Pricing Strategies and Profit Margin Explained
Getting pricing and margin right is one of the things entrepreneurs struggle with most, and it’s a battle every business owner must face. Are you charging the right amount? What is the actual profit on each sale? In this article, we cover four common pricing strategies, how to calculate your profit margin, and why overheads can quietly turn a seemingly healthy business into a zero profit one.
4 Pricing Strategies for Your Business
You need a pricing strategy, and it may well be a mix of approaches. Here are the four most common, with their strengths and weaknesses:
| Strategy | How It Works | Main Weakness |
|---|---|---|
| Hourly rate | Hours multiplied by an hourly rate | Ignores the value you create and the resources you put in |
| Cost-plus | Add up your costs, then add a markup | Clients don’t care about your costs or markup |
| Value pricing | A percentage of the value you create for the client | Hardest to do and needs deep expertise |
| Fixed fee | A set fee based on experience, often a regular subscription | Heavy clients can hurt you if delivery takes more resource than expected |
Hourly Rate Pricing
The first and most common approach is to take the number of hours and multiply it by your hourly rate. It’s widely used by service-based businesses. It does give you a price, but it doesn’t take into account the value you are creating, or whether you will actually make money, because time isn’t the only input. You also need to consider what other resources the business has to put in.
That’s why this strategy is described as very simplistic. It’s a good way to start, but it doesn’t generally work well with clients, and it doesn’t normally work well from a profitability point of view either.
Cost-Plus Pricing
The second approach is to add up all the costs incurred in doing the work and then add a markup. Both this and hourly pricing are simple to do, which is a plus. The problem is that clients, whether you sell products or services, don’t care how much something cost you, and they don’t really care about your markup. They want to know whether the price they are paying is good value for them. Neither of these first two approaches communicates that value.
Value Pricing Explained
Value pricing is probably the best strategy, but it’s also one of the hardest to do. For services, it means charging a percentage of the value created. For example, if you save a client £10,000 in tax and charge a percentage of that saving, that’s value pricing. You are showing the client what the value is, and that’s the key. You can say: this is what it’s costing you, this is how much we can save you, and then work backwards to set your percentage for doing the work. Zee’s business uses value pricing for certain types of tax projects.
There are some challenges:
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- You often have to give guarantees, for example that you’ll charge less (or nothing) if you don’t achieve the result. That’s a real risk unless you’re confident in what you’re delivering.
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- Many clients will try to revert to asking how many hours you spent.
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- You need to really know your subject area to price this way.
An example of why hourly rates break down: if someone with 20 years of knowledge can save a client £100,000 in an hour, their hourly rate can’t be £100,000. Depending on the percentage they charge, it might be £20,000 or £25,000. That’s why you sometimes need to combine approaches. We use combinations of value pricing and hours multiplied by a rate, and use cost-plus occasionally, though it doesn’t cover everything.
Fixed Fee Pricing
The fourth approach, commonly used by professionals, is a fixed fee based on experience. An example is through a regular subscription-style model, with standard packages covering a fixed fee for everything included.
It has pros and cons. A client who takes up a lot of your time can hurt your margin, while clients who need less are effectively paying for more than they use, so you are spreading the exposure across clients. It’s probably the most popular model among service providers because it gives the client certainty and gives you predictable revenue. However, it can hurt you depending on how delivery goes and how many resources it takes.
Differentiation and Pricing Power
These pricing strategies apply to service businesses, but a business that sells goods faces similar questions: what can you make, and how does your offering compare with your competitors? Pricing is heavily affected by whether you have something differentiated.
GoldHouse specialises in property investment, development and land, and has spent a lot of time niching in. That is our differentiator, and it’s why we can charge more than a general accountant. The questions to ask in your own business are: do you have the expertise, is it valued, and does it add extra value for your client? Differentiation is literally the difference maker, and while it requires a lot of marketing work, it directly affects your pricing power.
How to Calculate Profit Margin
Remember: if you aren’t making a margin, you aren’t in business. Here is a quick way to think about it, using simple numbers:
| Item | Amount |
|---|---|
| Price | £100 |
| Direct costs of delivering it (cost of sales) | (£50) |
| Margin | £50 |
| Margin percentage (£50 ÷ £100) | 50% |
The bigger the margin percentage, the better.
Your Two Biggest Margin Levers
Margin improves in two ways: your cost of sales drops, or your price goes up.
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- Price is the biggest lever, which is why pricing came first in this article.
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- Cost of delivering the product or service is the second biggest lever.
If you minimise delivery costs and increase your price, you increase your margin. But this alone is only half the picture.
Why Overheads Matter
Looking at your profit and loss account, the other half of the picture is overheads: your staff, your fixed costs of doing business, your premises and so on. Many entrepreneurs struggle here because overheads are hard to allocate and so they don’t look at them closely.
The Zero Profit Trap Explained
Say your overheads, spread out per unit, average £50. Look at what happens to the earlier example:
| Item | Per Unit |
|---|---|
| Price | £100 |
| Cost of sales | (£50) |
| Average overheads | (£50) |
| Profit | £0 |
That 50% margin turns out to make zero profit. This is the area where many people get caught, because they don’t look at margin by product or by service.
Many people respond by cutting overheads, but if you only focus on cutting, your business doesn’t move forward. Sometimes you have to maintain overheads so you can invest to grow. A better approach is to:
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- Work out the average cost per unit across your business. This isn’t easy, so you may need to put your management accounts into a spreadsheet to get to the numbers.
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- Focus on your pricing and margin first. Unless your overheads are stepped, they will generally get covered over time, and that’s where you make your profit.
Profitable Business Over Compliance
Most accountants spend their time on tax and compliance, checking whether you’re making profits and whether everything is being done properly. That matters, but it isn’t the most important thing. The most important question is whether you have a profitable business. If you don’t look at pricing and margin and understand how they fit together, you don’t understand the jigsaw, and the business can collapse.
Whether you sell goods or services, this is something to review regularly, either with support from your accountant or by doing it yourself. It’s the answer to the question Zee hears most from entrepreneurs: how do I price, how do I make a margin, and is my business actually making money?
Improve Your Pricing and Margin with GoldHouse Accounting
Understanding your numbers is the foundation of a profitable business, and it goes beyond tax and compliance. At GoldHouse Accounting, our tax advisors and wealth management consultants help business owners understand their pricing, margins and overheads, so every part of the business is working towards profit. Get in touch to find out how we can help you build a more profitable business.
This article reflects Zee’s personal views and experience. Examples use simplified, illustrative figures. This is not personalised financial or tax advice, so speak to a qualified adviser about your own business.
