Five Pricing Models for a Competitive Industry

Historically, one of the four pricing methodologies outlined below have been adequate for restaurateurs to develop suggested menu prices.

However, as competition develops and margins get tighter, a restaurateur must not only price for profit but to remain competitive within their market. The standard pricing models which are presently available allow for either pricing based on the market or upon food costs but none of them marry the profit margin and competitive factors in order to create the perfect relationship of highest price yet still competitive factors.

In 1988, I started working on this problem and developed a very simple yet powerful method called the Optimum Pricing Model. This model allows for competitive pricing while assessing profit potential.

Over the last few years, I have worked with clients to perfect the system and study the results. Coupled with strong portion controls, the Optimum Pricing Model has allowed my clients to sell profitable products at competitive prices and has enabled them to become more financially successful.

Outlined below are the standard forms of pricing a menu, detailing both their strengths and weaknesses. Following the review of the commonly used systems, we detail the Optimum Pricing Model.

The five pricing systems are:

  1. Direct Cost Pricing
  2. Competitive Pricing
  3. Average Cost Plus Profit Pricing
  4. All Costs Plus Profit Pricing
  5. Optimum Pricing Model

Direct Cost Pricing

The direct cost pricing method is the pricing methodology usually utilized by restaurateurs when developing selling prices. It is most often used as it is easy to implement and uses actual food costs as a
base.

A restaurateur will determine the food cost which they wish to achieve arbitrarily, ie; 30%. They will then determine the cost of the item to be sold. The determined food cost after preparation and wastage but before cooking is, for example, $1.25. The cost of the food is then divided by the food cost percentage which the restaurateur wishes to obtain, in order to develop a selling price. The calculation follows: $1.25 / 30% = $4.166666 or $4.17.

The system is that simple. By using any desired food cost percentage that the restaurateur wants to achieve, a resultant selling price can be determined.

In order to determine an appropriate food costpercentage many restaurateurs turn to the local restaurant associations to find out what the standard food cost percentages are for their market segment.

These percentages are then applied to the actual food cost to determine the selling price.

The major flaw with this system is that the restaurateur ends up using averages and not actual statistics. In addition to this, the menu planner has not taken into consideration other variable and fixed costs of the operation and will not be able to accurately determine if the restaurant will achieve a profit by selling items at the calculated price. Finally, by utilizing this methodology, the restaurateur may price all of their products above the level of other restaurants in the area and may not attract market support.

Competitive Pricing

Competitive Pricing is another common method of pricing in today’s market place. It is one method however, that could place the restaurateur in a precarious financial position. When the restaurateur examines the competitions price and duplicates them in their own establishment, many short comings are evident. The first is that the restaurateur does not know what the competition’s costs are. If they are considerably lower than their cost, the competition could be making a fair profit while they will not. More importantly the restaurateur does not know what the competition is making for profit. If they are losing money so will the restaurateur. Finally, by copying the competition’s prices and dishes the restaurateur has done nothing in regards to differentiating their product from the competition’s. This would close off the avenues to successful competition and growth of the restaurant.

Average Cost Plus Profit Pricing

The Average Cost Plus Profit system is an interesting method of pricing items but usually is only effective in certain styles of restaurants. This system is most commonly found in Donut Shops and sometimes in Ice Cream Parlors or Sandwich shops.

When the variety of products sold are so closely comparable in cost, only one average cost is allocated to all items. A profit margin is then added onto the cost of the goods sold and a selling price is established which has, as a base, the average cost of the goods sold plus the profit. The overhead cost is then covered by the difference in the selling price and the cost (which includes the profit margin). The concept of averaging the cost of goods sold for similar items is fine. However, the method of determining a selling price is not effective. For example, an ice cream shop may sell thirty to forty varieties of ice cream. A gallon of vanilla may cost $20.00, while a gallon of chocolate chip may cost $22.00 and a gallon of Rocky Road $25.00. However, these costs are then averaged and each cone, no matter what the flavour, is sold for $1.95. This example clearly illustrates the Average Cost Theory.

All Costs Plus Profit Pricing

The All Costs Plus Profit Pricing is one of the most effective but least used methods of pricing an item. It is effective because it takes into consideration all of the restaurant’s operational costs and the profit desired. As a result it suggests a definitive percentage which should be allocated to the purchase of food. That price is the food cost. Once the restaurant establishes what the food cost percentage must be, it uses it as a base to determine the selling price.

In order to illustrate this concept the following information should be considered. In most restaurants one simply uses the actual operating costs of the restaurant to aid in the determination of the operating costs.

First add up all the operational costs and include the desired profit of the restaurateur. Let us assume for our example that the profit percentage is 15% on the chosen item. Different profit margins are used for each different item. All the operational costs add up to 52.6% and the restaurateur wants to make a 15% profit. The total operational costs including profit is 67.6% therefore the food cost must be 32.4%. If the actual item cost is one dollar and that is to be 32.4% of the selling price then the selling price must be $3.09 in order to cover all the expenses and make the desired profit margin. If the restaurateur has more wastage or shrinkage than planned, the difference comes directly out of the profit. It is, therefore, imperative that the operational costs are carefully derived. If the restaurateur wants to sell the item at a lesser price the difference comes directly out of the profit margin. If the restaurateur wishes to make a larger profit for a particular item the amount allocated to the food cost must be reduced as the other operational costs are usually fixed. By using this method of All Costs Plus Profit Pricing the food cost is predetermined and the profit margin is almost guaranteed.

As perfect as this system seems, there is one little flaw. It does not provide for a competitive analysis. Therefore, by utilizing this system a restaurateur may price for profit but may also price above the competition. If the restaurant is over priced, customers will not be attracted to the restaurant.

Optimum Pricing Model

The optimum pricing model uses a combination of aspects of the theories outlined above. Once the restaurateur establishes the menu mix to be served, they should list all the products vertically down one side of a page. The names of the primary competitive restaurants should be listed across the top of the page.

As the Chef or Kitchen Manager is developing the standard recipes and costs for the restaurant, the restaurateur should be acquiring menus from each competitive restaurant in the area. The restaurateur should then fill in the grid with each restaurant’s price for the same or similar menu item which they sell. Once the information is filled in for each item, an average price should be determined. (Simply add the prices horizontally and divide the result by the number of competitive items for each item.) An example of how to conduct this methodology is illustrated in EXHIBIT II.

Optimum Pricing Model

Menu
Item
Joes Bobs Ruths Average
Daily
soup
$1.95 $2.25 $2.35 $3.28
Caesar
salad
$2.25 $3.25 $2.50 $2.67
Hamburger $4.95 $4.85 $4.25 $4.68
Hot
dog
$3.25 $2.95 $3.05 $3.08
French
fries
$2.00 $1.95 $2.25 $2.07
Apple
Pie
$4.50 $4.95 $4.25 $4.57

The average prices illustrated are the prices that the customer base will support. While a restaurant can price it’s menu anywhere from the highest to the lowest figures, it should stay within the range.

This range is what the customer base recognizes as fair for the product. Customers will likely consider that any price far below this average is made of inferior quality raw ingredients and that any price over this range is a ‘rip off’ for the same product. From these averages, then, the restaurateur can develop a proposed selling price that the market can and will likely support.

The second aspect of the Optimum Pricing Model is to determine whether a profit can be made at the price which the market will support.

Take the standard costed recipes that the Chef has developed and calculate each item’s food cost percentage and gross margin by using the proposed selling prices. If there is money to be made, the item should go onto the menu. On the other hand, if the food cost is too high and the gross margin too low, then the restaurant can not make money by selling the item even if their competitors can. Therefore this item should not be placed on the menu.

By utilizing the Optimum Pricing Model a restaurateur can ensure that they are not only priced competitively but have properly analyzed their profit potential to ensure product profit viability.

Conclusion

A restaurateur should not only watch their operational costs but should dedicate some serious time to menu price development. As profit margins get tighter, menu utilization and competitive pricing will be extremely important. By utilizing the Optimum Pricing Model, the restaurateur should be able to price competitively and profitably for the years ahead.