Dr. Theresa Nartea (firstname.lastname@example.org), Assistant Professor-Marketing & Agribusiness, Virginia State
Dr. Kimberly L. Morgan (email@example.com), Assistant Professor, Agricultural and Applied Economics, Virginia Tech
Did you know farmers who sell unprocessed foods to retail outlets typically receive just 11.6 cents of each dollar that the buyer pays for the item? The remaining amount is allocated to industry groups such as food processors, packaging and transportation, retail trade, food services, energy, finance and insurance and legal services (Fig. 1). These industry groups are important participants in the food supply chain, and allow individual farmers and consumers to focus efficient use of their time and resources on their careers.
Recent trends in the food industry reveal rising consumer interest in purchasing food directly from the farmer (Fig. 2). Currently, there are 336 farmers’ markets listed in Virginia (USDA, 2015). A major consideration for farmers who consider selling directly to consumers is deciding how much to charge for their food products. Economic principles tell us that market demand forces such as consumer tastes and preferences, availability of substitute products, and expectations about future product choices may influence the movement of product prices in the marketplace. On the supply side, farmers who choose to enter non-traditional market channels must have the ability to provide products that meet these demands and make a profit. Each distribution outlet may require different pricing strategies that require producers to respond with pricing adjustments based on product seasonality or volume. The prices a farmer is offered by a wholesaler, grocer, restaurants, or customers at the farmers market may vary widely, and is largely dependent on factors such as relationships and perceived value of products sold. The purpose of this paper is to inform Virginia farm owners and managers who are interested in selling their food and fiber products directly to retailers, restaurants, and consumers with solid calculations that show how selling a specific product through a unique marketing channel (restaurant, retailer, farmers’ market, etc.) will return additional profits to the farm.
Just as a farmer grows a diversity of crops, offering a range of product prices based on different sales outlets makes sense to achieve profitability. Keep in mind that it is impossible to manage a profitable business if you sell your farm products for less than what it cost you to produce and market! A wholesale buyer, grocery store, chef, and farmers’ market customer are all making purchases with a limited budget. Customers will try to buy your products for less to stay within budget, but as a farm business, long-term success is dependent on your ability to know your price schedules across a range of customers. Once you have spent the time to calculate your prices, you are better prepared to explain how your prices reflect the ability of your product to meet customer needs across a variety of sales channels.
As noted in our food dollar introduction, all firms involved in the food supply chain charge a price for the services they provide in moving the food from farm to fork. This price reflects the purchase and marketing costs incurred by the firm and their desired profit margin. In general, a wholesale buyer will offer a retail grocer food products at a price that includes a 30% profit margin. In turn, a grocery store manager will offer food products to the public at a retail price that includes the amount paid to the wholesaler, the costs incurred in moving the food to the store, and another 30% profit margin. Farmers selling direct to consumer need to consider their own production expenses and, estimate additional expected costs and benefits, including: transportation costs such as delivery vehicle rental or purchase, maintenance and repairs, fuel, and driver insurance; marketing costs such as promotional material design and delivery to target audiences, sales personnel salaries and expenses, and advertising fees; and, finally, desired gross margins which are necessary to calculate pricing schedules that accurately reflect farm profitability goals.
Keep Accurate Records
The key to profitable pricing is to keep updated and accurate records. The first step in calculating your product prices is to conduct a cost analysis of your product. With a detailed cost analysis of the product, you are able to determine pricing that is acceptable to the consumer while providing a reasonable profit to you. Records for each crop planted should include costs related to production, harvest, post-harvest, storage, and marketing (Table 1). Examples of production and harvest expenses are provided for several of Virginia’s crops and livestock by Virginia Cooperative Extension specialists in the form of Enterprise Budgets (VCE, 2014).
|Table 1. Items needed to construct accurate product pricing|
Hint: Remember the acronym PEACC PS by thinking of the words “Peace Please.” You will have peace of mind if you keep good records.
Determine Costs, Margins, and Profits
To begin constructing your product’s price, determine the total cost of producing your food or food product. Accurate accounts of your total costs allow you to avoid the common mistake of underpricing your product for your selected market channel. Total costs include total variable cost plus total fixed cost. Variable costs consist of those costs directly related to the production of the product and vary with the number of units produced. Variable costs directly related to production may also be referred to as “Cost of Goods Sold (COGS)”. Variable costs include items such as seed, fertilizer, direct labor, packaging, utilities and other costs that vary based on the amount of product grown in any given year or season. Farmers who choose to market food items beyond the food gate need to include added variable costs related to processing, packaging, handling, storage, and distribution of the product in the COGS. Fixed costs are all costs that must be paid whether or not a product is grown that year, and include depreciation, insurance, rent, taxes, and interest on investment (see VCE Enterprise Budgets for further explanation of fixed costs).
Agribusiness managers should carefully consider the desired gross margin for each food product, the second key component of the sales price calculation. The gross margin is defined as the income resulting from sales of a product after paying the COGS incurred. For this example, a 40% gross margin for food pricing was selected. It is important to note that this number may vary widely based on several factors specific to the market outlet, such as seasonality of the product, market location, number of competitors, available substitutes, and consumer demand for the product.
Gross profit is the gross margin percent expressed in dollar terms. This informs the producer of the income remaining after variable and fixed costs have been paid. Gross profit is calculated by subtracting total expenses from total sales:
Gross Profit = Total Sales – Total Expenses
Gross profit should be calculated for each product sold in each type of market channel. For example, greenhouse tomatoes sold to a wholesaler may return a gross profit of $1.10/lb. to producers, while these same tomatoes sold in a farmers’ market may return a gross profit of $2.25/lb. In this example, the gross profit represents the income from the same product sold in two different market channels, after the payment of the related variable and fixed costs. It is important to note that the gross profit received from sales of the farmers’ market tomato is calculated after payment of all related production and added marketing variable costs.
Calculate Sales Price
Farmers who decide to sell directly to consumers often ask “How do I price my product to make sure I’m making a profit?” Of course, this leads to the next question of “Can my product command a price that results in my farm earning a profit?” A commonly used approach to determine a selling price is cost margin-based pricing (Bruch and Ernst, 2011), and provides a method to determine a selling price for your product that is based on your individual costs and profit goals.
- Determine variable costs of production (expenses directly related to the production and/or added marketing costs of the product for any given year or season, noted as Costs of Goods Sold (COGS)).
- Determine desired gross margin.
- Divide variable costs (COGS) by (100% – Gross margin %) to get the minimum price you should accept for your product.
Selling Price = (COGS) / (100% – % of gross margin desired)
Example: For a desired gross margin of 40% and COGS of $2.25 per unit, the selling price would be:
Selling Price = $2.25 / (100% – 40%) = $2.25 / (60%) = $2.25 / 0.70 = $3.75
In this example, charging a price of $3.75 per unit means the product will return a $1.50/unit ($3.75 – $2.25) gross profit to the farm, before fixed costs are paid.
Profits and Break-Even Analysis
The decision to enter the food supply chain beyond the farm gate should be based on farm record-based calculations that show how selling a specific product through a unique marketing channel (restaurant, retailer, farmers’ market, etc.) will return additional profits to the farm. Once you have accurate cost data and sales prices for your product lines based on each specific sales channel, a “break-even analysis” will allow you to determine the point at which sales (revenues) are exactly equal to costs (expenses). Conducting a break-even analysis allows you to determine the number of units of a product required to be sold to cover all costs, including variable (COGS) and fixed costs. This makes it possible to determine the sales volume needed to cover your costs, defined as your business break-even point. At the break-even point, zero profit is made and zero losses are incurred. The break-even equation is useful in determining the break-even point for your product based on your selling price, number of units sold, COGS and fixed costs.
In this example, 3,333 units of X must be sold to cover COGS and fixed costs at the selling price of $3.75/unit. To calculate the break-even point for this specific product in a specific market channel at this selling price, multiply the number of units of X that must be sold to cover total costs by the selling price:
3,333 units * $3.75/unit = $12,498.75
Therefore the zero profit point for your farm is reached when total revenue equals $12,498.75, assuming a sales price of $3.75/unit. Producing an additional unit beyond the break-even quantity of 3,333 units at the selling price of $3.75 results in profits earned after variable costs (COGS) are paid (Fig. 3). To calculate profits earned for each unit sold beyond 3,333 units, multiply each added unit by the additional profit generated after variable costs are paid.
Additional profit = selling price – variable cost of producing one additional unit
= $3.75 – $2.25
= $1.50 profit per each unit produced after 3,333th unit
For example, selling a total of 5,000 units at $3.75 per unit would generate profits of $2,500.50 for your farm. The first 3,333 units sold will generate revenues to cover all fixed costs and variable costs, and the additional 1,667 units sold will generate revenues to cover additional variable costs and provide farm profits.
For more information about pricing your product for direct sales to consumers in Virginia please contact Dr. Theresa Nartea at firstname.lastname@example.org or 804-524-5491 or, Dr. Kim Morgan at email@example.com or 540-231-3132.
Figure 3. Breakeven quantity sold at selling price of $3.75/unit example.
Bruch, M.L., and M.D. Ernst. 2011, June. A General Guide to Pricing for Direct Farm Marketers and Value-Added Agricultural Entreprenuers. PB1803, Center for Profitable Agriculture, University of Tennessee Extension, University of Tennessee, Spring Hill, TN. Link: https://extension.tennessee.edu/publications/Documents/PB1803.pdf
Canning, Patrick. 2011, February. A Revised and Expanded Food Dollar Series: A Better Understanding of Our Food Costs, ERR-114, U.S. Department of Agriculture, Economic Research Service.
Low, Sarah A., Aaron Adalja, Elizabeth Beaulieu, Nigel Key, Steve Martinez, Alex Melton, Agnes Perez, Katherine Ralston, Hayden Stewart, Shellye Suttles, Stephen Vogel, and Becca B.R. Jablonski. 2015, January. Trends in U.S. Local and Regional Food Systems, AP-068, U.S. Department of Agriculture, Economic Research Service.
US Department of Agriculture. 2015, June 12. USDA National Farmers’ Market Directory. Link: http://search.ams.usda.gov/farmersmarkets/.
Virginia Cooperative Extension Enterprise Budgets for Crops and Livestock. 2014. Link: https://www.dropbox.com/sh/b4v7ftzo6qdri7j/gsnqRAkZ62