6 Steps to Rational PricingMarch 18, 2014 By: Brian Warrener
It’s never been a particularly good idea to use incomplete or arbitrary methods to determine the prices you will charge for your offerings. The relatively higher cost of the quality products and expertise expected by today’s customer, and your efforts to provide what they expect, makes it an even worse idea. The realities of the current environment demand a rational approach to pricing, one that is logical, reasonable and sensible – an approach that systematically includes all of the relevant factors that need to be considered in order to ensure maximum profit. Here it is, in order.
Step 1 – Write a Budget
Before you start pricing the items you’ll offer, you need to make sure that the income you generate is sufficient to cover the expenses of your operation and then some. Preparing a budget can be a daunting and unpleasant task. For the purpose of determining price, absolute accuracy isn’t a must. What is necessary is your best estimate of all of your expenses. Start with fixed costs like real estate, estimate revenue and then estimate the variable costs associated with that revenue. Apply a cost of goods sold to that estimate of revenue that results in a reasonable profit.
Step 2 – Determine Accurate Costs
Premium spirits, specialty adjuncts and fresh juices are the norm in today’s craft cocktails. They carry higher costs that need to be accounted for to ensure proper pricing. Financially, there is more at stake in a $14.00 craft cocktail than in a $7.00 rum and coke. Inaccurate assumptions about cost can lead to prices that are too low or too high, resulting in unrealized profit or low unit sales respectively. The best way to determine accurate costs is to write accurate recipes for each drink and use cost cards to determine the exact cost of each.
Step 3 – Apply an Appropriate Cost of Goods Sold Percentage
Once you have determined an accurate cost for each of your drinks, you can begin to determine selling price by applying a cost of goods sold percentage to that cost. Say you have a drink with a cost of $2.00 and a targeted CGS% of 20%. Divide the cost of the drink by the percentage or multiply the cost by a factor of 5. In each case, the result would be $10.00. This is a possible selling price, but there remain a number of factors to consider.
Say you have a second drink with a cost of $1.00. You apply the same CGS% of 20%, resulting in a possible selling price of $5.00. You may not want such a gap in the price of the two drinks. The first drink results in a gross profit of $8.00 while the second results in a gross profit of just $4.00. You don’t want to give your customers the ability to trade down to such a degree. You have them in your establishment for a limited amount of time and they will only consume so many drinks. It would be better if each purchase resulted in a similar gross profit. This is where the concept of contribution margin enters into your pricing decision.
Contribution margin is defined as the amount of gross profit you make per drink. It has been applied in the food and beverage industry for many years, if not so systematically. Say I apply a 25% CGS% to the first drink and a 17% CGS% to the second, less expensive drink. These two percentages would roughly result in selling prices of $8.00 and $6.00 respectively. I make $6.00 every time I sell the first drink and $5.00 every time I sell the second. These prices seem better. Getting my customers to trade up to higher cost items should result in more gross profit. The resulting gross profit when they choose less expensive items needs to be close to my higher cost offerings.
Step 4 – Check the Competition
It should go without saying that you need to be competitive in your market and so you should know what the competition is charging. The mistake many operators make is using only this comparison to set price. You can’t assume that the competition’s expenses, operation, expertise or product is similar to yours. You can’t assume that they are maximizing profit. You can’t assume they even know what they are doing. Strive to provide value as a competitive strategy and sometimes your prices will be lower than your competition and sometimes they will be higher.
Step 5 – Establish your Selling Prices
Having established your selling price you should be able to use your anticipated sales mix to determine your blended Cost of Goods Sold Percentage. See if it’s close to the number you budgeted at the beginning of this process. If it’s not, you need to go back to the drawing board or accept the new circumstance.
Step 6 – Evaluate The Results
Make effective use of the information provided by your POS system and monitor the results of any pricing changes you have implemented. You should be looking for changes in demand that may be the result of these changes. Prices that are too low may result in significant increases in demand. Prices that are too high often result in precipitous drops in demand. Make changes accordingly.