The pricing game

Features - Business

Playing chess in a different economy

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August 24, 2010
Bridget Behe

We now operate in a “new” economy -- the things that made us successful yesterday may no longer bring success. What helped generate profit in years past may not work well anymore. Pricing nursery plants today is a lot like playing chess; you move and watch to see what the competition does. They make a move and then you plot your next strategy. Years ago, pricing products had the appearance of being cost-based and somewhat mathematical. Today, there is more art involved in finding the right price than simply multiplying costs. When is the price right? When you not only cover all of the costs involved, but you also generate your profit goal.


Begin with Cost
Product cost is one part of the equation, but not the only part. Knowing your cost, not only of production but of transportation, marketing and overhead, is the first step to finding the right price. Many nursery professionals don’t make the time to develop systems to help calculate costs on a regular basis. And it is a system that is needed, since costs change about as often as the weather. Gathering information to accurately calculate costs is the place to start. Are your receipts for containers, fertilizer, media and plants in a shoebox or organized in files, either physical or electronic? Think, too, about the level of detail in your cost system. Do you have costs overall for the nursery or can you calculate costs by some (or all) key crops?  The more detail in your cost accounting, the more accurately you can tweak pricing to achieve profit goals. The key is to develop a system that works for your business and can give you the information you need in a timely manner.


Markup on Cost
What do most firms do with cost of production once they have it? Often, they will use that as the basis for setting a price, either wholesale or retail. Cost is used to markup items with a percentage. The percentage often becomes “standardized,” such as a firm marks up all 1-gallon shrubs 200 percent or all liners 150 percent. A simple markup on cost formula uses a set percentage and multiplies that by the item’s cost. If the standard percentage markup on cost for a 1-gallon shrub is 200 percent, and a container has input costs of $1.37, then the retail price is calculated by the formula:

The markup on cost percentage may vary by product line. The markup on smaller trees might be 150 percent but the markup on large trees might be 75 percent, while the markup on a new shrub cultivars is 250 percent. But how do you know if the price is right?


Price Points
Calculating costs is a great place to start, but not finish the pricing game. Pricing experts will encourage businesses to move a price up to the next a key price point.  These are numbers, or points, where a business can earn more profit without giving up many sales. It works along the lines of supply and demand. If the shrub discussed above cost $1.37 to grow and your company likes to begin considering pricing at a 200 percent markup, the price would be $5.48. However, $5.99 is a better price point because, psychologically, most people will still buy the product at $5.99 as much as $5.48. In this economy, the business might consider going down a point to $4.99, which may stimulate even more sales. Prices that end in $0.99 and $0.95 and sometimes $0.49 are considered a good “value” because they fall just below what is psychologically considered a big step up. That psychological barrier will keep some folks from buying the product because it might be too highly priced or beyond what they consider to be a value. Many times, you can increase price up to the next key price point without losing sales. These three price points work well for items under $50, and the points get farther apart as the entire price tag climbs. Consider the psychology of pricing after calculating cost.


Product Life Cycle
Another way to determine if the price is right is by the product life cycle (PLC).  Products, like plants and people, go through distinctive phases of growth in sales and profits (Table 1). In the introduction stage, sales of the new product may initially be slow, but begin to grow rapidly. At first, profits are negative due to high initial costs of product development, but during that period of rapid growth is when profit potential is highest. Prices are often high in the introduction and growth stages, since little competition exists and the real product innovators (those who must have the newest and latest) are excited to buy the new product, even at a high price. 

Once more people buy the product, sales grow rapidly in the growth phase of the product life cycle. Pressure from an increasing number of competitors drives prices down toward the end of the growth phase, and the pace of those reductions is set by how many competitors come in and how quickly they speed up their production. Late in the introduction phase and early in the growth phase is when most profits are made. Firms can keep prices relatively high and glean profits before too many competitors enter the market. As more competitors sell the product but fewer buyers are around, the product enters the mature stage. In the mature stage, sales growth slows and profits dry up, largely due to the overproduction of the product which drove prices down too low.

When new cultivars are released, they are in the introduction stage of the PLC.  This is probably the only opportunity to get a premium on the product. Prices can be higher earlier in the product life cycle, but we know in which direction they’ll go. Often, growers and retailers set the price of newer products the same as ones already for sale in the market. Profits need to be made early, or they can only be made by selling a tremendous volume of the product. Consider putting a premium price on newer plants so that you can return profits when it is most possible, in the early stage of the PLC. We know the pattern of sales and profits, but the unknown is the length of time the product will be on the market. It is that unknown that makes pricing products like a game of chess.

Another lesson to take away from the PLC is to be different. When buyers can’t distinguish your product from others, they will buy on price. Low prices may appear to be the magnet for consumers’ eyes these days, but you can help reinforce some differences using the concept of value. Value can be part of your winning strategy in the chess game of pricing.


The Value Concept
Many people believe the current economic climate forces us to focus on price. I’m going to encourage you to consider more than price, but focus on value. Instead of worrying about price, clearly define your value proposition and reinforce that message to consumers. Price is the dollars and cents on the tag. Value is what you get for what you pay. What else do you provide for customers in exchange for the price they pay? Can you provide information on that plant? Delivery? A larger (or smaller) size container? Online ordering or inventory management? Customer service and problem-solving? The value concept rests on high-quality plants and goes beyond it. After all, who ever said they market mediocre plants? Everyone claims high quality, but how you distinguish that for your customers can go a long way in their realizing the value in your products over the competition. Clearly discuss and define your value proposition as you communicate with customers in advertisements, online, and in-person.


Raising Prices
Given the cost increases of so many other products, now might be a good time to consider a price increase. When others are not raising prices, it becomes harder to accomplish the price change. Consider changing prices first on items that others don’t sell or are in the early stages of the product life cycle.
  
If it is more difficult to compare prices of competing products, the increase might not be as noticeable. If you raise prices, go up to the next key price point. If the current price is $14.99, you might consider increasing it to $17.99 rather than $15.99. Many, but not all, consumers perceive a $3 increase the same as a $1 increase. Don’t leave that $2 on the ground.


What About Discounts?
One more pricing component is discounts. When a firm discounts price, psychologically, we teach some customers to expect this again next year. Nearly every American who buys Christmas gift wrap does so in the days after Christmas because we expect the price to be heavily discounted.
  
Have you noticed retailers doing this discounting earlier each year? Table 1 shows the effect on profits at what heavy discounting can do. If a nursery has 500 1-gallon containers to sell (at a cost of $1.29 each) and is considering a $4.99 price point, what is the break-even point? Total cost is $645 and break even is calculated by dividing total cost by the price of $4.99. The nursery literally breaks even when the 129th unit is sold and profits will be generated on the 130th unit sold.

What is the total revenue possible at that price? If all 500 plants were sold, total revenue would be 500 x $4.99 = $2,495, which gives the firm a profit of $1,850 or $2,495 - $645 = $1,850. If the target profit goal was $1,600, the business would only need to sell 450 units. Calculate that by adding $1,600 to $645 cost ($2,245) and dividing it by the price ($4.99).

If the nursery wants to discount price by 10 percent to $4.49.  Typically, 10 percent off isn’t enough to stimulate much more demand, but it’s something to give customers to consider. The break-even point goes up to 144 units at this new lower price, meaning they have to sell 15 more plants before total costs are recovered, but they would achieve a $1,600 profit goal at this price selling all 500 plants. Consider a 20 percent discount to $3.99. Usually, this will get more people to buy when the price discount is deeper. This newly discounted price moves the break-even point up to 162 plants and changes both sales and profits. If the grower wanted to achieve $1,600 in profits at this price, the company would have to sell 63 more plants than at $4.49. Discounting even more takes a greater toll on profits. At a 25 percent price reduction, the company would have to sell 100 more plants to achieve the profit goal of $1,600. At a 30 percent reduction, it would have to sell 643 plants, not 500, to achieve a profit of $1,600.


Multiple-Unit Discounts
There is a way to price “a deal” to make it more effective, but equally profitable, for your company. What is the difference between a 25 percent discount and buy 3 get one free? Nothing, except the volume of product you will sell. If four units are sold, these two prices have the same capacity to generate profit. Yet, for a perishable product like plants, moving volume can help you reduce perishable inventory that will decline in value sooner rather than later. So, multiple-unit pricing gives the customer a strong sense of value (who doesn’t like free?) while helping your company to accomplish its goals.

The grower or retailer who can cover all of the costs of production and generate sufficient profit to sustain the business is the one with the right prices. If you sell out of product too quickly, did you set the price high enough? If there is a surplus on the market, do you have a competitive price to move enough units to make this item profitable? With all of your costs on the rise, take a long hard look at your prices.


Bridget Behe is professor, Michigan State University, Department of Horticulture, (517) 355-5191; behe@msu.edu.