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Calculating Prices and Service Rates

Is your Price Tag or Hourly Rate considering the hidden cost of doing business

For many business owners wanting to know the real cost of a sale can be a daunting task.The real dilemma is not knowing what to write on the price tag to be profitable. The same goes for businesses that provide an hourly rate service.

I have seen too many business owners realise too late that they have been under pricing their goods and services. The typical approach when pricing goods and services is to add up all the direct cost and then add a Markup or Margin.

"However this approach does not consider your Hidden Cost."

Before I put blog readers off, if mathematics is not your thing, there is a spreadsheet near the end of the blog that you can down load to enter your numbers.

For example, Biscuit2Crumbs (B2C), produce their own biscuits (Cookies) and their Direct Cost items for a 500g Pack of Anzac biscuits include:-

Ingredients =        $1.50
Power =              $0.10
Labor =              $0.60
Packaging =          $0.20
Freight =            $0.10
Total Direct Cost =  $2.50

B2C then apply a 30% markup for a level of profit and covering other cost such as Overheads.

Price to customer = $2.50 x (1 + 30%/100%) = $3.25/pack

We'll revisit B2C shortly, but for now, lets look at the cost in your business and why your financial reports have two cost categories. (eg. 1. Cost of Goods Sold & 2. Expenses)

Your Two Cost
Direct Cost, aka Cost of Goods Sold, COGS, or Variable Cost are costs that change in proportion with goods or service that your business produces. So if you sell twice as much, you can expect your Direct Cost to double. These Direct Cost are only associated with the production or provision of a service. (Raw material or products, Labor, Subcontractors, Freight and other direct cost) In effect, no production or supply means no Direct Cost.

Overheads, aka Expenses, Direct Cost or Operating Expenses is the other cost in your business. These cost are ongoing expenses to keep your business doors open. (Rent, Electricity, Insurance, Phone, Marketing, Accounting Fees, Interest, Repairs, Travel, Admin and Management Personnel and other indirect labor and cost)
With these two cost categories separated you are now able to determine the hidden cost of Overheads in your business as a ratio to sales. Knowing this enables you to determine the true cost of your products or services and what your price tag should read.

Back to B2C
Last financial year they turned over $500,000 in Sales. It's Overheads $150,000 for the same period.
The first calculation is the Overheads (O) to Sales (S) Ratio (R). 

R = O/S = $150,000 / $500,000
R = 0.3

This indicates that for ever dollar of income, B2C have $0.30 cost attributed to Overheads and $0.70 to cover Direct Cost and Profit.

Based on a Price of $3.25/Pack of biscuits, B2C has a $0.98 overhead cost. When we add the Direct Cost of $2.50 onto Overheads, the total cost to $3.48 to break-even. So in effect B2C is making a lost of $0.23/Pack of biscuits. However the real story is even worse when we used the correctly calculated Price below.

The Solution - Pricing with Overheads.
The Calculation method below can be easily added to a spread sheet or you can download our Pricing Spreadsheet if the maths if not your thing.

You can also use this method to calculate your hourly rates. Just remember your on cost with staff are superannuation, payroll tax for larger businesses, leave, leave loading etc and an efficiency factor. 
Say $60,000 pa income before PAYG, * 1.095 for super (9.5%) * 1 / 0.85 for ~efficiency (85%) / 1650 *billable hours per year = $46.85 / hour cost.


P = Price of item.
C = All cost associated with the supply of the item.
X = Overheads Cost based on Price
R = Ratio of annual Overheads to annual Sales. = O/S

Basically your Lowest Cost Price Tag should be the sum of all Direct Cost plus Overheads. So we can express this as:- 

P = C + X 

However X is the Overheads ratio of the Price or X = P.R (Same as P x R A dot "." means to multiply)

Therefore the X in "P = C + X" is replaced with P.R so we can now express this as:-

P = C + P.R (We need to get the two P's on the same side of equation)
P - P.R = C (Now simplify for P)
P(1 - R) = C (Now divide each side by (1 - R))
P = C / (1 - R)

Now lets put it to work.

B2C Break-Even Price or At Cost Price)

Annual Sales = $500,000
Annual Overheads = $150,000

R = $150,000 / $500,000
R = 0.3

The Direct Cost to produce the pack of biscuits. (See Above)

C = $2.50

Therefore the Break-even Price equals

P = C / (1 - R)
P = $2.50 / (1-0.3)
P = $3.57 (Yep! Well over the current sale price of $3.25)

With A Profit Margin

Add your profit margin to your price.

Assuming a 10% profit margin is required (M = 10%/100% = 0.1)

Revised Price (P) to include profit margin

Pp = P / (1 - M)
P = $3.57 / (1-0.1)
P = $3.96

What do you think B2C should do.... Keep the sales price at $3.25 or revise to $3.96.

"Hmmm, but what about competition and being priced out of the market?"
A very valid question and here is my take on it.

You could reduce your Overheads, however you are most likely running lean already. The secret is to ramp up sales. In doing so, your Overheads to Sales ratio will rapidly reduce to maintain a competitive price.

Download Pricing Spreadsheet, Click Here

Calculating Billable Hours
How many hours should you consider as billable hours.

This is a given, that there are 
  • 52 weeks per year
  • 4 weeks a year for annual leave
  • 2 weeks a year for sick leave (Yep, your staff will use them.)
  • 1 week a year for public holidays give or take a little
So thats 45 billable weeks a year.

Assuming your team works a 37 hour week that means your billable hours are 1665 per year. Round it down to 1650 and that covers long service leave. Many businesses use 1600 as well.

Staff Efficiency
Your staff are not 100% efficient. Fatigue, rest room breaks, coffee breaks etc all come into play. The level efficiency will change depending on the work and the environment. The the example above we used a typical office at 85% efficiency.