or…. How long is a piece of string?

I got to thinking the other day about that piece of string. You know, the one everyone’s heard of but nobody seems to know how long it is.

I wondered what it was about that piece of string which set it apart. Because every piece of string I’ve ever seen has a quite definite length. It might stretch a bit here and there, it’s easily tangled – but give or take a few millimetres, it doesn’t take rocket science to determine its length.

Just hold that strand of thought while I segue to a familiar business situation to which the string metaphor is so often (and infuriatingly) applied. How do I set my selling prices? “How long is a piece of string?” Or worse…”The market will decide.”

The first and most important thing to say is that this string has a quite definite length. And the only thing the market will decide is whether you got your measurements right.

In simple terms your selling price is your cost price plus a margin to cover both the cost of running your business and your profit. The profit is the jam in your sandwich – the slack in your piece of string. The lower you can get your costs and the higher you can get your selling price, the more jam you will have and the more string to play around with. The converse is also true. If your costs are too high you may find all the jam squeezed out of your sandwich and your string so tight it could snap.

Determine your costs

The costs are simple enough to calculate. Direct costs are the raw materials or stock you buy in plus the labour you employ to turn that into a saleable product. In a service company the cost of staff directly involved in providing the service are a direct cost. Indirect costs are typically the business overheads – rents rate, insurance, advertising and management salaries.

While you’re calculating the costs, don’t forget to build in what some accountants call “opportunity cost” – that’s the cost of not doing something else.

In a small business that might include the fact that you could get a job. Choosing to run your own operation costs you the salary and benefits you would otherwise be receiving from an employer. Or, instead of investing your capital in plant and machinery, you could invest it elsewhere and generate a guaranteed return. There are other opportunity costs too. Maybe you and your spouse are so tied up in the business you need to pay for domestic help or for repairs or gardening which you would otherwise have done yourself.

Calculate your base price

Once you have got to grips with the costs you can calculate your base price. This is a set of numbers which must become engraved on your soul for it is the axis upon which your business will turn.

For a product it’s determined by the margin you would have to charge to cover your costs for a fixed volume of sales. This volume is your best estimate of what you can expect to sell in a year.

In a service business, the base price is total costs divided by the volume of service you can provide. Volumes can be based on the number of employees multiplied by the number of working hours available, less at least 20% for sickness, holiday leave, public holidays, training courses, slack time and so on.

What are your profit drivers?

But, what is your customer really buying? Before you finally set your prices, determine what the profit drivers are for your business. Price is rarely the only factor in a sale. Even with a commodity product, customers will pay more for pre-sales advice, speed of delivery, installation, after sales support – everything that helps to build reassurance in the customer’s mind that he has made the right decision.

If you are selling a service you have a bit more room to cut some slack in your string, but there will be a market price, whether you are offering a haircut or a health and safety audit.

You can buy a ball of string at your corner shop or at the supermarket but you wouldn’t expect to pay the same price. The market will stand higher prices at the corner shop because it offers the convenience of proximity to its local community and other benefits, which might include a Post Office counter, 7/11 opening hours and even less tangible benefits such as its role as a social hub. The supermarket, on the other hand, is almost totally driven by price competition, so will focus on driving its purchase costs down to create some slack in their string. They will also try to add value to the sale of commodity products by adding less price-sensitive items to their portfolio – insurance, travel, credit cards, loans, etc.

Start with research to find out what your competitors are offering and what they charge. Don’t just focus on price but the totality of their offers – service, delivery, guarantees etc. And review your internal processes to see where you can add value yourself without adding to your costs. Also do some qualitative research to better understand your customers’ needs.

Just remember that when you set your prices, there should be two winners – your customer who gets great value for money and your business, which makes a great profit.

And, as for that piece of string, I suggest we let the market decide how long it is.