Category Archives: Pricing

Pricing, Market Value, and Economic Damage

In a previous article I discussed a pricing formula that involves calculating your costs and adding a markup for profit based on market value. Today I will expand on what market value is, how to avoid damaging your local market by underpricing, and what to do if economic damage has already been done.

In economics, the market value of a product or service is the amount a willing and independent buyer and seller would exchange after proper marketing when each party acts knowledgeably and prudently. The key elements of this definition are proper marketing and knowledge on the part of the buyer. Unfortunately, this industry has a number of factors that are working against sellers by applying downard pressure on the perceived value of cake decorating services in the minds of customers.

Most customers don’t purchase custom cakes that often. More often than not, a customer’s only frame of reference for how much a cake should cost will come from the grocery store, so when it is time to shop for a more premium cake that grocery store price will be a psychological anchor dragging down the expectation of value.

The explosion of TV shows dedicated to cake decorating doesn’t help. A show that realistically portrayed the process involved in creating a decorated masterpiece would not be very exciting, so they edit the shows to compress what may be a 22 hour process into 22 minutes. The price of the resulting cake is usually not shown, so viewers without industry knowledge will dramatically underestimate the labor required.

These two issues alone wouldn’t be so bad if sellers were diligent about setting firm prices based on their costs, paying themselves a reasonable wage, consistently marketing their products, and educating customers about how long their designs will cake. In reality, this business has such a low barrier of entry, some sellers may not take the time for due diligence and as a result set prices far below what they should be. This only reinforces the low value of custom baked goods in the eyes of customers.

The reasons for this may vary — it could be a lack of confidence, there could be an outside source of income (such as a spouse’s salary) masking the true performance of the business, or the seller may not have the business knowledge to know there is even a problem. Cottage food laws have not helped the situation since they lower barriers to entry even further. If these laws required even just an hour or two of basic business training on how to market and set prices alongside the required food safety training things might be different.

So, as a seller, what can you do? To fight the aforementioned headwinds you have to be aggressive about demonstrating the value you can add over cheaper alternatives. Highlight your competitive advantage, whether that advantage lies in high quality ingredients, decorating skills, or appealing to a niche, but try to avoid going negative about the competition.

You will also want to make sure the customer knows the level of complexity involved in the designs they choose. You don’t need to be exact, but if they want a design that will take 60 hours to execute but can only pay $3/serving, you’ll need to redirect the conversation to increasing their budget and/or selecting a simpler design.

If you get pushback from customers who want to pay a lower price without compromising, reiterate your price in a polite yet firm manner. Continuing pushback should result in you giving the customer a choice between their desired order at the original price or a simpler order at a lower price. Failure to select either of these options means that they are no longer your customer, and you can wish them the best of luck with their event.

Also think twice before offering coupons or discounts, or signing up with a service like Groupon. If you have a quality product, you should not be competing on price, and discounts tend to attract exactly the type of customer you want to avoid. A similar problem occurs if you set your prices too low to start with because you’re new; when you finally increase your prices to reasonable levels, you will probably lose most of your customers and have to start from scratch, while at the same time trying to erase your reputation as the “cheap” bakery.

It is possible that your local market has already been poisoned by severe undercutting, to the point where pricing at market value for your products will lead to paying yourself below minimum wage with zero profit. This is a tough situation, since you can’t really bring this up directly with your competition. If the undercutting businesses are operating illegally based on local food safety laws, one solution is to contact your health or agriculture dept with the names of the alleged illegal businesses.

If the offending businesses are operating legally, you may be able to work through a third party (such as the SBA or the local Chamber of Commerce) to set up some free business training, which could be offered by the third parties to all the bakeries in the area. Another alternative is to shift your target market to a niche that is not being served in your area, pursue a different channel (e.g. wholesale), or pursue exclusive arrangements with popular venues.

The crux of this issue is that every business that offers products to the general public is responsible for the economic health of the industry they participate in. This includes hobbyists who advertise and sell their works, even if they don’t think they really have a business. If you don’t want to go through the effort of charging what your products are worth, you are better off not selling to the public at all and sticking to providing products for friends and family.

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More About Allocated Overhead

Let’s expand a little on the allocated overhead component of the pricing formula with an example. There are two pieces of information you need to calculate allocated overhead: how many orders you fill each year, and how much you spend in overhead annually.

Let’s say you are getting ready to launch a new home-based bakery business, so since you have no actual sales history to determine annual volume you estimate that you will be selling two wedding cakes per week on average. Your estimated annual volume would be 100 orders, leaving two weeks a year for vacation.

Looking at the overhead spending for your first year (which you should already have budgeted), you might have $400 for insurance, $100 for the city business license, $200 for a cottage food license, $400 for accounting and legal fees, $1800 for advertising ($150/month, including web site costs), $600 in additional utility costs ($50/month), and $600 in supplies & depreciation, which includes the cost of replacing worn out supplies and buying new general use supplies throughout the year. That’s a total of $4000/year.

Divide your annual overhead total of $4000 by the number of orders per year (100) and you come up with an allocated overhead cost of $40 per order. So if the ingredients for a wedding cake cost $60, you will be spending ten hours total on the order, and you pay yourself $15/hour, the total for ingredients and labor would be $60 + (10 * $15) = $210. Then you would add allocated overhead of $40 (which would typically be the same for every order) to bring the true cost up to $250. Adding a 20% markup for profit gives you a final price of $300.

If you have a different business model and focus on a higher volume of smaller orders, you would be able to spread out the overhead cost across more sales throughout the year. Assuming a volume of 10 orders per week, or 500 per year, the $4000 in annual overhead would work out to just $8 per order.

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The Magic Pricing Formula

One of the most common business-related questions I see regarding starting a new bakery is how to price your products and services. If you can legally charge for food in your area with your current setup (for example, some states restrict home bakeries), the answer is a simple formula:

Price = Ingredient Cost + Labor Cost + Allocated Overhead Cost + Profit

To price ingredients, you need to to know how much you are spending per unit on each ingredient and how many units of each ingredient are in your recipe.

Your labor cost is based on how many hours it will take to complete the order (including prep, baking, decorating, packaging, and cleanup) multiplied by your hourly wage. If you rent a commercial kitchen by the hour, I find it’s convenient to capture that cost under labor since it is directly related to the time spent on order processing.

Your total annual overhead expense is how much you are spending per year on stuff that’s not directly related to creating products but is still necessary to run your business, such as insurance, accounting, license fees, utilities, advertising, etc. To find the allocated overhead cost, just divide your annual overhead expense by the number of orders you fill per year.

The first three items added together represent your cost. The last component, profit, will typically be a markup in the 15-45% range. To determine how much to mark up your cost, you need to do some market research to see how much similar products are selling for in your area. If you find that your cost is already higher than market value before applying markup, you need to reduce your costs, find a new market, or both. Do not try to price your products below market value.

This magic formula can be applied to just about any product or service. Of course, the formula’s accuracy is only as good as your data, so be diligent and make sure to revisit your pricing structure every year or so to account for inflation.

If you enjoyed this article and want to help fund future content, you can send a contribution via PayPal. Thank you for your support!

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