Up Your Business is an exclusive GEARS Magazine feature in which I share stories, insights, and reflections about business and life. Imagine my reaction to getting the following letter from the HVAC company that repaired the air conditioner in my home last month.
Dear Mr. Tschetter,
Here at Best Price HVAC Company, we take pride in providing our customers with the best quality parts and skilled craftsmanship at the lowest possible price.
In order to do this, we need to charge enough to cover our business expenses, parts costs, employee wages, and make a reasonable profit.
Of course, because sales go up and down, there’s no way we can predict what the outcome of a month will be, and unfortunately, last month we fell short of meeting our company’s financial needs. In fact, we were about 15% short of what we needed.
Therefore, we’ve revised your previous bill covering the repairs we performed for you. We’ve adjusted the total to reflect a 15% increase to cover the shortage. The attached bill reflects that adjustment. Please remit the difference at your earliest convenience.
We want you to know that we always do our best to keep our prices as low as possible, but sometimes it just doesn’t work out at the end of the month.
We look forward to serving you in the future. Loyal customers like you are important to us.
Joe King, Owner
In golf, a do-over is called a mulligan. I guess we could call this a bill-again. If you didn’t already figure it out from the owner’s name, “Joe King” this didn’t really happen, but it illustrates the importance of price.
Lately, I’ve had a significant number of conversations with shop owners who were struggling with pricing issues. Their pricing policy is the one thing that most shop owners avoid tinkering with and many of them fear it and some ignore it until they reach a financial tipping point.
However, price is the single most important aspect of your business to manage. Manage it constantly with consistency to determine, monitor, measure, and adjust your prices in order to achieve your profit goals.
If a shop owner starts a conversation with me about price by saying, “My philosophy on pricing is (fill in the blank)”, my immediate thought is to fill in the blank with “dumb luck.” Even highly successful shop owners that set prices based on their philosophy are running on dumb luck. As casino owners know, at some point, luck runs out.
Pricing should be based on a foolproof method. Those who have a method, foolproof or not, are more likely to say, “We determine our prices by (fill in the blank).” While pricing might contain some aspect of philosophy, it needs a primary basis in a method, system or process that provides consistent results.
Without consistency in process, results are random, and it can’t be managed. As the saying goes, “If you can’t measure it, you can’t manage it.” Of course, there’s no way to manage a philosophy. Maybe that’s why philosophers are notoriously underpaid.
Pricing philosophies include things like:
- We try to be just below the dealers’ prices. What does this have to do with your business? Does it cover your costs, expenses and make a profit?
- We aren’t the cheapest or the highest in town… we try to take the middle range. So, you let your competitors set your prices! Maybe they’ll buy your business when your luck runs out – if there’s doesn’t run out first.
- We don’t care what the others charge; we just try to be fair with our customers. Maybe you should make a copy of the HVAC letter… you might need it.
- We raise our prices by about 5% to 10% every year. That’s great, but what if your prices weren’t right, to begin with? You’ll just be increasing the wrong price, likely to another wrong price.
Let’s look at the things that are essential when establishing a pricing method. Bear in mind that while the HVAC letter was a joke, its premise is spot on… due to business fluctuations, there’s no method that will be perfect 100% of the time. Constant improvement is what matters, though.
Before you can even begin to develop a price method, it’s essential that you have a financial model to measure against. Otherwise, it’s kind of like saying, “That’s a tall man over there;” but compared to what? He’s tall in a roomful of jockeys, but he’s short in a roomful of basketball players.
Your model should be patterned after what you desire your shop’s ideal financial performance to be. As you’ll see, it’s more than just pulling numbers out of the air… you’ll need to apply logic and intuition to make a model that’s both functional and doable. Of course, it involves setting sales goals, managing variable costs and expense budgets, as well as desired profit. However, it also involves understanding your historic data and ever-changing market factors.
So, where do we start? The mistake most people make is setting a sales goal first and then deducting variable costs and the budget load for overhead and other fixed expenses. Whatever is left over is profit. If that’s not enough profit, they either look for ways to increase sales, reduce costs, cut expenses, or some combination of all three. It’s like a dog chasing his tail.
What if you did the exact opposite? Start with how much profit you want to make. Next, add all your fixed expenses and overhead to that amount. You can determine all these expenses right from your checkbook or income statements. These are expenses that occur just by being open for business… whether you sell something or not. The list includes things like rent, insurance, utilities, wages, and salaries, etc. Simply add up all these items for the last 12 months.
By doing this, you’re essentially making your profit goal a line item on your list of expenses. Why shouldn’t it be considered an expense? Technically, isn’t it the amount you’re entitled to receive for your return on investment (ROI)? It’s no different than the landlord expecting to get the rent.
Now, determine how much you need to sell to cover your fixed expenses and profit plus your variable costs for things like parts, towing, sales commissions, etc. Variable costs don’t occur unless you sell and produce something. They’re normally rendered as a percentage because they vary with sales. Apply historic data along with your knowledge and intuition to determine your average variable cost percentage for the previous 12 months. This percentage is calculated by dividing the total variable costs by total sales. For example, if your sales for the past 12 months were $1,000,000 and your variable costs were $300,000, your variable cost percentage is $300,000 / $1,000,000 = 30%.
For the sake of this article, let’s assume the following to be the annual numbers for this model.
- Profit Goal = $250,000
- Overhead & Fixed Expenses = $730,000
- Historic Variable Cost Percentage = 30% of Sales
- Sales needed to cover overhead and fixed expenses of $730,000 plus Profit of $250,000 are calculated as follows: $980,000 / 70% = $1,400,000 (Note: 70% is the reciprocal of 30% which is used to answer the question, $980,000 is 70% of how much?)
So, by adding this shop’s actual overhead and fixed expenses to the profit goal, and by determining its historic average variable costs as a percentage of sales, we’ve been able to calculate the sales that are needed to produce the profit goal.
The remaining challenge is to build a pricing model that will achieve the required sales of $1,400,000. That model must incorporate the elements of consistency and constant feedback for managing prices as circumstances change throughout the year.
You’ll need to consider key factors like numbers of jobs performed annually, numbers of major jobs versus minor jobs, the production capacity of your team, market constraints, seasonal factors, and more.
In part two of this article, I’ll explain how to get the key factors you need out of your shop management software. Regardless of the software you use, these numbers should be readily available. Then you can use a specific price formula for every job you estimate – a price formula that will assure that you’re on the right track to a foolproof method instead of dumb luck.
I’ll also share several actual cases where price strategy was used to not only boost profits, but to accomplish things like: attracting an entirely new class of customers, eliminating nonprofitable jobs, reducing workload for shops that are busting at the seams with work but not making enough profit, increasing the numbers of jobs for shops that are operating below capacity, and even how price strategy can reduce operating costs.
If for any reason, you don’t feel that you can afford to wait for part two, please feel free to send me an email or give me a call. I’m happy to help you through the process for your specific shop.
About the Author
Thom Tschetter has served our industry for nearly four decades as a management and sales educator. He owned a chain of award-winning transmission centers in Washington State for over 25 years.
He calls on over 30 years of experience as a speaker, writer, business consultant, and certified arbitrator for topics for this feature column.
Thom is always eager to help you improve your business and your life. You can contact him by phone at (480) 773-3131 or e-mail to firstname.lastname@example.org.