. Making money can be done simply by understanding the true level of your costs and making sure that you cover them-that's the secret, plain and simple.

Profits = Selling Price - Direct Costs - Overhead

This is the basic calculation for making money. Your profits are determined by your selling price, your direct costs and your overhead. You must know all three of these numbers in order to make a profit-this is the key. If your selling price does not cover your overhead in addition to direct costs you will be LOSING money. Not a situation you want to be in.

So, how do you determine the correct selling price to cover your overhead? Here are 5 simple steps to get you there.

  1. Determine the components of your overhead.
    Overhead is everything that you are not charging directly to a job. This includes all of the following items:
      Sales costs     Production supervisor     Rent  
      Marketing & advertising     Office equipment     Office & Cell Phones  
      Office staff     Office supplies     Insurance  
      Accounting     Legal fees     Bad debts  
      Education     Association dues     Other  

  1. Calculate your total annual overhead expense.
    Add up your costs on the above items for the past year. Even better, look at the last two or three years of expenses and see how your costs are changing. This will help you plan for growth. If you have a computerized accounting system, these numbers should be right in your system. Or, your accountant can help you to determine your costs. Don't worry about the expense, this information will be well worth the investment in your accountant's time.

  1. Calculate your overhead as a percent of sales.
    This part should be easy once you have finished step 2.

    Annual Overhead divided by Annual Sales = Overhead Percent

    For example, if your annual overhead is $180,000 and your annual sales are $500,000, your overhead is 36% of sales:

    180,000 500,000 = 0.36 or 36%

    Once you have calculated this number, don't ever forget it. You need to know it, watch it, and make sure you track it. If you think of it in terms of every job that you price, a portion of your selling price needs to go to cover your overhead (Overhead Percent). So, you need to treat this as another major expense across all jobs. If you don't cover your overhead, you'll be losing money.

    Another very important thing to remember is that your overhead percentage will grow as your sales grow because you will need more infrastructure to support a larger business.

  1. Determine the right markup for your business.
    Your markup is what you use to increase your direct costs (your materials for the job, labor directly associated with the job, and other costs directly related to the job) by to get to your selling price. It's the bit you add onto the direct costs to cover both your overhead and allow for profit as the example below illustrates.

    The following formula shows you how to calculate the right markup to ensure profitability. Two assumptions in this formula are that (1) you want a 10% profit and (2) your Overhead Percent is 36% (as calculated in section 3).

    Markup % = 1/[1 - (Overhead Percent + Profit Percent)]
    Markup % = 1/[1 - (0.36 + 0.10)]
    Markup % = 1/(1 - 0.46)
    Markup % = 1/0.54
    Markup % = 1.85, which translates to an 85% markup

    Once you have determined the right Markup Percent to achieve a 10% Profit, you can calculate your selling price as follows. Assumptions here are that your Direct Costs are $1,000 for the job.

    Selling Price = Direct Costs x Markup Percent
    Selling Price = $1,000 x 1.85
    Selling Price = $1,850

    So, with a selling price of $1,850, will we achieve our 10% profit? As the following calculation illustrates, yes we have!

    Job Price $1,850
    Direct Costs -1,000
    Overhead -665
    Net Profit $185

    The right markup for you depends upon a number of factors, but, most importantly, it is driven by your costs (direct and overhead) and your competition. If you markup too little, you may not cover your overhead (which means operating at a loss). If markup too high, you risk not getting the job. Again, you should seek the counsel of a professional accountant to help you determine the proper markup for your business.

  1. Price for success.
    Now you know some of the basic concepts to price your jobs for a successful business. Figure out your direct costs, overhead, desired profit and markup percentages, and you will have the basis to price for success.

    Armed with this knowledge, you will hopefully be less tempted to discount your price just to get a job. It'll just mean you'll have to get an even higher contribution to your overhead on the next job.

    Additional resources:
    • Check out a book, Markup & Profit, by Michael C. Stone, for more details on this topic.
    • For financial topics, we always recommend that you seek the advice of a professional accountant to determine what's right for you.