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Profitability and the Four P's: Part I

 
By Caroline J. Beck
09/01/2010

Establishing a profitable price for your product is oftentimes a mercurial business. It requires a thorough understanding of costs, market trends, and consumer interest. Some of these elements are easy to define. However, there are many other factors that if overlooked can mean the difference between business success and failure.

One classic approach to analyzing your best unit price and market position is to use a marketing review of the four “P”s – product, placement, pricing and promotion. This process helps unearth any unforeseen or unexpected cost factors that affect sales and profitability. Taking a careful look at the true costs in each of these areas ultimately determines the actual return – profit or loss - to the producer.

Part I of this series presents a look at the first two “P”s: product and placement.

PRODUCT

The profit exercise starts by defining a per unit “cost of goods” (COG). For the most part, cost of goods is easily identifiable and relatively simple to quantify. It is the cost of producing your product until it is released into the distribution chain (aka “ex-warehouse”). The COG includes such material items as the product (harvested or wholesale) and packaging. But, these “fixed costs” are not static, and many producers can get caught blindsided if they build a price structure around one year’s inventory.

Many of the elements that go into creating your product are commodity-priced, so there can be some significant cost swings year to year. In the olive oil business, the ratio of supply/demand impacts the price of oil, bottles, closures (like cork), labels, stickers and hangtags. As an example, in the past five years, we have witnessed huge variables in the bottling industry, including swollen freight costs, which have had a big impact on profitability in the packaged goods sector. Poor harvest years with low yields increase bulk oil prices. Even vagaries in the paper industry affect label and packaging expenses. So, it’s wise to track trends over a few years and establish medians before building any fixed material costs into the equation.

Manpower can be an equally elusive element. Large-scale growers and producers can quantify product-related manpower costs by amortizing employee-related expenses (salaries, benefits, etc.) against output. Smaller producers don’t always track their own time and effort with the same precision. If you are starting out, estimate reasonable rates for your services and factor them into your expenses. You may not start out paying yourself but as you grow and expand with staff that will expect to receive a paycheck, you’ll be better prepared to continue on a track to profitability.

PLACEMENT

The next category of profit analysis is placement, or product distribution. This is one of the elements (the other being Promotion) that is represented by the “cost of sales” (COS) line item in your business plan. Unlike COG,this area is definitely not so cut and dried.

It is well-known that every link in the distribution chain along the way from your warehouse to the consumer’s kitchen, expects a cut for the service of exposing your product to an interested buyer. You can find a very thorough explanation on this process and the industry-standard margins you will be expected to offer in much more detail elsewhere on the site. What the “pricing margins” exercise will not reveal is the wide range of other practices that can erode profitability.

If you are small enough to sell-out your inventory by going direct – either though the internet, farmers’ markets or local retailers that you can service yourself, many of your distribution costs are fairly obvious. But even then, costs for local delivery and single-store servicing are expenses you will bear. Add to that phone calls to check on inventory, store visits to maintain good relations and shelf positioning, and last-minute orders that weren’t part of your day. These all add up and can easily erode that 10% standard profit margin you have built into your analysis.

Once you step outside the environment of directly servicing boutique retail stores, local mom-and-pop retailers, and tourist shops, a whole new set of unexpected and “hidden” requirements are waiting for you.

If you plan to expand your territory and approach larger grocery chains, big box warehouses or even the gift trade, be prepared for additional demands, sometimes shocking, and consequent costs. With the increased interest in gourmet and healthy options, the specialty foods business is competing directly with the much larger packaged goods giants for shelf-space, and with big business comes ruthless competition, and it comes at a hefty price.

Programs required by large-chain retailers to gain a single “store keeping unit” (SKU), defined both as a single product identifier - generally tracked by a bar code - as well as a single product facing row on a grocery store shelf, can include many of the following expenses:

Slotting Fees You can be expected to pay up front for “SKU real estate”.
In-Store Demonstrations You will be expected to staff and supply free product sampling on days of the retailer’s choosing, not yours. If you are working with a national chain, hiring out professional demo staff can be pricey, and you can’t necessarily expect a first-class representation of your product.
Free Fill You may be expected to fill your shelf space for free the first time. This generally amounts to a free case of product.
Scandown, Specials, Promotions These are pricing events planned according to the retailer’s schedule, not yours. At best, stores and/or distributors share this cost with the producer; oftentimes the producer has to bear the cost alone.
Shared or non-Shared Required Building brand awareness for your product is never a bad thing, but losing all control over it and being required to pay for it can be frustrating experience.
Advertising Charges for damaged products and a wide array of anything else the retailer sees fit to charge back against your account.
Bill Backs If product is not sold, you have to come and pick it up at your expense, and you only get paid for the product sold. This sometimes happens after the fact.
Guaranteed Sales If product is not sold, you have to come and pick it up at your expense, and you only get paid for the product sold. This sometimes happens after the fact.

Worst of all, if you don't play by the rules set by the distributors and chains, then, quite simply, you are not going to get on the shelf, let alone stay on the shelf. And these “hidden” costs can add up to a significant percentage because they really will be “fixed” expenses and not offset by any guarantees of volume sales, making them very difficult to factor into a single unit COG.

In Part II of Profitability and the Four “P”s, we will explore pricing and promotion strategies that can positively impact the success of your business. The next segment will look at ways to effectively determine “price floors”, “price ceilings” and everything in between, including competitive positioning and the new consumer mindset about premium, luxury brands like extra virgin olive oil.