Once you know how much the merchandise or job costs, you mark it up to provide a profit. One way is to use what’s known as “keystone” pricing, which simply means doubling the cost to arrive at the selling price. This provides a 50% gross profit margin. That’s why retailers can put goods on sale for 40% off and still make a profit. It works fine, but it isn’t always the best choice.
You can also use manufacturers’ suggested retail pricing, which even further simplifies the calculations. Nationally uniform prices, of course don’t reflect local market conditions, much less the individual business owner’s costs of doing business. Remember, too, that they’re designed to help the manufacturer move more merchandise, not necessarily help you make more money.
Using a standard markup sounds simple, but that’s really only the beginning of sound pricing strategy. You also have to be sure that the gross profit is large enough to cover your overhead, or the indirect costs of operating your business, and still leave a net profit. Whether you’re marking up merchandise or deciding on a labor rate, you’ve got to build in something to cover the rent—and all those other bills you pay every month.
Every business has indirect expenses (not related to the cost of a piece of merchandise or a particular employee’s labor on a job) that have to be paid. The obvious ones include your building and what it costs to operate it (utilities, maintenance, taxes, insurance), your fixtures, tools, office equipment, vehicles and other fixed assets (their cost on an annual basis is your depreciation expense), your salary and benefits (especially health insurance), not to mention the office manager and other general employees. Don’t forget to add in your property and casualty and liability insurance premiums, accountant’s fees, advertising and marketing expenses, office supplies, telephone, and so on and so on. While you’re at it, make sure you include an annual contribution to your own retirement plan, be it a 401-K, SEP-IRA, or whatever.
Finally, add something for net profit. That’s the whole point of running the business, right? The net profit, by the way, is not the same as your salary as the manager or owner. Your salary is payment for your labor managing the business. If you’re the owner, the net profit is the return on your investment and the compensation your receive for the risks you take. There’s a big difference.
The total dollar amount of your shop’s gross profit, the figure that has to be larger than your overhead expense, is also dependant on how much merchandise you sell or how many jobs you complete. These are determined, at least in part, by the prices you charge. If your prices are too high, customers will run away, so it can be a vicious circle. Cost-based pricing is all well and good, but ultimately, the prices you charge are determined by what your customers are willing to pay. That’s where a whole raft of other factors comes into play.
Dave Donelson distills the experiences of hundreds of entrepreneurs into practical advice for small business owners and managers in the Dynamic Manager's Guides, a series of how-to books about marketing and advertising, sales techniques, motivating personnel, financial management, and business strategy.