How to price your product or service so it makes a profit

Your price sits between cost price and customer value

Tom starts as a self-employed gardener. He looks at the websites of three local gardeners, sees hourly rates between €50 and €58 and picks €52 so that he looks attractive. He has not calculated what an hour actually costs him. His competitors may have a paid-off van, a partner with a salary, or be charging too little themselves. Copying their price means copying their choices without knowing whether your business can live on them.

The sections below show how to price your product or service from three anchors, how to calculate a cost price and what a discount really costs. The example uses euros; the logic works in any currency.

Why price is your strongest profit lever

In a study of the average economics of 2,463 companies, McKinsey consultants Michael Marn and Robert Rosiello found that a 1% price improvement at unchanged volume raised operating profit by 11.1% (source: Harvard Business Review, September 1992). A later McKinsey update for the average S&P 1500 company found that a 1% price rise at stable volume generated an 8% increase in operating profit, more than three times the effect of a 1% increase in volume (source: McKinsey, February 2003).

These are large listed companies, not a benchmark for start-ups. The mechanism still applies to you: the thinner your margin, the more a small price change matters. Take a business with a net margin of 5%: if it raises prices by 1% at the same volume and costs, its profit grows by a fifth.

How to price your product or service: three anchors

None of the three works alone. Use cost as the floor, value as the direction and the market as the reality check.

How to calculate your cost price

1. 01

   Direct costs per unit

   The costs that rise with every product or job: materials, packaging, shipping, payment and platform fees.

2. 02

   A share of the fixed costs

   Rent, insurance, depreciation, software and bookkeeping, spread over the volume or billable hours you realistically expect, not your maximum capacity.

3. 03

   Your own pay

   As a sole trader, the price must cover your income including tax, pension and insurance. In a company, your salary is a normal fixed cost.

4. 04

   Check the contribution margin

   Price minus direct costs is the contribution margin. Across your expected sales it must cover fixed costs, your pay and a profit. The break-even analysis shows the volume you need.

Customer value: what is your offer worth?

Customers pay for what they gain: time saved, revenue earned, lower risk or less hassle, always compared with their best alternative. Price also signals quality, so a price far below the market can make people doubt the work. A few structures help you capture value without a race to the bottom:

• Packages: two or three versions let customers compare your options instead of comparing you with a competitor. Keep each above cost price.
• Volume tiers: a lower price for larger orders is healthy only if your cost per unit really falls.
• Subscriptions: a fixed monthly fee makes revenue predictable and fills your planning in advance.

Worked example: a gardener's maintenance subscriptions

Tom expects 1,050 billable hours a year, and a typical visit takes two hours including travel.

At €52 an hour Tom would work €10 below his floor, which over 1,050 hours is €10,500 a year, about a fifth of the pay he needs. Instead of a cheaper hourly rate, he sells year-round maintenance subscriptions.

Fictitious Firmfocus example. Per hour after direct costs = (annual price - direct costs) / hours. Amounts exclude VAT.

Complete earns a little less per hour than Basic. Tom accepts that, because one large customer fills his diary without extra sales effort. He also offers a neighbour discount: when two adjoining households both take Basic, each gets €4 a month off. That costs him €96 a year, while the 20 minutes of travel he saves per visit add up to two hours, worth €124. He offers Basic to twelve households after a spring leaflet round and five sign up, which gives him €4,920 of recurring revenue and 60 planned hours before the season starts.

The maths of discounts and price increases

A discount comes straight off your contribution margin, so you need more sales to stay where you were. A price increase works the other way: you can afford to lose some customers.

Firmfocus calculation with the formulas above; discount and increase as a percentage of the old price.

Tom's Basic package has a contribution margin of 89% (€876 of €984). A 10% discount would need 12.7% more subscribers, and his earnings per hour would drop to €64.80, close to his floor, while his hours are limited. He keeps only the neighbour discount, which pays for itself.

What is not allowed: fixing prices with competitors

Every country with competition law bans agreements between competitors on prices, and the ban covers small firms and freelancers too. It includes informal understandings, discounts, surcharges and the timing of price increases.

Small start vs larger start

Three pitfalls

• Starting too low to win customers: customers who come for a low price leave for a lower one. Use a time-limited introductory offer instead of a permanently low price.
• Discounting as a habit: small concessions add up to a lower real price. Ask something in return, such as a longer contract or payment in advance.
• Forgetting costs: your own pay, unbilled hours, depreciation, payment fees and extra work. Review prices every year against rising costs.

Pricing connects to your startup capital and to how you pay yourself. The full overview is in money, pricing and income, part of Start a business. To compare your margins with your sector, use the profit and cost benchmark.