Setting the Right Price How to balance costs and profits when charging for the items you sell

Q: I want to turn my hobby of making gift baskets into a homebased business, but I don't know how much to charge for the items I sell. Should I take the cost of the materials and add a small profit? Can I charge the same price as the gift baskets sold at the mall?

A: Setting prices has always been more art than science. Set your prices too high, and you scare customers away. Set your prices too low, and you lose money on every sale. Amazingly, most business owners still set prices the old-fashioned way--by charging the same as the guy down the street.

Ask yourself the following five questions before you put your products or services on the market:

• Do you know how much it costs to produce your company's products or services? This may seem like an obvious question, but it isn't. Especially in small professional services firms, lawyers, doctors, accountants, architects and other professionals often neglect to factor in the value of their own time when it comes to pricing their services. That's why an accountant who charges fixed fees to prepare tax returns may think that he's making a ton of money during tax season, when he's actually selling his time for a fraction of his hourly rate. His practice might be far more profitable if he hired a junior-level accountant or a bookkeeper to prepare the returns so that he could spend his time on the higher-level tasks of reviewing the returns and dealing with complex tax questions.
• Do you know how much money you make on every sale? Most business owners focus on two metrics--sales and net profits--to gauge their business success. Gross margin, the ratio of gross profit to sales revenue, measures your company's efficiency in turning raw materials into income. Think of it this way: For every $1 of sales that your company takes in, how much do you have left over after paying for labor, materials and the other components involved in making your product or providing your service? If the answer is 50 cents, your gross margin is 50 percent. Remember that this does not include rent, utilities, sales and marketing costs, debt service and other general operating expenses that you need to pay to run your business day to day.
• Do you have administrative or selling costs you need to cover? Just because your company's gross margin is 50 percent or higher doesn't necessarily mean that you're making money. That's why your pricing needs to reflect your total cost of doing business, which, in many cases, can be much higher. As businesses grow, they often fail to factor in the cost of their administrative staff--the receptionist, the office manager, the customer support person, the bookkeeper, sales reps and all the other front and back office employees who keep the organization running. When you set your prices, remember that you need to pay your employees, too.
• Do you need to pay commissions to a third-party broker, reseller or sales force? If you run a restaurant or a retail store, customers walk in the door, and you don't have to worry about paying for sales leads and referrals. But that isn't true of a manufacturing or service business. Many small businesses without their own sales force rely on independent reps or agents to bring them business. Depending on the industry, these reps can charge commissions as high as 20 percent on every sale. That may not be a problem for a company that sells a product with a 50 percent gross margin, but it can be a huge problem for a company with a gross margin of only 10 percent. That's why, if you need to rely on third parties to help sell your product or service, it's important to build in enough margin to give your resellers a cut and still make a profit.
• Do you remember the last time you reviewed your company's pricing? Once a business owner goes through the painful exercise of setting prices, he generally doesn't want to do it again. After all, nobody wants to break the news that prices have gone up and risk losing a customer. That said, it's a good idea to review your pricing every quarter--especially if the price of one of your key components or labor costs have increased.

If you had trouble answering any of these questions, it's probably time for a pricing tune-up. If you've got a good relationship with your customers and a specialized product or service that the market wants and needs, you should be able to raise your prices without losing business--and build a solid financial foundation for your company's future.

Rosalind Resnick is the founder and CEO of Axxess Business Centers Inc., a storefront consulting firm for start-ups and small businesses. She is a former business and computer journalist who built her Internet marketing company, NetCreations Inc., from a two-person homebased start-up to a public company that generated $58 million in annual sales.

The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.