The Discipline of Pricing
By Timothy J. Castle
The pricing of coffee is essential and a determining factor in the success of a company. Whether charging too much or simply not enough, it is best to understand the options that are available and make the right decision for your business.
coffee has historically been one of the most volatile commodities in the world, the pricing of coffee has been a critical component of success for anyone in the business. Pricing has been used not only as a way to stay competitive, but also as a tactical weapon against less savvy roasters and green coffee sellers. Because costs can change on a daily basis, and customers often want coffee contracted to them many months in advance, aggressive sellers can quickly find themselves in a world of hurt, if they aren’t careful. On the other hand, sellers that are too passive, in a declining market, for example, can miss out or lose business to competitors that are more willing to let their prices reflect the current market. By the same token, the coffee seller that raises prices too slowly can find themselves without the reserves they need to pay for higher priced coffee.
The Pricing Ploy
Pricing coffee is a lot like a game of poker, where you have read your opponents and know your hand, and hopefully that of your competitors. You also need a lot of discipline, which is about knowing the difference between a calculated risk and an outright gamble. This holds true even in the case of specialty roasters who say, “Well, I’m not trying to make a fortune, but I know I’m selling a high quality product that deserves a good margin, so I am going to charge ‘X’ number of dollars more than I paid for my coffees.” Such a roaster could easily go broke charging a price that although profitable, and based on what they paid, it is not the price of the coffee that is coming in when making the next round of purchases. First of all, they probably haven’t built up the reserves to pay for more expensive deliveries. In addition to that, they can’t raise prices overnight, since it takes timing and preparation.
While pricing may be compared to a game of chance, however, it is also an important skill, and one that is recognized as an expertise by at least one trade organization, the Professional Pricing Society (www.pricingsociety.com/default.asp). In fact, one can even become a certified pricing professional. There are also several companies that offer exhaustive advice on pricing and consult, according to their web sites, with many large, sophisticated companies. Furthermore, there are extremely complex software packages that will compute pricing, giving a multilayer variables and situations. Now, this is not to say that a single store roaster with a modest café should seek out a certified pricing professional, but with pricing too much is at stake.
Larger coffee companies know that pricing the coffee they’re selling is serious business. They know that if their prices are too high, even after the market has fallen, this may provide a windfall for themselves, and also for their competitors, thus making a potentially weak competitor strong enough to compete in ways they haven’t before. Furthermore, when an experienced sales manager sees a competitor dropping their prices to attain more business, they may do the same, just to reach the breakeven point, and assuming that the competitor will drop even further. Sure, their competitor might sell more volume at their new low levels, but they also know that at a certain point below, their competitor will lose money or begin delivering an inferior product. Either way, this same sales manager will come out smelling like a rose, knowing that a competitor selling below cost or cutting corners to win back margin won’t be a serious competitor for long. Again, in this example, discipline is key. As a coffee seller, you need to know your bottom line, not just to make money on the coffee you need to own, but on the coffee you will need to buy the next time your contracts run out or your inventory depletes. Many larger companies have relatively simple formulas that tell them whether a certain measurement of the coffee market trends in one direction or another, and if they will need to either raise or lower their prices. Now, they may stray from that position from time to time, but they do so with a clear sense of why their doing it, and may even credit that gain or loss to another account to indicate the reasons they went off their established policy. For instance, if a big company knows that their customers are evaluating their coffee lineup over the next couple of weeks, they may delay a price increase until that evaluation is complete, but they’ll charge the forgone revenue to their marketing budget instead of the cost of goods sold, or at least annotate their books to indicate why the loss occurred. Such moves, however, are only for companies with the large reserves necessary to sustain the ensuing hits to their income statements.
To get an idea of how a variety of coffee companies, primarily roasters, price their coffee we called the folks responsible for pricing at several different companies. We’ve included the comments here of a few that we believe lend insight as to how this discipline is practiced - and practiced successfully, thus far, by the folks that we talked to.
From the Pricing Experts, Themselves
As a preface, we might as well start off with how NOT to manage pricing, and that would be well exemplified by a Midwest company that has not altered their pricing in six years. According to the buyer, this was due to some dramatic shifts. “We were paying ten dollars a pound for one of our exotic coffees, then roasting it, and selling it for $6.25.” He went on to point out that they were lucky, and inadvertently may have helped reduce potential competition. “One positive thing, though, is that we’ve pretty much discouraged any competitors from coming into our market, and we have taught our customers to use our coffee everyday because it’s so inexpensive. However, I can’t say it’s been our strategy, just the way things have worked out,” he said.
Luckily for this company, things have worked out rather well, and they have been strongly profitable over the years. Retrospectively, they might say that the profits they sacrificed by keeping their sales low were really a marketing expense, and part of a strategy to discourage competitors. But when these things happen without planning, it raises the concern that something else could have just as easily happened. For instance, coffee prices could have spiked upward, and stayed up for a long period of time. They then might have left their pricing in place and suffered serious losses. Further, without planning, no stop-loss measures can be put in place to alert management to cost increases that necessitate a price increase.
The same can be true of costs decrease situations, where the competitors then decrease their prices and management does not adjust pricing, either because they aren’t paying attention or because they decide that it’s better to keep a more dedicated, smaller group of customers.
For larger companies, the greater available resources make it possible for the function of pricing to be assigned to someone with an experience in finance, and a broad understanding of all the costs involved in getting a product to that company’s customers. Ken Di Lillo, vice president of Finance of International Coffee & Tea, LLC, which operates the “Coffee Bean & Tea Leaf” stores, had a number of comments in relation to his company’s price methods for its coffee, both with regard to its retail customers and wholesale accounts. “We look at our pricing of wholesale products and the retail products twice a year, based on market conditions. To thoroughly evaluate pricing, we keep a “Bill of Materials,” which identifies all of the component pieces for pricing, such as raw materials, overhead and packaging film, etc. With increasing volumes, we’re able to absorb increases in the cost of the coffee itself by spreading overhead costs over a larger production.”
Di Lillo pointed out that he looks not only at how similar businesses price their coffee, but where pricing on mainstream coffees are as well. “We obviously look at the commodity price of coffee, and the commodity price market trends, as well as the competitive wholesale pricing trends for specialty and commercial coffees. We do evaluate what the competition is doing. It’s critical in the wholesale arena. We can’t ignore the traditional coffee producers, although we concentrate on the other specialty coffee producers.” In other words, the company looks at all the alternative sources available to customers.
Di Lillo also noted that retail pricing involves just as much, if not more knowledge of what competitors are doing. “On a retail side, evaluating the competition is much more important to the whole process. There, the commodity price is sometimes only a minor factor, because we do a lot of coffee pricing on a fixed price and long-term basis. The demand for specialty coffee, and therefore the cost, is somewhat separate from the commodity market price of coffee, since we are only buying the top 1% in terms of quality,” he said.
In response to how much a factor the rising costs of employee benefits have a bearing on his pricing decisions, Di Lillo was quick to acknowledge, “We do put those items into our analysis as well, when you’re offering coffee to a retail customer you have to evaluate all of your costs; the cost of product components, wages, medical benefits, all of those things are constantly rising and we know that the market isn’t going to absorb it all. In this competitive world, you have to constantly look for improvements to remain competitive - you can’t stay the same.”
Di Lillo concluded by drawing attention to a cost component that many coffee companies have yet to acquire. “The only other comment I would want to make is that we feel -- very strongly -- that the people that produce our coffee should benefit from what we’re doing. We have a social responsibility to them, and that is a real part of our cost. In Costa Rica, where we purchase a lot of our coffee, for example, as well as in Sri Lanka, where we get our tea, we want to pay a fair market price for these products so that our suppliers can pay their employees fairly. We also commit to build community centers or schools, which provide education and other benefits to the people involved in coffee production. I had the pleasure of going to one of the farms in Costa Rica, and other neighboring farms from where we get our coffee, and it’s heartwarming to see the difference our involvement makes.
Together with our local supplier, we encourage their neighbor farmers to use good practices in terms of non-chemical fertilizers, soil management, etc. on their family farmers. We certainly want to pay a fair price, and one at which we can be competitive, but we’re not just focused on buying green coffee for less, since there’s always cheaper coffee around. We certainly don’t want to work with producers that don’t care about the quality of life of their workers, the long term affect on the environment or the quality of their product.”
Developing a Plan
Frank Dennis, c.e.o. of the Swiss Water Decaffeinated Coffee Company, Inc. of Burnaby, BC, Canada, formerly worked for Kraft Foods Canada, Inc. and has some experience in regards to pricing coffee for a large multinational corporation. While not willing to discuss the specifics of his former employer’s policies, Dennis did make some general comments about the pricing process. “I think it’s useful for specialty roasters to be aware that there are a lot of ways to establish pricing, and that it’s just as important to lower your prices when you’re making ‘too much’ money, as it is to increase your prices when you’re suffering losses. The larger companies know this, and they put policies in place that more or less adjust pricing automatically across a variety of circumstances. I noticed this a year and a half ago, when coffee prices spiked, almost doubling in five months from roughly seventy cents in September 2004 to $1.35 in March 2005. Because it had been so long since coffee prices had gone up, many companies with less experienced management didn’t respond. Some newly established companies, in fact, had never seen prices as high as that of last year, and many of these newer roasting companies didn’t increase their prices for some time. A few still haven’t, even though prices still have not retreated to where they started out. The larger companies, however, have adjusted their prices several times already. This is especially crucial in the coffee business, where you may have coffee booked out 18 months at low prices and you figure that you then don’t need to raise your prices until then, even if the market has shot upward. The problem is that even if you don’t have to pay the high prices immediately, you need to start building the reserves in order to pay those prices in the future. Likewise, in a downward trending market you may have to lower your prices, to the extent your reserves will allow, so as not to lose business. This holds even if you’re costs aren’t going down immediately, due to previously contracted coffee. In today’s market, selling based on your cost of replacement, what it would cost you to replace the coffee you’re currently selling, is a cardinal rule of the coffee business. My point is that pricing is a discipline, and needs to be practiced as such,” Dennis concluded.
Pricing, while not rocket science, is pretty important and deserves a lot more attention than many people give it, especially in an industry based on a commodity known for its extreme volatility. So while there are no rockets involved, fiery crashes are still possible and need to be avoided. There is a brief report, “How to Organize the Pricing Discipline,” by Jeffrey Johnson, of Rapt, Inc. that is available from the company’s web site and offers a general overview of pricing policy that, while not specifically directed to the coffee industry in any way, provides some guidance as to how to go about developing a pricing policy. For more information, please visit: www.rapt.com.
About the Author: Timothy J. Castle is a past president of the SCAA. He is currently the head of Castle Communications, which specializes in marketing and publicity for the coffee and tea industries. He is a regular writer for Tea & Coffee Trade Journal.
Tea & Coffee - May/June, 2006
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