Setting prices is an interesting game, because pricing is a system with a number of different constraints, only some of which you have any control over. You can’t control what your competitors are doing, how healthy the local economy is, or any of that stuff. But you do have some control over your costs. That’s why it’s so important to understand your unit economics when setting prices, to ensure that each client you work with is profitable for your business.
Even if you’re using a heuristic like 2.5x operating cost, you should verify that this makes sense for your business, and for each of your customers. Because chances are, not all of your customers are profitable at 2.5x or any other methodology that only takes into account operating costs.
That’s because there’s other costs associated with your clients. Those are hidden costs, and they’re hidden because they don’t sit in the operating part of the income statement. Instead, they’re tucked away into other parts of your financials.
But when you’re thinking about your unit economics, it makes sense to understand the total cost of servicing a client, not just the operating cost.
You might just find that some customers are less profitable than you thought they were. And some might be outright unprofitable, and in need of a price adjustment.
Let’s dig into these hidden costs now.
The financing cost: you are lending your clients money
Every unpaid invoice is a loan you’ve extended. You did the work, you covered the payroll and the license fees, and now you’re carrying the balance until your client gets around to paying.
Here’s the version that makes it concrete. Say you have $100,000 in accounts receivable and a $150,000 balance on your line of credit at 8%. That’s $12,000 a year in interest expense. But look at the relationship between those two numbers. If your clients paid what they owed, your line of credit balance would be $50,000, not $150,000. You are borrowing from the bank to lend to your clients, and $8,000 of that annual interest expense exists purely because of the lag between doing the work and getting paid.
Interest expense sits below operating expenses on the income statement. It’s disconnected from the customers who caused it, so it never makes it into anyone’s pricing model. But you know exactly how much each client is borrowing from you, and for how long. That means you can allocate the cost, and if you can allocate it, you should be pricing for it.
There’s a second layer here that’s worth naming: you’re taking on default risk. You aren’t going to collect 100% of your A/R. Banks accept default risk and price for it by charging higher-risk borrowers more. You are not a bank. You aren’t in the business of lending, and you certainly aren’t being compensated for the risk.
The opportunity cost: what that money could have been doing
The financing cost is what the money costs you. The opportunity cost is what you gave up by not having it.
Ask yourself a simple question: if the number in accounts receivable were sitting in cash instead, what would you do with it?
Hire the tech you’ve been putting off? Buy the tooling that removes ten hours of manual work a week? Fund the marketing that’s been perpetually next quarter? (As a marketer, I’m telling you that this is the correct answer).
You’d do something with it, and that something have a return. If your business typically returns 10% on capital you put back into it, then $100,000 sitting in A/R for a year is $10,000 of return you didn’t earn — roughly $833 for every month it sits there. Opportunity cost is what you forgo when you choose one investment over another. Financing your clients’ working capital is a choice, and it’s competing directly with investing in your own business.
Adding it up
Operating costs plus financing costs plus opportunity cost equals the true cost of a customer.
Run that math and some clients look different than they did. A customer at a 5% margin on operating costs alone can land at zero, or below it, once you account for the fact that they pay 45 days late every single month. That’s not a bad customer, necessarily. It’s a mispriced one, and you can’t fix a pricing problem you can’t see.
If you want to wrangle in these hidden costs, the easiest starting point is to understand them. That’s one of the things Benji Pays can help you with.
Talk us to us to learn more.
