Do you have a Fear of Money? Conquer your Fear Episode 1:
Recently this has been a hot topic of conversation around our house. My wife and I have been discussing that there is a high degree of fear in many small businesses when it comes to how much to charge for the services that they provide.
I have heard a lot of noise, yes noise, from people about how they can’t charge higher prices for their service because others charge less. While I am a firm believer in the power of the free market and allowing competition to foster a culture of efficiency, if you charge less than what your product is worth then you are going to go out of business. I do understand that there are times when you are going to charge less, for example when you are trying to rapidly grow your market share by undercutting the competition. Here’s the point: that is not a sustainable long-term strategy for a profitable business, in particular when your service is of the low-volume, high specialisation kind.
So here is one of the easiest and most telling measures used in businesses (regardless of the size) to determine how efficient they are: The Cost-to-Income ratio (did you feel excitement as you read that?)
This is very easy to work out and it tells you a whole lot about your business, some of which is going to scare you. To work out the ratio, all you have to do is take all of your costs and divide that number by all of your income. As a practical example, a business with annual costs of R4 000 000 and an income totalling R4 900 000 (looks good to begin with) will have a ratio of 0,82 or 82%. I can hear the small business owner in the back of my head saying ‘R900 000 is quite nice’ but is it?
Consider two things:
1. Most major South African financial institutions have a heart attack in the board room if their cost-to-income ratio exceeds 0.60 or 60%
2. Most small businesses are not making a surplus of R900 000, many are making small or nothing (sobering thought)
So what does this mean practically? If you have high costs and low volumes of transactions or sales, you had better have a very good cost-to-income ratio or your business is going to close soon. If your business does 40 transactions a year with costs of R20 000 per transaction, you should be making 35-40% on top of that to maintain a healthy ratio that in reality means you can pay yourself a salary.
I hope that I have made you think about your business and what you should be making (if you have not yet done so, please take out your calculator and figure out your ratio). Use the big-business ratio as your guide and remember that the costs include salaries (yours too). Use this as a guide to understand how you should be pricing your services and if you are not, ask yourself why.
Next Instalment of do you have a Fear of money? Conquer your Fear Episode 2: The Price is the Price