How Much Should I Pay Myself?
By Dave Costello, TCV Growth Partner -
I’m currently reading an interesting book called The Richest Man in Babylon. It was first published in 1926 and was written by George S. Clason. It is really a book about the accumulation of wealth and the process by which we can all make that happen. What is amazing to me is that the concepts that Mr. Clason wrote about in 1926 are still the concepts that are used today by people to accumulate wealth! Shows you that certain processes are timeless!
What caught my attention in the book is that his first lesson in the accumulation of wealth is to pay yourself. As the author wrote in the terminology of Babylon, for each ten coins you put in your purse spend but nine! In other words, don’t spend any more than 90% of what you earn; the other 10% is what you pay yourself. Good advice then and good advice now!
How this corresponds to running your business in my mind relates to the performance of your company and how you price your products or services. Here’s an easy example of how to think about this. If you are a house painter and a customer asks you to paint their house, and you determine that the cost of the paint would be $1,000, would you charge that customer $1,000 to paint the house? Certainly not! Charging $1,000 would cover the cost of the paint but it would not pay the painter for any additional supplies or equipment needed and more importantly for the time spent in painting the house.
So why would you do this in your business? Do you think you are adequately pricing your products/services?
I know that pricing is difficult since I see that in my own consulting business. So how do you address the question? What information do you need to begin to help you in pricing your products/services?
In my mind it starts with good accounting records. You need to have a good idea of what it costs you to build that product you are selling or provide that service you deliver. But this is only the starting point. Its pretty easy to understand that you have employees you are paying and likely some employee benefits you are providing like payroll taxes, health care or retirement benefits. Beyond that you have office space you are renting and supplying, insurance you are paying, utilities to keep the lights on, vendors you are buying raw materials, inventory or other items that are part of the products/services you are selling/providing, professional fees such as accounting, law, marketing, etc., etc., etc. All of these costs should be recorded in your accounting system and become components of the COST of providing the products/services that you sell.
Is that the end? Sorry, there’s more.
Your accounting records should be able to tell you the breakdown of Cost of Goods Sold (COGS) and Selling, General & Administrative (SG&A) expenses. COGS are the direct costs of making your product for sale or producing the service you provide. It’s not always easy to get this breakdown I know. Sometimes you must make assumptions for allocations, and those assumptions may not always be accurate. But better to make the assumptions and the effort to properly allocate costs.
What is not included in COGS is essentially overhead or SG&A. These are the costs for running the business outside of the costs of making your product. These are costs that you can’t eliminate.
So now you know your costs to produce, and you know your overhead costs. All you have to do is divide by the number of products you produce, or the hours spent to provide the service you sell and that’s your pricing, right?
Maybe. Not likely, though. We could also answer “it depends”. And what about a profit that results in a return to the owner/s?
I’ve seen owners who take a salary from the business that is lower than they deserve. Maybe that’s OK if there is enough profit in the business at the end of the day that makes the owners total compensation sufficient. But what happens if profits are marginal AND you are taking a lower salary than you deserve. In my opinion that’s not providing adequate compensation for the effort the owner is putting in. And what if you have other investors you need to provide a return on their investment using the profits generated? No one ends up being happy in this case.
Another question I have is are you charging enough for your products/services? The marketplace for your products/services would help you understand that and it’s a very competitive marketplace. This could be termed “market-based pricing” where you charge what is typical in the market. It’s possible your strategy is to be a low-cost producer expecting that you would sell more items since your price is lower. But if that’s not generating sufficient profits is that working? Or is it a matter of not marketing properly or you have untrained salespeople not hustling? Or is the market telling you there are too many inefficiencies in your operations if you are charging a market rate? Hard to know for sure, but experienced businesspeople like my partners with TCV Growth Partners would be happy to have a conversation to see if we could help.
So, back to The Richest Man in Babylon. Remember that the start of accumulating wealth is to keep one coin for every ten that you generate in sales. In thinking about that, are you paying yourself enough? Put another way, is your business generating the kind of performance that adequately compensates you, the owner, for your efforts? If you are unsure let’s have a conversation. You can reach me at email@example.com.