How do you achieve value based pricing? Is it your idea of the value of your product, or is it what it cost you to produce it? Is there some outside, independent measure of value? Or is it based on a perception? These are the questions branded product producers struggle with to develop their pricing strategy.
Cost Based Pricing
In the CPG world of retail sales, you don’t really have the luxury of charging based on a simple formula of production costs, plus overhead, plus profit margin. There are simply too many competitors in your category that have already set the stage. Your price is often determined by the marketplace long before you’ve even finished the design of your product. But with that said, let’s examine cost-based pricing.
While it’s true that you certainly can’t sell at a loss, it’s also true that your cost of production will vary based on the quantity produced. This makes it extremely difficult for new producers to compete with established brands that, due to their superior sales, can achieve quantity discounts on their supplies.
Many new producers are forced to enter the market with little or no profit margin. This is due to their initially small production and sales resulting in relatively higher cost of goods. Some new producers take this into account and even enter the market at a loss to gain the traction they need to achieve the sales volume that will eventually enable them to purchase their supplies at quantity discount levels.
We have heard hundreds of new product producers justify prices that are too high for the market by saying, “Well, that’s what I have into it.” This philosophy may work at the higher price points with more unique, high-end and in-demand products. But it won’t work for most consumer package goods products.
Lost Leader Pricing Strategy
Generally, the market does not offer consumer pricing that is lower than their cost of goods. However, many retailers have adopted a “lost leader” pricing strategy on some popular items in order to attract customers to their stores. This can severely damage your pricing strategy when other retailers see this price and demand it in order to continue carrying your product.
New producers are tempted to set their pricing as close to their costs of goods sold (COGS) as possible to gain access to the marketplace. We have learned from experience, you can take your prices down, but you can’t pull them back up again.
Don’t Forget the Cost of Sales
Another problem with cost-based pricing is that the producers may not have all the costs. So, when they set their prices, they’re carved in stone as far as the market is concerned. Then, after their products start selling and the producer begins servicing what they have sold, they discover hidden costs they had not considered when they originally set their pricing.
The cost of sales (not the cost of goods) is often overlooked because it is not apparent until the buildout-expansion stage. This is when the producer discovers the cost of staying on the shelf in far-reaching territories. The costs of shipping, taxes, special packaging, special labeling, supporting distributors, merchandising, representation and customer service explode as you move into new markets. But you’ve already set your prices based on your known costs when you entered the market.
Price Point Pricing
Price points are simply the various prices that CPG products are sold at. They usually are just below a full or half-dollar amount such as $4.99, $5.99, $6.99 and $4.49, $5.49, $6.49. This is based on the concept that the customer sees $3.99 as a whole dollar less than $4.00 when it is actually only a penny less. Sure, there are popular variations where the pennies change to attract the customers’ attention, such as $4.88 or $4.47. These variations are part of the pricing strategies of particular retailers who want to distinguish themselves from other retailers.
Velocity Price Point
Within every category is what we call a “velocity price point.” The velocity price point is the price point at which products in a particular category move the fastest. The higher your price is over the velocity price point, the slower the movement you can expect. The lower your price, relative to the velocity price point, the higher volume you can expect although, now there is a stigma, “Nothing that cheap can be any good.”
The consumer is aware of the velocity price point for every item in the store. It’s easy to discover. All you have to do is look at a category and notice that the most popular pricing is grouped around some number that is the most repeated within that category. We advise all our CPG clients to discover the velocity price point for their category before they set their own prices.
The velocity price point is so powerful that most buyers won’t consider products with prices too much higher. This means that the producer is under extreme pressure to meet or beat the velocity price. In most cases, your retail buyers dictate what price point they will consider for a product in your category.
Value Based Pricing
1. Value Through Low Price
The term “value pricing” is widely used and can mean several different things. For instance, value pricing can mean that your pricing is communicating a superior value for the money. An example might be that you price your products so that the retailers can see their full margin at $3.99 shelf price when most of the other products in your category are $4.99. This is using price to convey value. It’s based on the concept that the customer believes that they are getting the same thing for a dollar less. The value here is in the low price.
One problem you run into is that the retailer won’t pass on the savings to their own customers. They’ll just pocket the difference and charge the velocity price for the category!
This pricing approach to conveying value may get the first sale. But if the product doesn’t deliver the same quality as the higher-priced competition, it won’t get the future sales. Generally this approach requires a compromise in value which may be forgiven by the customer because of the price. We don’t recommend this approach. The value here is the price.
2. Value Through Increased Quantity
Another way to achieve value-based pricing is with increased quantity at the same price. In this pricing strategy, you deliver measurably more volume and communicate value by holding your price. This approach is good for specials, promotions, and advertising campaigns. Like the “lost leader” approach, you are gaining attention by delivering a measurable value. Examples include, “20% more”, “2 for 1”, and “Buy 2 Get 1 Free!” The value here is in the increased volume.
3. Perceived Value Through Third Parties
Value pricing can also be part of an active marketing campaign where you use accolades, awards, and endorsements to distinguish your product without reducing your popular price. This approach requires in-store signage, floor displays, and in-store demos. This can be an effective way of communicating higher quality to your customers. But it requires an ongoing campaign which is an additional cost of sales. The value here is the perceived value due to 3rdparties.
4. Perceived Value Through Higher Quality & Price
Some producers use the velocity price point as a benchmark of what the customer is willing to pay for the value they receive. Then they deliberately set their prices higher than the velocity price point based on the theory that the customer will believe that their product must be higher in quality to command such a price. The justification for this approach is usually that even though the sales volume may be less than at the velocity price point, you will make it up financially at the higher price point. The value here is the higher price.
This gets to the strategy of product positioning. Probably the most important element of positioning your product is its price relative to the competitors in your category.
So, as you can see, value can be communicated in a variety of ways. In the retail marketplace, its price first, then quantity, then quality, and finally third-party endorsements. Quality effects subsequent purchases, brand loyalty, and reputation. But the consumers’ first purchase is usually based on price.
How to Price a Product
When we started the Barefoot Wine brand, the supermarket buyers told us the price we would have to meet in order to even gain access to their stores. We had to work our prices backward from the shelf price the buyers were demanding. We highly recommend that CPG product producers do the same. Don’t be surprised by all the hands hungry for bucks between your warehouse in the store shelf.
In this process, we had to take into consideration the stores’ margin and any promotional or temporary price reduction. We also had to take into consideration our distributors’ margin and any incentive programs we offer their salespeople. And, we had to take into consideration freight, taxes, and other special fees.
Don’t Forget to Factor in the Cost of Sales
What we didn’t take into consideration that really hurt us in the early days was the true cost of sales. We didn’t know that we would have to do a lot of the distributors’ and retailers’ work. We didn’t believe that a representative on our payroll was required in every territory. Because we are new to the business, mistakenly thought that distributors and retailers who had a financial interest in the success of our product would do the jobs necessary to achieve that success. We were wrong!
So, yes, add in the cost of sales as much as you can project these costs. As a good rule, add at least 20% of the total of all the costs that you can measure once your product leaves your warehouse. If it demonstrates itself to be less, great, you’ll be money ahead. But not including an allowance for the cost of sales can be devastating. It took us years to recover!
Working backward from the shelf price basically tells you what you have left for costs of goods, overhead, and profit margin. It’s like solving a puzzle to discover what you can afford to pay for supplies.
This is exactly the opposite of cost based pricing. Now, it’s not what you have into it so much as it is what you can put into it and still stay in business. The marketplace is determining your price and what costs you can spend for your supplies.
How Distributors and Retailers Price a Product
The Rule of 99
But wait, there’s more! One of the factors that we had overlooked early on (and later became expert at) is what we call “The Rule of 99.” As mentioned above, shelf pricing tends to end in $.99. If you know this, why leave money on the table?
How to Influence Your Product’s Shelf Price
Generally, you will have little control over what your product sells for on the retail shelf. But you can have an influence. For instance, if you know, that your retailer wants to see 25% profit of the shelf price, then you know that your retailer must purchase the product for no more than 75% of the shelf price. If you know that your distributor wants to see 25% of what he sells it to the retailer for as profit, then you know that he has to buy it from you for no more than 75% of what he sells it to the retailer for.
Start with the shelf price and make sure that the retailer can’t make more than 25%. Make sure that the distributor’s price to the retailer is exactly 75% of the shelf price and no less. Control the distributor’s price by setting your own FOB warehouse price to be no less than 75% of what the distributor will sell your product to the retailer for. Now, nobody can make more than their stated minimum profit margin. If you’re sloppy with your numbers, other members of the distribution channel will pocket the difference.
You know that the retailer will price your product at the nearest 99 cent price point. So if you are not very trim and thoughtful on your pricing to them, they will take all the money between what they have to see and the nearest 99cents.
When Retailers will Take Less Than Their Stated Profit Margin
Another interesting aspect to the rule of 99 is that retailers will typically take less than their stated profit margin in order to “reach” the price point ending in $.99. This means you can tweak your prices upward slightly without necessarily effecting the shelf price. In this case, they will actually make less than their desired percentage of profit to hit the nearest 99 cents. This may seem trivial until you do the math on thousands of cases of your products!
Lastly, you have to redo this process every year as money inflates and suppliers demand more for their goods. Who will be the first in your category to raise their prices? Whoever it is will take a hit unless your entire category increases its price at the same time. Proceed with caution!
Setting your price is both a science and an art. It requires thorough market research, understanding of how you want to position your product relative to the prices of your competitors, allowing for everyone in the distribution chain to make their margins, limiting your cost of goods to the supply allowances dictated by your price point, covering your cost of goods, and your cost of sales, covering your overhead and hopefully some profit … and not leaving any money on the table! No matter how you look at it, pricing is a challenging process and a moving target!