This article at the CakeBoss website asks – and partly answers – the question in the title: how much should I charge for my cakes? I like this topic, because it’s much more tangible than the work we more commonly do on the pricing of services or software applications. And who doesn’t like a bit of cake?
As in the last case study, this one takes a broadly cost-based approach to pricing: adding up the cost of ingredients, labour, overheads and delivery. And as in that case, this provides only the baseline minimum price that should be charged.
Actually, let’s go into this “baseline” idea in a little more detail. The true baseline is the cost of ingredients. If you need to spend £4 on ingredients for a cake, there is no point selling it for £3 – you might as well not have bothered.
Labour costs may or may not be in the baseline, depending on how regular your work is and what alternatives you have – essentially, your opportunity cost. If you (or your employee) has 40 hours available to work this week and only 30 hours of planned in, that 10 hours might go to waste if you don’t use it on something. If it’s your own time, you probably have something else you could do – even if there is nothing to catch up on at work, you could watch a film or have a bath. How much is it worth to you to give up that pleasure?
If you’re not looking at a specific job but setting your general pricing policy, however, you should usually assume that you will consistently use all or most of your staff time. If it turns out that you don’t, you would probably reduce staff numbers until they match demand (or if it’s your own time, you might take a part-time job to supplement your cake earnings). You won’t sell all of the time available – you probably will not operate at 100% efficiency, or you might even want to keep a small reserve of staff resource available just in case of emergency jobs – but it’s unlikely you will set aside more than 10-20% of the total cake-making time you are paying for. Let’s say it is 20%. Then the labour cost is the number of hours spent making a cake (including design, speaking to the customer, and so on as well as actually baking), divided by (100%-20% = 80%), plus direct employment costs such as national insurance and pensions.
Delivery costs usually are a direct variable cost which you will either pay out to a courier, or will handle yourself based on the same time and materials calculation as for the cake itself. Fairly straightforward.
Overheads are the really interesting part of this. You have to pay your overheads anyway, no matter how many cakes you sell. If you sell one cake a year, to make a profit you would have to include your entire annual overheads in the cost of the cake. This is unlikely to be affordable unless your customer is Elton John. Alternatively if you sell ten million cakes a year, the overheads per cake will be tiny. Most likely you are somewhere in between.
So you should just divide the annual overheads by the number of cakes you sell, right? Wrong. Here’s why.
Some customers have lots of money. These people are probably willing to pay more for a cake than average. Some people have not much money at all and are able to pay less. Let’s see how we can best serve both groups of people. Imagine your home town has three families: the Camerons, who will buy a cake every week for up to £52, the Cleggs, who will spend £28 and the Milibands who will only spend £20. Each family will buy 50 cakes a year if they can afford them.
It costs you £10 in ingredients and labour to make a cake. Your overheads are £2000 per year. So let’s see how we should include those overheads in the price.
Perhaps you’d like to sell all 150 cakes and divide the overheads equally between all the cakes? £2000/150 = £13.33. So you need to charge £10 + £13.33 = £23.33 for a cake. But at this price the Milibands can’t afford to buy, so you will only sell 100 to the Cleggs and the Camerons.
This in turn means you need to recalculate and divide the overheads by 100 instead. £2000/100 = £20. So your new price is £10 + £20 = £30. But now the Cleggs can’t afford it either. So you end up selling just to the Camerons.
Because you’re only selling 50 cakes now, you have to recalculate again. £2000/50 = £40, so your new price is £10 + £40 = £50. This is just enough for the Camerons to afford, so you will still sell 50 cakes. But there is not much room for profit, and those cakes are quite expensive now.
Let’s start again. Imagine that you make your cake with three different colours of icing. The Camerons like blue cakes, so you make a blue cake for them. The Cleggs like yellow and the Milibands like their cake in deepest red.
Now you have a new pricing policy. Blue cakes are sold at £37. Yellow cakes are £25. Red cakes are £18. How does this work out?
Each family can afford the cake you’ve made especially for them. The blue ones contribute £22 towards overhead (plus £5 to profits), the yellow ones £12 overhead + £3 profit and the red ones £6 overhead + £2 profit. Each sells 50, so your overheads are covered by 50 x £22 = £1100, 50 x £12 = £600 and 50 x £6 = £300 – a total of £2000 – and you make £500 profit too. Not are you better off, but so are all three families: the Camerons get the same cakes but cheaper than before, and the Cleggs and Milibands can now afford to eat cake too.
This approach, called price discrimination, allows you to tailor your product for different markets and apportion the overheads accordingly. If you get the prices right, you are better off and so are all your customers. There is a catch to this, however. What if someone decides to buy a cake that wasn’t designed for them?
Young David the Miliband brother may think he deserves a blue cake. Well, that makes no difference because Ed won’t let him spend the money on it. They can’t afford it.
But how about if the Camerons feel like slumming it and decide to buy a red cake? It will save them £19, after all. Even though they can afford £37, why should they spend it if they can instead keep the money to spend on tickets to the polo?
For this reason, you need to make the blue cakes more attractive than the red ones so that people who can afford blue will still buy it. You might do this by reserving the best flavours or the top quality flour for the blue cakes; or by making the red ones smaller, or applying the icing less neatly. You might make the red ones available only early in the morning, so that people who want cheap cakes have to get up early to buy them. You could even wrap the red cakes in garish VALUE CAKES packaging so that the Camerons would be embarrassed to serve them when the Ashcrofts come visiting in their yacht.
Paradoxically, some of these approaches require you to deliberately lower the quality, or perceived quality, of the red cakes. It seems odd that reducing quality would increase profits and make your overall customer base willing to pay more – but it can.
In reality your customer groups will not be a mutually exclusive set of rich, average and poor customers. The same customer will sometimes be willing to spend more money and sometimes less. A rich customer might buy the expensive product most of the time but will still trade down occasionally, while a poor one might generally buy cheap but will splash out now and then. The same person who may make do with a low-end cake for their birthday may spend more when it’s their wedding. You need to find the right mix of products which encourages people to spend more money when they have it, but still captures a price-sensitive market too.
You may want to use different brands for the different price levels – as the supermarkets do with their Value or Basic ranges, their standard mid-price products and their Finest or Taste The Difference premium products. This way they capture three different customer segments in the same store and earn maximum revenue from each, while clearly signalling to each customer group the quality tradeoff they are making for their money.
There are many other pricing techniques you can use in your cake business: loyalty cards, free offers, short-term discounts, customised recipes or designs for companies (which are much less price sensitive than consumers for this type of purchase), taster portions and more. Some of these are covered in other posts and they are all explored in my book, which you can order here. Price discrimination, though, is probably the most powerful tool you can use to increase profit and revenue in this kind of market.