Matching Your Passions With Profits:
First Steps To A Profitable Pricing Strategy
As part of the Tru Vue® Retail Makeover, winner Sheri Wright sat down with Ken Baur, makeover consultant and president of KB Consulting, to review the financial side of Sheri’s business at her shop Fourth Corner Frames and Gallery in Bellingham, WA. Ken’s work with Sheri inspired, Matching Your Passions with Profits, a series of articles with advice on how to improve profitability and create a sustainable business that enables custom framers to keep doing what they love.
One of the biggest challenges of running a small business is determining how much to charge for your products and services. Most small business owners become entrepreneurs because they have a passion for what they are selling, not because they necessarily like to work with numbers. But correct pricing is a critical part of being successful in any business.
In my experience, I have seen that many shops don’t make the money they should to maintain profitability that allows for long-term sustainable growth and success. This is because many custom framers do not analyze their total business cost incurred for their framing projects and thus fail to price them profitably.
During the Tru Vue® Retail Makeover at Fourth Corner Frames, I had the chance to discuss with Sheri how to look at costs when determining pricing and the steps to take to customize pricing for your unique business. Please be aware that a pricing strategy which maximizes profit for a custom framing operation involves many additional factors beyond what will be discussed in this post. This is the beginning of our pricing educational series, and we will cover the basics as we begin the journey of matching your passions with profits.
There are two critical steps you must take to ensure you have a profitable pricing strategy for your frame shop.
Determine the total cost of producing framing projects
The fundamental principle of proper pricing involves knowing the exact costs associated with operating your individual company. No two companies have the same rent, utilities or labor, which means that no two companies should have the exact same pricing if they are trying to maximize profit.
As you can see, Shop A and Shop B have different cost structures. Shop A is in a remote area so they have a higher Cost of Goods Sold stemming from delivery costs, but lower Operational Expenses because of lower rent and fewer employees. Shop B is different as they are in a large metro area; therefore their Operational Expenses are higher based on the cost of living in their area i.e. greater rent and wages. As a result these two shops should have different pricing.
There are two basic categories of costs to running any business:
- Cost of Goods Sold (COGS), which is the cost of buying the materials used to create the products you sell. It includes the cost of all the materials you buy and the cost of getting them delivered to you.
- Operational Expenses, which includes all the costs associated with running the business — rent, utilities labor, etc. To find all the operational costs for your particular business, you can look at last year’s tax return, and the profit and loss statement prepared by your accountant. The profit and loss statement will list each expense your company had for that tax return.
Some operational costs are the same every month. These predictable expenses are called fixed costs, an example would be the lease of a retail space. Other expenses go up and down according to the amount of sales you make; a good example of this would be credit card processor fees. These changing expenses are called variable costs, and they are a bit harder to predict when you forecast upcoming expenditures.
Add a markup to your Cost of Goods Sold
Obviously, we know we can’t sell finished projects for the same price as we pay for the materials we used to make them. We know we need to markup the materials to make money, but by how much? How do we know what the right markup is to be pro table? The answer is not to use a markup that matches the prices of competing framers- why? Because they have a different cost of running their business. Remember no two companies have the same cost structure and no two companies should have the same exact pricing.
The answer also isn’t simply to use the pricing that comes with your POS system, because the designers of that system have no idea what it costs you to run your business. You need to determine the costs and then input your customized pricing based on your total costs of running your business in the system. The answer is that you must markup your materials high enough to cover the operational expenses you found on your profit and loss statement, and then add a little more to create a profit after you pay those expenses. Here is how to calculate the proper markup for framing projects:
The answer also isn’t simply to use the pricing that comes with your POS system, because the designers of that system have no idea what it costs you to run your business. You need to determine the costs and then input your customized pricing based on your total costs of running your business in the system. The answer is that you must markup your materials high enough to cover the operational expenses you found on your profit and loss statement, and then add a little more to create a profit after you pay those expenses. Here is how to calculate the proper markup for framing projects.
To earn a profit, your gross margin dollars must be greater than the total of all your operating expenses.
Shop A has $150,000 in custom framing sales / TBI (total business income), $45,000 COGS (cost of goods sold), and $110,000 in operational expenses.
Let’s calculate the Gross Margin:
$150,000 (TBI) – $45,000 (COGS) = $105,000 (GM)
In this example, the company’s operational expenses ($110,000) exceed the gross margin of $105,000 ($150,000 – $45,000). Remember, your gross margin dollars must be greater than the total of all your operating expenses. Therefore in this example, the company is losing money.
This company needs to increase its markup, as the current markup on $45,000 of materials is only producing $150,000 in sales. The company is spending $155,000 (45,000 + 110,000). This creates a loss of $5,000.
The company in this example is using a 70% markup:
Unfortunately, this is not enough. They need sales of at least $155,000 just to break even. But breaking even is not a sustainable business goal. The goal is to make a profit. Hence, they need to cover expense AND have a 10% profit (10% of sales). 10% of $155,000 is $15,500. Therefore, this company would need $170,500 in sales to make its profit goal (added $15,500-10% of $155,00). Therefore, the new markup needed to achieve $170,500 on material purchases of $45,000 would be:
So, this company would need to increase how it marks up materials by 73.6%. If they make that adjustment, they will turn a $5,000 loss into a $15,500 gain. Many of us who use POS systems relate better to multipliers instead of markup percent. In those terms the multiplier for a 70% markup is 3.3 times the cost, and the multiplier for a 74% markup is 3.9 times the cost.
How did Shop A get into this situation?
To illustrate, let’s look at Shop A’s net profit from Year 1 & Year 6. As you can see, even though in Year 6 Shop A has grown its custom framing sales by $50,000, the lack of adjusted pricing has equated to a loss of $5,000. If you recall, the Shop A owner entered the framing business because he had had a love of art but not numbers. Therefore, he did not think through the importance of accounting for expenses in the pricing.
He did utilize a POS system but only the default numbers. His margins were steadily declining because of the rise in costs of materials that were not updated for years, resulting in not enough money to even pay himself. Unless the owner analyzes his costs and reassesses his pricing the shop’s chances for survival in the long term are not good.
The topics covered in this article are the basics — the premise that pricing is most pro table when it is based on the individual operating expenses of the business. In the example in this article, we learned that this company needed a markup of 74% to achieve a 10% profit. It is important to note that if this company does any discounting, it will reduce the markup it has set to a lower amount. It’s important to know that the markup is where you set prices, and the margin is what you take to the bank after you sell something. If you reduce your markup by discounting, your margin will fall and so will your profits.