Your prices can make or break your business. You’ll need to cover costs and generate a profit, but if you set prices too high, you won’t sell anything. Thankfully, entrepreneurs have been puzzling over pricing for as long as local businesses have existed, so plenty of resources exist to help you. Below, find our roundup of key terms and popular philosophies on pricing for small business.
The Key Terms for Small Business Pricing
Cost of materials: the cost of the items needed to make a product or deliver a service.
Direct labor costs: the cost of the work that goes into manufacturing a product, selling a product, or providing a service.
Overhead costs: all other expenses aside from labor costs and cost of materials. Overhead costs fall into two buckets: fixed costs, which don’t change relative to the number of products or services you deliver, and variable costs, which do.
Examples of fixed costs include labor not directly related to making a product or delivering a service (i.e. bookkeeping, legal services, etc.), office rent, and insurance. Examples of variable costs include office supplies and phone bills.
The Philosophies of Small Business Pricing
Cost-plus pricing
For a given product or service, add together the materials, labor costs, and a proportionate amount of your total overhead costs. Decide what percentage of the sale price you want to keep as a profit, and then solve for the price.
Competitive pricing
Find out the prices charged by competitors in your area and base your own prices off of that.
Price skimming
Set your prices high when a new product or service appears on the market, which will help you earn back any development costs, and then scale back when competitors appear.
Psychology pricing
For most products and services, adjusting a price so that the first number appears low can drive sales. For example, more people will buy a toaster for $9.99 than $10, even though the difference is only a penny. On the other hand, luxury brands often go for round numbers to set themselves apart from their lower-end competitors.
Bundle pricing
Selling items or services together as a package can spur your customers to make a bigger purchase. Just be sure that your profit for one of the items in the bundle is enough to compensate for a smaller profit on the other item or items.
Personalized Pricing
Price personalization is pricing that is built around the preferences and profiles of local customers. With personalized pricing, small business owners can simultaneously offer different types of pricing options for different types of customers (from families to veterans), as well as different contexts (from rainy days to busy weekends).
How to Calculate the Right Price
Direct labor cost for a latte:
Time required = 5 minutes
Wage = $15 an hour
Hours worked by employee annually: 980
Total payroll tax and benefits spending for employee: $2,940
Average hourly payroll tax and benefits spending for employee: $3
(Hourly wage + hourly tax and benefits) x hours to make latte = direct labor cost
($15 + $3) x (5/60) = direct labor cost
$18 x 0.0833 = direct labor cost
$1.50 = direct labor cost
Direct labor cost for offering a massage:
Time required = 1 hour
Wage = $25 an hour
Hours worked by employee annually: 1500
Total payroll tax and benefits spending for employee: $7,500
Average hourly payroll tax and benefits spending for employee: $5
(Hourly wage + hourly tax and benefits) x hours to give massage = direct labor cost
($25 + $5) x 1 = direct labor cost
$30 x 1 = direct labor cost
$30 = direct labor cost
Pricing a latte using the cost-plus method
Cost of materials = $1
Direct labor costs = $1.50
Overhead costs = $1.50
Desired profit percentage = 20% of price
Cost of materials + direct labor costs + overhead = price x 0.80
$1 + $1.5 + $1.5 = price x 0.80
$4 = price x 0.80
$4/0.80 = price
$5 = price
Pricing a massage using the cost-plus method
Cost of materials = $11
Direct labor costs = $30
Overhead costs = $2
Desired profit percentage = 25% of price
Cost of materials + direct labor costs + overhead = price * 0.75
$11 + $30 + $2 = price * 0.75
$43 = price * 0.75
$43/0.75 = price
$57 = price
Bundling a latte and a biscotti
Total cost of latte: $4
Total cost of biscotti: $2
Price of latte: $5
Price of biscotti: $2.50
Price needed to break even on the bundle = cost of latte + cost of biscotti
Price needed to break even on the bundle = $6
Example of a profitable bundle price: $7
Bundling a full-body massage and a scalp massage
Total cost of full-body massage: $43
Total cost of scalp massage: $15
Price of full-body massage: $57
Price of scalp massage: $20
Price needed to break even on the bundle = cost of full-body massage + cost of scalp massage
Price needed to break even on the bundle = $58
Example of a profitable bundle price: $70
Further Reading
We hope our roundup gives you plenty of food for thought on pricing for your small business. If you’d like to read more, here are some resources we recommend.
- “Pricing a Product” in Entrepreneur
- “What Figures Do You Use to Find Direct Labor When It Is Missing From a Formula?” from the Houston Chronicle
- “15 Best Pricing Strategies That Will Work For Your Small Business” on Medium
