Wednesday, November 24, 2010

Pricing Strategies in an Inflationary Market

As supply costs in the food and beverage industry are inflating at alarming rates, now is a good time for effective food service managers to revisit their menus and develop some pricing strategies to position them for continued success in the marketplace. Quite a few operators are rightfully concerned about recent price increases. Still, this actually provides a nice window of opportunity to make some changes to menu prices and actually increase profit.

While I would like to provide a tried and proven formula food service managers could use for pricing their menus, the fact is that menu pricing is more of an art than a science. There are just too many different factors that come in to play and probably one of the biggest mistakes managers make is to price their menu offerings based on formula rather than thinking about some of these factors.Any business that is considering their menu prices should not only consider their supplier costs, but also a competitive analysis and some form of consumer price sensitivity research.

Having spent over 18 years as a manager in the food and beverage industry, I have heard so many of my colleagues make this erroneous statement – “You have to maintain a food cost of 33% or less or you can’t make it in this business.” Many food service managers take this to heart so much that they figure out their ingredient costs for an item and then multiply times 3 to get their menu price. This is a foolish pricing strategy, as there is significantly more involved in developing a successful menu.

The first thing to remember in pricing strategy is that it there is a difference between food cost/gross margins and gross profit. Gross margin is the percentage of the difference between your selling price and your supplier cost divided by the selling price (food cost is simply 100% – gross margin %)

Gross Margin = (Selling Price – Supplier Cost)/Selling Price

Gross profit is the dollar amount difference between the selling price and the supplier cost.

Gross Profit = Selling Price – Supplier Cost

The most important thing to remember is that gross profit is what pays the bills, not gross margin!

Below is an example of two restaurant managers with a company that owns a small chain of fine dining establishments. In this scenario, their supplier raised the cost of a bottle of their most popular wine from $6.00/bottle to $9.00/bottle. Each manager has a different strategy for dealing with the price increase.
Original PricingRestaurant 1Restaurant 2
Supplier Cost$6.00$9.00$9.00
Menu Price$20.00$30.00$24.00
Food Cost %30%30%37.5%
Gross Margin%70%70%63.5%
Gross Profit$14.00$21.00$15.00

In Restaurant 1, the manager believes in maintaining his margin, so he raises his price to $30.00 per bottle. All is good in his world, as he is now making $7.00 more per bottle of wine than he was before and he is still maintaining his 30% food cost.

Restaurant 2 features a savvier manager. She knows her customers and is afraid that with such a steep increase, more of her customers will skip the wine to keep their dinner bills down. She still raises her prices to increase her gross profit, but her increase is not nearly as much as her counterpart at Restaurant 1 and she is losing a bit of her margin.

Chances are that Restaurant 1 will lose some sales because their price increase is so steep. Restaurant 2 is more likely to maintain the same volume of units sold. They compare notes at the end of the following month and find the following results:

Restaurant 1 Last MonthRestaurant 1 This MonthRestaurant 2 Last MonthRestaurant 2 This Month
Food Cost %30%30%30%37.5%
Gross Margin %70%70%70%63.5%
Gross Profit$1,400.00$1,050.00$1,4000.00$1,5000.00

By keeping her price increase at a lower level, Restaurant 2 did not lose any units sold and made $100 more dollars than the previous month even though her gross margin decreased. Restaurant 2 made $350 less than the previous month, even though he maintained his margin.

This is obviously an oversimplification of what can happen in these difficult times, but as prices go up from suppliers, menu prices will have to go up, as well. If not, an establishment will have to get a lot more customers to make the same amount of money that was being earned prior to the supplier increases. At the same time, an overreaction and too much of a price increase may make it easier to lose customer loyalty to competitors who are not as aggressive with their price increases.

In developing a strategy to deal with higher supplier costs, food service managers should remember to focus more on profit than on margin. For many establishments that have a loyal customer base, it is fairly easy to site articles that are showing 200% - 300% increases in supplier costs and then tell customers that a price increase was necessary, but that the increases were kept to a bare minimum.

With a bit of attention to consumer spending habits, the competition and supplier costs, smart operators have the opportunity to turn the proverbial lemons into lemonade.

Rick Leibowitz, North Country SBDC
Note: This was originally written in March 2008, while Rick was working for the East Central Indiana SBDC...even though some supply costs have leveled a bit, we think this information is still relevant.
Previously published HERE.

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