Small-Business Answer Book

Pricing, Paying Yourself and Lowering Taxes

Q:Pricing has always been an issue for me. How do I know when to raise or lower my prices?

A: Setting your prices too high or too low is a common problem for entrepreneurs. Set them too high, and you can lose customers to the competition. Set them too low, and your profit margin will suffer.

Pricing takes into account a number of factors, including market conditions, the target customer and the entrepreneur's own intuition. Many entre-preneurs arrive at their pricing by measuring their costs and then adding a percentage (25 percent, for example) on top. This percentage, or profit margin, is where the trouble lies.

New entrepreneurs usually start by pricing lower than the competition to gain some traction in the marketplace, but their prices can stay too low for too long. It might be time to increase prices if your competitors all charge more than you do, your profit margin is steadily shrinking due to rising operating costs, or the business doesn't have enough capital to expand even though the customer base has grown. If you're fearful about your customers' reactions to a price increase, remember that small, incremental increases are generally easier for them to accept. There are even ways to increase prices without looking like you're raising them, like ending the use of discounts, coupons and product samples. Rest assured that most customers will stick with you if they find value in your product or service.

Many people will advise against lowering prices because your company will give up too much margin. One situation where you may want to lower your prices is if you're losing valued customers who say you've gotten too expensive. Depending on your product, you may be able to improve your profit margin instead by lowering your overhead and operating costs--such as by renegotiating the prices your suppliers charge.

Q:How much should I pay myself?

A: This is a particularly tricky question. As a sole proprietor, it's your choice how much to pay yourself, and it can be tempting to pay yourself too much, especially if you're living hand-to-mouth while waiting for the business to grow.

A good rule of thumb is to pay your business costs before you pay yourself. Estimate the minimum dollar amount your company will reliably generate every month in terms of steady business, and then deduct your monthly overhead (electricity, office supplies, rent, payments to suppliers and so on). These costs must be paid before you get paid, unfortunately. Smart entrepreneurs also set a small portion of their income aside every month for annual taxes (estimating the amount is where an accountant comes in handy). The net amount left over is your monthly take-home pay.

For the first year, it's better to err on the side of caution and pay yourself less instead of more until you get a feel for your overall expenses, including surprise costs such as local business taxes and equipment purchases. As your business settles in, you can set up a 401(k) or SEP-IRA that deducts a specific amount from your business account once a month. If you already have one going, you can increase the amount that's deducted each month.

Another tip: Set up a separate checking account to keep the company's money separate from your personal money. This way you can accurately track how much you've paid yourself come tax time, and it's something the IRS likes to see.

Q:My tax burden is killing me. How can I lower my taxes?

A: As you might imagine, taxes are a big topic for business owners. Lowering your tax burden can be done, and here are a few ways to do it.

Look for additional deductions. There are many business expenses you may deduct from your overall income, including training, advertising costs, interest on business loans--the list goes on. You'll want to be careful, however, that you don't trigger an IRS audit. Your accountant can help you find hidden deductions.

Start a retirement account. Federal law allows sole proprietors to put up to 20 percent of their annual income into a retirement account such as a solo 401(k), a SEP or a Keogh. Sole proprietors who set up the company as a corporation can sock away up to one-quarter of their income. This one move will significantly lower your taxes, and it's also an important step for your personal financial solvency.

Hire family members. By spreading the income around, you can increase the amount that is taxed at lower tax brackets. Check with your accountant to make sure you do it right, and make sure family members get paid fairly.

Hire independent contractors. Hiring independent contractors instead of employees automatically lowers your payroll taxes.

Pay overhead expenses early. Your electric and phone bills might not be due until mid-January, but pay them by December 31 if your cash flow allows so these deductions can be applied to this year's taxes instead of next year's taxes.

Chris Penttila is a Washington, DC-based freelance journalist who covers workplace issues on her blog, Workplacediva.blogspot.com.

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This article was originally published in the December 2006 print edition of Entrepreneur with the headline: Small-Business Answer Book .

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