"Cost and prices, time for the numbers. What should I do?" A few weeks ago Karen Faulkner finalized the purchase of a bakery which specialized in bread. The prior owner had decided to sell the business because it lacked profitability. There were plenty of customers which suggested to Karen that the problem was with costs or pricing. The last price increase on any of the products was in 2002, ten years ago. Karen thought she could turn things around and would start by repricing her products. "This isn't a hobby, it's a business and if I don't get this right, there won't be a store." Karen was overwhelmed, but she decided to start by repricing the signature product--the honey wheat loaf. "I'll start with the honey wheat loaf; it will be a 'pricing beta test'."

Notes and numbers were spread out on the table so that Karen could figure out costs and margins. Once she estimated cost, the difficult decision would be to decide on a price. A loaf of honey wheat still sold for $5.25. If the price needed to increase, what was the best price? What price would cover costs and keep customers buying loaves? Was it better to raise prices incrementally or all at once to avoid sticker shock?

The Ingredients

Karen was a graduate of a local college of business. She put her degree to use in a variety of ventures. Karen had owned a business in the past inspecting homes. She was comfortable owning and running a business and thought a better pricing strategy could turn the bakery around.

The bakery was located in a medium-sized community with a stable economy supported by employment at the local university. The bakery was located downtown and served a lunch crowd from the nearby high school and businesses. The building was next to a small plaza where customers could sit outside for lunch. There were also tables at the front of the bakery. The atmosphere was friendly and the scent of baking bread filled the shop. The bread store was well known and liked in the community. It was perceived as selling healthy, high-quality foods; it sold a premium product. Schools visited on field trips and the free samples drew visitors. If asked to describe her customers, Karen said, "I think of them as shoppers like me; aware of quality and willing to pay a little more for something healthy with no preservatives."

The Mix

Karen knew she had to price the bread based on what the market would pay, but she also knew she needed to make sure the price was high enough to sustain her business. It made sense to her to use a spreadsheet to estimate costs and contribution margins. "Time to do the numbers." Karen decided to estimate the cost of goods sold and contribution margin for both 2002 and 2012. She made a list of the ingredients in her loaf and their costs as of 2002. Honey, wheat, salt, yeast, and water were the bread's ingredients. It seemed simple but it wasn't. One batch of bread that made 48 loaves and required 56 pounds of wheat, 12 pounds of honey, 0.4 pounds of salt and three pounds of yeast. In 2002, honey was $1.32 a pound, salt $4.15 a pound, yeast $1.64 a pound, and wheat was $0.17 a pound. It cost $8.50 an hour for labor. Were there other costs she needed to include: packaging and overhead?

Prices had risen significantly for everything except yeast in the ten years between 2002 and 2012. Honey was now $4.02 a pound, salt $7.47 a pound, yeast was $0.98 per pound and wheat was $0.30 per pound. Wages hadn't changed at $8.50 per hour. A batch of bread needed a half hour of labor to mix the batter. While employees needed to be around when the bread rose and baked, employees usually did other work during this time and she decided to allocate only 0.5 hours labor per batch of bread.

The variable costs could and did change over time, but their variability made it difficult to forecast their values in the future. Karen wondered how or even if she should somehow incorporate this uncertainty into her calculations and decision. She had seen how commodity prices had changed significantly in just the few weeks since she bought the bakery.

Karen did not include fixed costs in her calculation. She had bought the business, not the building so there was monthly rent, not a mortgage. Water wasn't included in the cost structure, but without it there wouldn't be bread. Should part of the water bill be allocated to the loaves? And what about insurance, taxes, and other fixed costs? Were they part of the cost? Business theory stated that fixed costs should not be included in pricing decisions (Stiving, 2010), yet many business allocated fixed costs to product lines in their pricing decisions (Shim & Sudit, 1995). Since Karen had not collected fixed cost information she decided to ignore them and focus on variable costs.

And then there was pricing. Covering costs was critical but what would customers be willing to pay? If Karen raised prices how would customers react? Should she increase all at once or a little? Should the price cover costs now or anticipated costs for the next couple of years so the change could be "one and done?"

The Rise

Pricing seemed like more of an art than a science. What did competitors charge? The loaves on grocery store shelves looked industrial, tasted bland, and shipped by truck from a factory. A grocery store field trip yielded a wide variety of prices and products. Over the last few years, grocery stores started selling artisan and other kinds of loaves that looked like what she was selling in her store. Focusing on honey wheat, Karen found loaves at a couple of stores that looked like her loaves and sold for $5.25 or more a loaf. Those loaves seldom went on sale, but sometimes were put in the day-old section of stores. The difference was the ingredient list.

What exactly were some of the ingredients on the label?

In the grocery store, the typical bread loaf was something she thought of as factory-made. Those loaves often went on sale. The price was $4.10 for higher quality brands, but they often sold at a discount of $2 a loaf. The texture and taste was inferior to her product, but she knew some customers wouldn't notice the difference and cared more about price. She decided those were not the customers she wanted to target. Convenience and price were their focus.

There was another bakery in town, but it made and sold rolls and didn't sell bread. Since it didn't make products similar to her loaves she didn't think she had to worry about competition from it.

Karen thought her product was a premium loaf, made by her bakers and sold while it was still oven fresh. Her bread was baked fresh and without preservatives, a quality product. Many customers realized the premium qualities of her bread and often commented on the texture and taste. Her customer base seemed less concerned about price and more concerned about quality. They could see the loaves in the back of the store, talk to the bakers and better yet, smell the scent of freshly baked. In short, customers were willing to pay a premium for a higher quality product. Yet, Karen wondered if they would find alternatives if she raised her price. In a Canadian study the price elasticity for bread was -0.43 (Pomboza & Mbaga, 2007) suggesting that a one percent increase in price would lower demand by 0.43%. While this resulted in fewer loaves sold, it also resulted in higher profits for the store if Karen raised her price. Karen did not have information on whether customers would substitute inferior grocery bread for her higher quality bread if she raised her price. It was simply an unknown. Karen's research convinced her that she had a unique product. Competing on price seemed like a bad idea. But if she baked it and priced it for profits, would they buy?

The Loaf

Now that Karen had calculated the numbers and had researched her competition it was time to decide on a price. There were many ways to start. She could estimate the mark up from the cost of goods sold and the margin percent based on 2002. Then she could use those percentages along with the 2012 commodity prices to estimate a 2012 price. Or Karen could estimate costs and multiply that number by some multiple like 2X or 3X to determine the price. Some bakeries priced goods this way. Karen wondered, "Would focusing on profit margins be a better strategy?" Even then she struggled with what to do about the volatility of commodity prices. Should a model incorporate that uncertainty and, if so, how?

Were there other pricing strategies? Should she use a markup from the competition? What if her numbers showed a big price increase was needed? How would her customers react? Did she need to change the price in stages and test the reaction or would it be better to do it all at once? What about the future? If she was increasing prices anyway, should there be a margin for the possible changes in commodity prices? This was much harder than the homework problems she solved in college while earning her business degree and the stakes were higher. This decision could make or break her business and its future. This was bread making 101.

Karen knew the price change was just the beginning. Standing in the store and monitoring sales was important not only to keep the personal connection her customers valued, but also to hear and review in real time how sales changed as the price increased.

CASE QUESTIONS ---> (Please assist with all these questions below to answer the problem successfully..)

1. Analyze the financial situation
2. Analyze competitive environment
   1. What is the structure of the market and does the business have pricing power?
   2. Is there sufficient product differentiation among the competitors?
   3. Is market entry by new comers easy or difficult?
3. Based on your analysis of 1) and 2) above, clearly articulate Karens core business problem?
4. Based on your learning on pricing and price discrimination, develop alternate pricing strategies for the firm?
5. Do you detect any problems with the decision maker?
6. Assess the risks to the business in Karens current thinking.
7. What risks do you perceive with your recommended business model?