Pricing your Product

Pricing is much easier when you have only one product. All of the activities you undertake in your business-fixed (like a mortgage) or variable (like the price)-must be covered by the price of your one product. However, if you are producing several goods, your fixed costs must be applied proportionately to the various products according to their use.

It would be nice to have both an extensive marketing program and the lowest price. But in most cases, this just isn't feasible, and trade-offs need to be made. The money for your marketing programs must come from the consumer, so some programs may not be possible if you have low prices.

Traditionally, companies have used costs as the basis for setting prices, with no regard to the value a customer places on the product or how competitors are pricing. A market-driven company will "price on value, knowing costs."

This is known as target pricing. What you do is study the competition and your customers to identify a point where your product must be priced to be competitive. Once the target price is identified, you decide on a desired profit. You then work backward to calculate the costs at which your product must be produced to meet the profit and target price.

These calculations must take into account the target profit margin, price reductions for retailers, costs of promotion and future distribution costs. To properly calculate you company's costs, you must include current and planned activities for distribution, promotion and product development.

Pricing Strategies

Pricing strategies specify the role of price in implementing your marketing strategy. Your pricing strategies state what you want to achieve by setting a particular price. You can have several strategies; they aren't necessarily mutually exclusive.

You should determine pricing strategies for each marketing strategy you have set. And they should be consistent with the distribution and promotion strategies you have planned.

 

Marketing Strategy	Pricing Strategies
Increase overall size of the market by increasing the number of users.	Reduce economic risk. Offer low price to encourage trial. Offer better value.
Increase the overall size of the market by increasing the rate of purchase.	Increase frequency of consumption. Broaden the number of usage situations to include lower priority uses.
Increase market share through retention of customers.	Meet price competition.
Increase market share through acquisition of customers.	Undercut the competition. Offer premium price.
Introduce a line of substitutes	Encourage trade-up. Clearly differentiate quality differences in a line of substitutes.
Introduce a line of complementary products.	Expand the range of products bought by existing customers. Attract new customers through superior value.

Pricing Programs

You can arrive at your pricing strategies through various pricing programs, such as:

Penetration pricing: A low price to stimulate demand

Use this when:

• Lower prices will result in overall increased growth in the market or increased demand for your product;
• You sell higher-margin complementary products that are being pulled along with the sale of lower-priced products;
• Your company enjoys economies of scale; or
• Your competitors have high cost-structures.

Parity pricing: Setting the price near or at competitive levels and using other market variables to implement strategies

Use this when:

• Your total market volume won't grow with lower prices; or
• Your competitors can easily match any price decrease.

Premium pricing: Setting a price above competitive levels

Use this when:

• Your company can differentiate a product in terms of higher quality or special features; or
• You have little excess capacity and it's difficult for competitors to enter the industry.

Monitoring Costs

If you are offering a number of products, you can't get the information you need from a conventional profit-and-loss statement. Instead, you need to track your costs both for the company and for each product. Without product-specific information, you won't be able to tell which products are doing well and which need additional marketing support.

In order to gather all the relevant information, you have to track two types of costs:

• Variable costs: (direct costs of manufacturing): costs that are specific to the manufacturing of the particular good or service (that is, labour, raw materials and supplies); and
• Fixed costs: ongoing costs that occur whether your business is shut down for a time or in full production (for example, depreciation, insurance, taxes, selling and administration costs, and utilities).

Fixed costs can be broken down into two kinds of costs. Traceable fixed costs can be related to a product line on a non-arbitrary basis. Non-traceable fixed costs are incurred on behalf of your business as a whole and can't be assigned to a specific product line.

Contribution Analysis

Contribution analysis studies how the final selling price will contribute to fixed costs. Ideally, a product would cover all the fixed costs and contribute a net profit, but this doesn't always happen. Many products in a company's business only cover their variable costs and part of the fixed costs. You must decide if these products are worth continuing-is the product necessary to the product line?

Fixed costs exist whether you produce the product or not. Ask yourself: "Is it better to produce a product that pays for itself and part of the overhead or to do nothing (that is, not produce it) and cover none of the overhead?"

If your business has excess capacity, you would be better off keeping the products that are covering only part of the costs. However, if capacity is full, selling a product with low or negative total contribution may not be advisable. If your resources and sales are going to the low-contribution product instead of the higher ones, you aren't maximizing your profitability.

The following is an example of a table used to monitor the contribution of various product lines.

	Company Total	Product One	Product Two	Product Three	Product Four
Variable costs of goods sold	205	50	70	40	45
Gross profit margin	$915	$250	$380	$180	$105
Other variable costs	30	0	20	10	0
Variable contribution margin	$885	$250	$360	$170	$105
Traceable fixed costs:
Sales salaries	280	70	95	65	50
Manufacturing salaries	180	50	70	40	20
Packaging salaries	105	30	25	20	30
Advertising of specific product lines	115	30	50	20	15
Rent and utilities	70	20	30	15	5
Total traceable fixed cost	$750	$200	$270	$160	$120
Total contribution (see calculation)*	$135	$50	$90	$10	($15)
Non-traceable fixed costs:
Company advertising	$40	$40	$40	$40	$40
General and administrative overhead	$60	$60	$60	$60	$60
Total	$100	$100	$100	$100	$100
Net operating profit	$35	($50)	($10)	($90)	($115)

Salaries can be split according to hours spent on a product or some other reasonable basis. Rent and utilities can be split on the basis of volume allocations.

Company advertising and general and administrative overhead can't be allocated to specific products, so are non-traceable fixed costs.

Determining which products should receive additional support becomes clearer after we calculate the percentage variable contribution margin (PVCM).⁶

PVCM = selling price - variable costs / selling price.

⁶ Guiltinan,Joseph and Paul, Gordon. Marketing Management, Strategies and Programs, Fourth Edition. McGraw-Hill; Toronto, Ontario. P.226 The PVCM shows which products contribute the greatest amount to overhead and profit for each additional dollar spent to increase sales. From the above example:

From the above example:

	Company Total	Product One	Product Two	Product Three	Product Four
PVCM	0.79	0.83	0.80	0.77	0.70

Although Product Two has the highest total contribution, additional dollars should be spent on Product One because this is where the greatest gains will be enjoyed.

Setting Prices

The two important tools for setting prices are:

• break-even analysis; and
• cost-volume relationships.

Break-Even Analysis

You can use this tool for initially setting a product's price or for calculating the effects of a price change. It will help you to understand that for certain prices, you need different levels of production to break even-that is, cover all your variable and fixed costs. The break-even point is where your total revenue equals your total cost. Below break-even, you will incur losses. Above this point, you will realize profits. You should ignore "sunk" costs, such as research and development for a product. Depreciation on equipment should be used as a cost rather than deducting its full costs.

Break-Even Point = Total Fixed Costs (B) / Unit Contribution (A)

The following table shows an example of a break-even analysis for five different pricings of one product.

Unit Selling Price	$21.95	$23.95	$25.95	$27.95	$29.95
Unit Variable Cost	$7.95	$7.95	$7.95	$7.95	$7.95
Unit Contribution (A)	$14.00	$16.00	$18.00	$20.00	$22.00
Estimated Sales	27,500	$27,000	$25,000	$20,000	$18,000
Revenue	$603,625	$646,650	$648,750	$559,000	$539,100
Fixed Costs (B)	$400,000	$400,000	$400,000	$400,000	$400,000
Variable Costs	$218,625	$214,650	$198,750	$159,000	$143,100
Profit (loss)	($15,000)	$32,000	$50,000	$0	($4,000)
Break-even (units) (C)	28,571	25,000	22,222	20,000	18,182

Cost-Volume-Profit Relationships

Economies of scale measure the impact of changes in volume on fixed costs. You could find that your ability to increase the volume of output will allow you to decrease the per-unit cost.

Product 1	2000 units	4000 units
Unit Variable Cost	$40	$40
Total Variable Cost	80,000	160,000
Total Traceable Fixed Costs	240,000	240,000
Total Direct Cost	320,000	400,000
Divided by Volume	4000	8000
Average Unit Cost	$80/unit	$50/unit

Increases in volume have the greatest impact on products with high PVCM because most of the costs are fixed for these products.

The experience curve effect is where variable costs decline as volume increases. This can bring about better results when you increase the volume.

Experience curves can be due to:

• More-efficient production processes;
• Higher discounts because of greater volume of purchases; or
• Workers becoming more efficient.

Exceptions to the Pricing Rules

You should be aware of the types of deals and allowances that are generally used to support the marketing of your specific products and categories in the targeted food retail outlets: competitive research is key.

Private label products are becoming increasingly popular in grocery stores. This gives you an alternative opportunity to access the food retail market. If retail buyers want your product for store branding, they will expect you to quote a "net net" price-which doesn't include deals and allowances-with a cash discount. The retailer will typically absorb the promotional costs and listing allowances and will determine the retail pricing.

Club warehouses and stores offer foods under "everyday low pricing" schemes-a constant low product price is offered to the consumer as opposed to "high low" pricing supported by trade deals and allowances and special consumer promotions. These outlets will also expect you to quote a net price for your product..

Trade Terms

The following are some of the options that may form part of your pricing strategy.

Listing Fees

These are normally single payments made to retailers or distributors to encourage them to carry your products. The listing fee accounts for one-time set-up costs for administration, warehousing, computer listing, quality control and consumer advertising.

Listing fees are negotiable and depend primarily on the product category and potential success of the product. The more certain the retailer or distributor is that your product will be successful, the less the necessity to recapture initial set-up costs. However, if your product isn't a success, the retailer or distributor will want to recover all initial costs, including the costs of removing the failed product from store shelves and warehouses.

In addition to listing fees, you must support your product with such extras as promotional ads and store demonstrations to help get listed. The retailer will often ask for free goods when you're introducing a new product.

Most retailers don't charge listing fees for certain commodity groups, such as produce, meats, bakery and bulk items. For grocery items, fees can be as low as $200 to $300 per product or higher, depending on the product category and the retailer's policies.

Cash Discount

This is a discount offered for payment of an invoice within a specified number of days from shipment or receipt of goods. The industry standard is one percent to two percent off the invoice if paid in 10 days, or the net invoice payable in 30 days.

Discounts-Leaks and Swells

This is a general allowance that's given to offset the cost of product shrinkage or damage within cases.

Damaged Goods

Damaged product is usually returned within a certain time for compensation or sent to a reclamation centre (central warehouse). The supplier is billed via a debit note on a monthly basis.

Guaranteed Sale

If a product is risky or its potential success is questionable, the buyer will usually expect you to guarantee the sale of the product. You must agree to repurchase any unsold portion of the initial order. However, if the product is perishable-for example, produce or meat-the buyer will normally absorb the risk and take responsibility for the entire lot.

Price Protection

Market conditions might fluctuate so that the product price declines and becomes lower than the price you originally quoted. If this happens, you are expected to compensate the difference for any stock the retailer is holding.

However, if market prices increase, the buyer will expect you to give sufficient notice so that he or she can purchase some product in advance of the price increase.

Many retailers won't accept price increases in November and December, because this is their busiest time.

Product Liability Insurance

Major distributors and retailers probably won't carry food products from manufacturers that aren't insured against lawsuits if consumers were to become ill or injured after consuming their goods.

Deals and Allowances

You can use promotional deals and allowances to encourage retailers to list and sell more of your products. These tools also help maintain a sufficient turnover of your product so that it doesn't get delisted due to poor sales.

Deals and allowances alone won't move additional product, but they will motivate buyers to list or promote your product over another and pass savings on to consumers through lower retail prices. Deals and allowances are usually negotiable, depending on the product categories and potential success of a new product.

Often suppliers will offer the same deals and allowances to all retailers and distributors on a net basis. Published deals are common, where every retailer and distributor is offered the same allowance for the same period.

Note: Although most distributors and retailers pass on deals and allowances to be reflected in the final price to the shopper, this isn't always the case. You may be able to recommend the ultimate retail price, but you can't control it. You can negotiate with the distributor or retailer to gain some influence in the final price, but ultimately it is the retailer's decision. That's why they call it the "manufacturer's suggested retail price.”

Co-operative Advertising

You pay a percentage of the invoice price to the retailer or distributor to cover some of the costs for advertising the product in newspaper ads, flyers, etc. Generally two percent to five percent of the invoice value is used for co-op advertising. However, this percentage can vary from as little as one percent to as much as 15 percent, depending on the product category.

Manufacturers normally "purchase" a package promotion at various times throughout the year to meet their advertising needs. These promotional packages and ad costs are set once a year and listed by retailers for suppliers.

Most retailers book ads up to six months in advance.

The promotional package prices are often negotiable, but only once the product is in the store.

It's important to keep in mind that these co-op advertising funds alone won't pay for retail ads. Additional funds will be needed to cover ad costs.

Suppliers of produce, fresh meats and bulk foods usually don't pay for co-op advertising. However, they are expected to offer deals or off-invoice allowances to retailers to lower product prices during consumer promotions.

Promotional or Off-Invoice Allowance

This is normally a dollars-off-per-case allowance, which lowers the regular cost of the product to the retailer and offers savings to the shopper. Suppliers usually offer this allowance three to four times a year.

In general, the trade expects a 10-percent allowance for a minimum of four weeks. When you offer the allowance, give the retailer a minimum of eight weeks lead time.

Many retailers purchase 80 percent to 90 percent of their products on deals over the course of a year. In most cases, the allowance is used in conjunction with other merchandising vehicles-such as co-op advertising-to achieve in-store merchandising objectives. A retailer won't buy and advertise an item if it doesn't have an off-invoice allowance.

Ad Cost/Bill-Back

This is an allowance that supplements costs for such retail advertising as co-operative advertising, flyers, newspaper ads, point-of-sale material and media (radio or TV) within a store group.

Display Allowance

This allowance encourages in-store display activity and is paid to the retailer for all cases ordered and displayed during a specified time. Payment is usually by a separate cheque following proof of performance by the retailer.

Inventory Deal Allowances of Free Goods

It's good business for you to offer incentives that will encourage retailers to carry your products for the first time. Incentives may include one case free for each store or a case allowance for a certain period-for example, 60 days-after an initial order.

Free Goods

"One free with 10" means order 11 cases, pay for 10. "One free with three" means order four cases, pay for three, etc. To calculate your actual cost, multiply the number of cases you're paying for by the price per case. Then divide that figure by the number of cases ordered. For example:

One free with 10 at $10.75 per case: 10 x $10.75 = $100.75 $100.75 divided by 11 = $9.77 per case actual cost

Here's an easy reference to see what free goods are worth expressed as a percentage. (The percentages below are rounded off to the nearest 10th):

• 1 free with 2 = 33.3%
• 1 free with 3 = 25%
• 1 free with 5 = 16.7%
• 1 free with 10 = 9.1%
• 1 free with 12 = 7.7%
• 1 free with 20 = 4.7%
• 1 free with 25 = 3.8%

Volume Rebates

Volume rebates, usually one percent to five percent, are based on a percentage of the invoice price paid to the distributor. The volume rebate increases on an incremental increase in sales. The objective is to encourage the distributor to move additional cases over a given period. At the end of this period-for example, one year-an adjustment is made on the final payment to reflect the actual cases purchased. This is a retail performance incentive.

Volume rebates, once offered to a retailer, are often difficult to withdraw. Before offering them, you should determine if your competitors are doing so, because rebates aren't offered for all product categories.

Over and Above

On occasion, suppliers may offer allowances-for example, lump sum payments or per-case rebates-"over and above" the originally negotiated arrangements with retailers. This is done to strengthen promotions, clear out inventory at retailer warehouses or possibly when launching a new product.

Note that retailers welcome "over and aboves," but may expect such deals on a consistent basis. You should negotiate "over and aboves" annually, and the activity provided by the retailer in return for the allowance should be determined in advance of payment.

You might also want to request confirmation that a particular deal or discount was passed on to the consumer. Ask if the retailer is willing to provide proof of performance, such as a copy of newspaper advertising or pictures of large or end displays. This material will be useful when you're selling to other retailers or promoting your products to independent stores.

Truckload Allowance/Minimum Delivery Size

You may wish to offer a purchaser a discount for taking an entire truckload of product. For example, you could offer $1,000 off a 45,000-pound truckload, worked through to a per-case saving that will vary depending on the weight of the case.

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