How do you know what to charge for your services? Accurately pricing labor is not easy, but it can be the difference between losing money and being very profitable. These are the most common approaches rental companies take when setting their prices:
- Cost Based: figure out how much it cost you and mark it up.
- Customer Based: Also called value based pricing, you set the price based on what you customer thinks your service is worth.
- Competitor Based: determine the price based on what your competitor’s are charging.
The best approach for pricing labor is going to be a combination of all three. No matter what method you choose, you must know what your labor costs you to make sure you aren’t losing money. This is complicated because the people that work at a rental company do so many different things from counting inventory to interacting with customers. It’s not like a factory worker that makes a set hourly wage and does the same thing over and over again. Every order and every day is different making it difficult to determine your true costs.
There are two types of costs:
- Fixed Costs: you pay these regardless of how many orders you have. Examples of fixed labor costs are things like manager’s salaries, guaranteed hours to employees and employee benefits.
- Variable Costs: these increase with the number of orders you have. Examples of variable labor costs are time to prep orders, time to deliver and labor to set up or tear down for customers.
Your labor costs are mixed: a portion of the costs are fixed (you pay them even if you have zero orders) and a portion of the labor costs are variable (they increase with the more orders you process).
To figure out your cost, the first thing you need to do is distinguish between fixed and variable costs.
You can look at your historical data and used one of two methods to figure out how much of your total costs are fixed versus what percentage is variable. (Note: these methods only work within a relevant range. If you scale from a $1 million company to a $10 million company, the cost behavior will change.)
- High Low Method – super easy but not as accurate. This method only uses 2 of your data points (the highest and the lowest) to separate costs into fixed and variable components.
- Linear Regression Method – as you may guess, this one is harder to figure out but it is more accurate. This method uses all of your data points to separate costs into fixed and variable components.
I’m not going to go into great detail about how to do the math behind these methods, but I’ve created a spreadsheet that will do it all for you. I also put notes on the spreadsheet so you can understand how the numbers are calculated.
Let’s look at High Low Method first.
- To start, gather your labor data costs – I recommend at least 12 months (the more data the better but don’t go back so far that the costs aren’t accurate since labor costs increase over time). Next figure out how many orders you processed for each month of data. Here is completely fictitious data for us to use:
Month # of Orders Delivered Labor Costs Jan 100 $9,000 Feb 70 $7,500 Mar 150 $14,000 Apr 120 $8,500 May 130 $12,500 Jun 110 $9,000 Jul 90 $7,500 Aug 140 $12,000 Sep 160 $10,500 Oct 170 $15,000 Nov 115 $8,200 Dec 80 $7,000 - Looking at the highest costs and the lowest costs months, calculate your variable costs. The difference between your low cost month and your high cost month is all variable cost. The variable cost increase was $7500 and it took 100 units to create that cost
- To determine fixed costs, we can take the total costs at the high level (or the low level), which in our case is $15,000 and deduct the variable cost element ($75 in variable costs * 170 orders = $12,750). What is left are the fixed costs, which is $2,250. Again, this spreadsheet will do it for you.
In the high low method, we used 2 data points (ignoring the other data) to create a line and find the rise over the run and estimate our costs. Since the method relies on two extreme data points, it may not accurately reflect your business model. For example, if your high and low numbers are outliers and not indicative of your normal business activity then the analysis will not be useful (garbage in = garbage out). If you want a more accurate representation of your data, you can use the Linear Regression method, which will use all of your data points to find the best fit line.
Linear Regression Method (technical name is Simple Ordinary Least Squares (OLS) Regression)
Linear Regression will help you figure out your fixed and variable costs based on ALL of your data points (not just the highs and lows). The good news is that no math is involved: excel and Google sheets will do all the work for you. What matters for pricing decisions is interpreting the output. I’ve set the formulas up in Google sheets since it’s free and everyone can access, but the linear regression tools in Excel are more robust. If you prefer Excel, follow the instructions here.
Google sheets, however, does have sufficient information. Use the second tab in this spreadsheet, titled Linear Regression Method to run a regression on your data. Just replace the fictitious data in the sheet with you data, and the sheet will auto-populate for you.
Using the same data we used in the example above, here is the scatter graph with the best fit line:
3 numbers to look at on your regression model:
1. R-squared (R2) Value – At the top of the line graph area, you will see an R-squared (R2) value. This is the statistical measure of how accurate the model is. In our model it measures how well the number of orders delivered explains the labor cost. So, if the R2 value is .748, that means that number of orders 74.8% accurate when forecasting labor costs. The closer you get to 100%, the more accurate the model is. If R2 is 0 that means that the number of orders doesn’t affect cost at all.
2. The Intercept = the Fixed Cost Estimate – The intercept is the expected total cost when x equals 0. In our case, it is the expected total costs when we have zero orders. Fixed costs is calculated for you on this spreadsheet.
3. The Slope of the Line = the Variable Costs Per Unit – Slope is the steepness of the line and it explains how much the total costs change as the number of orders change. Variable costs is calculated for you on this spreadsheet.
With the high low method, you can only use one variable, but the great thing about the linear regression method is that you can use multiple variables, which makes it much more powerful. For example, if you want to determine fixed and variable costs based on number of orders AND the month of the year, you can do that. (This would be great to determine if you should charge different rates for different seasons). If you want to use multiple variables, I recommend using Excel over Google Sheets; you can follow the instructions here.
You can easily try both methods using this spreadsheet that will do all of the math for you. Enter your data, and it will tell you fixed versus variable cost. Open the spreadsheet then Go to File – Make a Copy. Then enter all of your data and it is only viewable to you.
Now that you have you have distinguished between fixed and variable costs, you can do a Break Even Analysis.
The break even section of the spreadsheet will show you how many units you need to sell to cover your fixed costs. Contribution Margin is how much you make on each order after you cover your variable costs. For example, if you charge $100 for your labor, and your variable costs are $75 then your contribution margin is $25.
You hit your break even point when you do enough orders to cover your fixed costs. In our high low example, our fixed costs are $2250. If the contribution margin is $25, then it will take 90 orders to break even (90 x $25 = $2250). If you have more than 90 orders, you will profit $25 per order since you have cover all of your fixed costs with 90 orders. Knowing your contribution margin is the secret sauce to profitability.
Now back to where we started: pricing labor…how much should rental companies charge for your labor?
Here are the most common pricing methods again:
- Cost Based: You really understand your costs now, and you know your break even point. You can use the cost based approach and add in profit.
- Customer Based: set the price based on what you customer’s are willing to pay.
- Competitor Based: determine the price based on what your competitor’s are charging. You can set prices lower than competitors to win more business; higher than competitors to be more profitable; or right in line with competitors so that price is neither an incentive or deterrent to doing business with you.
As I mentioned before, the best approach is a combination of all three pricing methods. You know your costs; now, it’s time to add in your knowledge of the market. Here are some common pricing strategies in the rental industry that combine more than one method:
- With Penetration Pricing, you set your price lower than competitors to win market share. Note: this is usually a temporary strategy as it is not sustainable long term. I’ve seen new rental companies do this when they enter a market. This allows them to win customers away from more established competitors.
- With Premium Pricing, you set your prices higher than your competitors. You are in essence saying “we charge more because we offer more value.” This once can be hard to do if there isn’t something you offer that really sets you apart. I’ve seen this strategy used when rental companies offer event styling services to help clients select which rentals are needed to create a desired look. They may even offer to help design the layout and determine the placement of the rentals. They can charge more for this white gloved service, and customers will pay it (especially for weddings).
- With the Loss Leader Approach, you could set your prices below your costs for certain items. Grocery stores use this all the time. They will advertise an item on sell that is below their costs (and lower than competitors) to get you in the store because they will know you will purchase many other items and overall they will be profitable. I’ve seen rental companies advertise low-priced tents but charge high delivery and set up fees so that overall they have an acceptable profit margin.
- If you are offering a service that none of your competitors offer yet, you can use a Skimming Strategy. With this approach, you charge a very high price until competitors enter the market. The idea is to maximize profit until you have to start competing. Rental companies also use this strategy during busy seasons when there is not enough supply to meet the demand levels.
- Economy Pricing is setting a low profit margin and hoping you will make up the profit with volume. Your labor will not be a big profit center for you, but if you know your costs, you won’t lose money either. This is probably the most common approach in the rental industry, but it is essential that you know and cover your costs. With a low profit margin, there is not a lot of room to make an error.
- Simplicity Pricing (what I call it) is by far by favorite as a consumer. This is why Amazon rules retail – their Prime model is simple and rewards loyalty. They have built delivery fees into the price of the products so I’m not disappointed when I go to checkout. How many times have you abandoned a cart when you saw how much the shipping would be? Since there are so many variables with delivery of rentals, it is hard to just build all the fees into the price, but I’ve seen this strategy work successfully when rental companies provide free standard delivery on a minimum size order (for example, free delivery with orders over $500). This is also very common when a company has a narrow product variety and focus on a certain type of rentals (inflatables, margarita machines, games, etc).
Using the spreadsheet, play with the price you charge for labor and see how it affects your break even point. Note: click File – Make A Copy on the spreadsheet so you can manipulate the data to fit your needs. You may choose to make changes such as using Total Labor Hours Billed instead of Number of Orders Shipped, which will help you determine what your hourly rate should be.
Segmenting Out Your Costs
To get accurate costs, you need to do this exercise for each segment of your business. For labor in rental companies, I would break it down as follows:
- Pickup orders (the cost of preparing orders should be built into the rental price)
- Delivery orders
- Delivery orders that include set up
You could continue to segment out delivery orders with multiple items versus delivery orders with one item. Or delivery orders with labor for tents versus labor for chair setup. The more defined your segments are, the more accurate your analysis will be.
Set a Price + Analyze + Test + Adjust + Repeat
The key to building a sustainable business is to analyze, test and adjust. Don’t set a price and just forget it. Put a reminder on your calendar to do this exercise once a quarter (or at a bare minimum once a year). Use this analysis + feedback you get from customers + analysis of competitors prices to adjust your pricing strategy.
If you are a Revental’s vendor, you can always schedule time with me (just email info@reventals.com), and I’ll be happy to help you with these models and your specific needs. And if you aren’t a Revental’s vendor, contact us about becoming one!
