You are in college and it is the summer. You decide to paint houses to make a little pocket money. A neighbor of yours is interested. You look at his house and then figure out the cost of the paint will be $500. Would you charge him $500 to paint the house?
Please say no.
The answer is no.
Sophia is a friend of mine. She doesn’t paint houses. And she graduated college a long time ago. She recently opened up a little café located in a corporate center that provides breakfast and lunch. “We have a lot of really nice customers,” she told me. “I’m really happy with how things are going.”
Unfortunately, I don’t think her happiness will last very long.
When I looked at Sophia’s books, here’s what I found: She certainly had customers from the breakfast and lunch crowd coming in. She was paying about thirty cents on the dollar for food, which isn’t bad. The rest was covering her rent and employment expenses. But when the smoke cleared each month, one thing was missing: Sophia! There was nothing left to pay her. She’s the owner, and her café is only bringing in enough to support her employees and vendors. This is not a business— it’s a charity. This is like painting your neighbor’s house and only charging for the paint. There’s only one charity that should be getting Sophia’s money every week. And that charity is Sophia.
Is Sophia starving? No – she’s just living off the salary her husband makes from his corporate job. But if she’s not making any money from her business, then she’s wasting money – money she could be earning doing something more profitable somewhere else. Sure, Amazon and Google and all those other tech firms in Silicon Valley can drum up millions of dollars of losses in the pursuit of building “value” for their “brand.” They’ve got deep-pocketed investors to support them.
But not Sophia.
How much should Sophia charge for a tuna salad sandwich? The answer, of course, partly depends on what the market will bear. Office workers probably aren’t going to pay $20 for a tuna sandwich, no matter how good it is. But other factors go into that price. The cost of tuna. The cost of the roll. And the lettuce, tomato and relish (tuna salad is delicious with just a hint of relish). But of course those are not the only costs. Each sandwich that Sophia makes incurs overhead – a little bit of rent, the lights, the heat, the salaries of her employees. How can anyone figure out how much to charge for a tuna salad sandwich without knowing all of these costs? Smart business owners don’t just pull their prices from the air. They always start with the final, absolute cost of a product and then apply a mark-up for profit.
And yet, Sophia is ignoring one of the biggest items that make up the cost of a tuna sandwich: That would be Sophia!
So let’s put the market aside for a second and focus on the cost. If, after figuring in the costs for a normal salary, benefits and a profit margin, the price of a sandwich needs to be $1 higher, then she needs to be charging $1 more. Period.
What happens if, after figuring out the cost it turns out that she’ll need to charge $20 for a tuna sandwich? Well, it better be one good sandwich (just a reminder – relish will help). Otherwise, Sophia shouldn’t be selling tuna sandwiches. And if all her other sandwiches start coming in at much higher prices after considering her salary she might have to make some other, much harder decisions. Taking a lower salary should be her last choice, by the way. But wouldn’t you rather make these decisions now, before you’ve lost too much money?
Unfortunately, Sophia is not working with all the facts. She’s working on hope. She’s hoping that the business will grow so that it can afford her. Or that by some miracle, profits will rain down from the sky. But successful business people don’t work on hope. They work off of data. They buy for a dollar and sell for three. They don’t wildly gamble. They look coldly at the information, no matter how good or bad, and place educated bets. They are honest with themselves. And Sophia’s not being honest by excluding her salary from the overhead. If you’re not paying yourself, then you’re not working with all of the information you need to place those educated bets. You’re basically painting your neighbor’s house for free.
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View Comments (28)
Okay, now tell us how to figure out what to pay ourselves. Missed the mark by a mile.
This article didn't deliver what the title promised - unless one is a new restaurant owner. I have run my own environmental education consulting business for more than 20 years.
What I think most people don't realize are the hidden costs of being a consultant. Say I charge $100 per hour. That sounds great, on the surface. However, I will only have so many billable hours each year - a lot of can't be charged to a client. (Like billing, marketing, long-range-planning, and other basic administrative work, such as doing taxes.)
Most people don't realize that there is a self-employment tax of 7.5% - in addition to the 7.5% tax that every one pays.
As my husband and I are both self-employed, we get our health insurance through the Affordable Care Act. We're happy to have it - but for our family of four we pay $20,000 a year in premiums, plus high co-pays, for the cheapest plan available through Kaiser (the Bronze Plan). Two years in a row we spent $10,000 in co-pays - so that was $30,000 a year in medical expenses.
We also have to fund our own retirements, as we will have no pension.
Given the title, I had hoped for a more in-depth discussion of what is reasonable to pay yourself than the article delivered.
I was disappointed as I reached the end of the article. Perhaps I was expecting actual guidelines or percentages or formulas to calculate the amount to pay myself. The information is basic and somehow I feel misled by the title.
I was really hoping this was going to help me decide how much to pay myself? If someone has specific examples on what is the best amount based on taxes and reinvestment in the business, I would be very appreciative.
My business is doing well and could probably pay myself in the 6 figure range. I am trying to figure how much I should be spending on creating new business and if I should be clamping down on travel costs, etc.
Any help would be appreciated.
Very informative.
We're glad you thought so! Thanks for commenting.
First one or two year of your business, you should not worry about paying yourself. New business is like a plant. You need to give it a time to establish the roots. Once you see your business has solid roots then yes, pay yourself!
No pricing formula is perfect, especially when starting out in the food industry. If it was simple everyone would be doing it.
A menu is a variety of items, where each item will likely carry a different profit margin. Being competitive is a priority consideration in a start up. You first need to appreciate your selling nuance that’ll be a factor in acquiring customers.
Will it be value via quality, quantity or presentation? Each will affect a different demographic customer base and ultimately effect sales volume. That volume will affect how you distribute your overhead and pricing.
I’ve known clients who had daily loss leaders but usually made their profits balance with the add ons to the overall sale. Until you know what you’re selling, setting a formula for profit is initially a hit or miss equation. Do it wrong at the onset and you’re likely to undermine the foundation necessary to build upon.
Salary is an attribute of a successful formula built on the experience of building a successful business. An initial minimum wage is part of the investment into a new business. An ‘ongoing’ minimum wage is part of a formula partial to failure.
Thank you for sharing, Thomas. Very informative!
I will give this to my grandson who is 14 years old. I am sure it will make sense to him.
The article is a good reminder that no matter what business you have started - don't forget to pay yourself. Doesn't matter if it's tuna sandwiches or cosmetics. Figure out what it costs to keep your doors open, then do the math - whatever that math is for your business.
Great comment, Yolanda! Thank you for sharing.
Great perspectives! Doing business today versus doing business 30 years ago is day and night. The recipe is 33% food cost, 33% labor and 33% overhead profit. This used to work however today’s reality defers. A lot of expenses sky rocket. Mandatory regulations and unexpected price hikes require overnight adjustments. Measure twice and decide accordingly! It’s getting tougher daily!
Thanks for sharing, Leo!