Chapter5: Product Pricing

Pricing is perhaps the most underdeveloped skill of farm retail market managers. The technical and uncertain nature of setting prices deters many operators from assigning prices to products effectively. Knowledge of existing pricing strategies and an understanding of price-setting determinants will enable market operators to maximize profits. It takes practice, trial and error, and experience to learn these skills.

The importance of pricing is illustrated in the following example. The example shows how overpricing a product can affect revenues.

In August, sweet corn was priced at $1.50/dozen. At this price, 125 dozen ears of sweet corn were sold. Total revenue for sweet corn in August was $187.50. If the price were lower, say $1.00/dozen, 200 dozen ears of sweet corn would have sold for the period. The total revenue for sweet corn would have been $200.00, which is $12.50 higher. In essence, sweet corn was overpriced.

The next scenario shows what happens when the product is underpriced. Preventing a product from being underpriced is just as important as overpricing. For example:

In early July, sweet corn was priced at $1.50/dozen. Quantity sold was 125 dozen, for a revenue of $187.50. If the price of sweet corn were higher, say $2.00/dozen, 100 dozen would have sold, for a total revenue of $200.00. Even though less of the product was sold, the higher price compensated for the difference. In essence, the product was underpriced.

These examples are an indication of the tricky nature of price setting. They also illustrate an important concept: Items can be overpriced as well as underpriced. Often, the relationship between price and amount sold is not known. There are factors that help to indicate the possible relationship between the price and quantity sold. Familiarity with these factors will help managers run a successful operation.

Costs

If the goal is to maximize profits, items cannot be sold for less than they cost to buy or produce. Using wholesale values is an easy way to determine the cost of an item. However, this does not give the true cost of the item; thus, several additional expenses involved in marketing must be incorporated. Operational expenses such as wages, taxes, utilities, insurance, and depreciation expenses for buildings and equipment must be incorporated into the price of each item sold. Costs such as spoilage and shoplifting must also be added to each item to arrive at the = cost for the item (See Chapter 1 - Table 5: Enterprise Budget/Break-even Analysis).

Once this cost is determined, several methods can be used to determine the price that must be charged to guarantee profitable returns. The two most common methods are markups based on the cost of the item and margins, which are based on sales. The following examples show how to calculate margins and markups.

Markups

A markup is a percentage of the cost of goods sold. Consider the markup on a vegetable that costs 80 cents to produce, with a profit percentage of 60 percent:

Cost = 80 cents + Profit = .80 x .60 = 48 cents

Selling Price = .80 + .48 = $1.28

For each $1.28 in sales, however, only 37.5 percent is true profit. Managers using this method oftentimes overstate profits and, consequently, make much less than anticipated. This misconception of the relationship between costs and profits can be avoided by using margins.

Margins

Margins differ from markups in that they are based upon the selling price. The following example shows how the margin equation yields the necessary result with the desired profit. An example is the pricing of a vegetable that costs 80 cents to produce. The desired profit percentage is 60 percent:

Costs / (I - Desired Profit Percentage) = Selling Price

.80 / (1 - .60) = $2.00

The margin equation illustrates that the selling price must be $2.00 in order to obtain a 60 percent profit margin. The accuracy of this equation makes it a much more reliable way to calculate profits.

The margin method assures the manager that costs will be covered and that a guaranteed profit will accrue only if enough of the product is sold. Success in using margins happens only if the product sells at the higher price. As the first two examples in this section illustrate, the price may be too high or too low for profits to be maximized. Use margins and markups to set a ballpark price and incorporate other factors into the price-setting process to find the best price for each item.

Demand for the Item

Relative scarcity of an item is important in pricing decisions. Consumers will pay more for a product they want if the product is scarce. The first sweet corn harvested in a season can sell for a higher price than sweet corn sold during the peak of the season. Because sweet corn is not readily available early in the season, consumers are willing to pay a premium; the higher the demand, the higher price. However, scarcity alone does not warrant a higher price. The consumer must really want the product to pay the higher price.

Conceptually, the price of an item is the amount the "market will bear." If all of the product sells quickly at the price set, perhaps the price is too low. However, if the product doesn't move, a lower price is probably warranted.

In years of high yields there may be more product to sell than customers to buy. If the price is set lower consumers will buy more. Conversely, in years of low yields a higher price can be charged because people are willing to pay more. The law of supply and demand prevails; the larger the supply, the lower the price the smaller the supply, the higher the price.

Imagine a report is published that states a certain product will increase longevity. Consumers are likely to buy more, making the product scarce and warranting a higher price. If the same product is reported as a health hazard demand will drop and the price will decrease.

Other Considerations

All demand considerations are critical in setting the price of items being sold, but other non-demand-type considerations may also affect the optimum price of an item. A crucial factor is local competition. All sophisticated price setting practices are worthless if a competing market is selling products of equal quality at lower prices. Thus, be aware of competitor pricing. Another consideration is quality. If consumers recognize that the quality of the product is above that of a competitor's, they may be willing to pay a higher price.

[Back]    [Next]