The following is a fantastic guest article that really gives a comprehensive look at what to charge for your farm products. It provides useful information and great insights about marketing, price, calculating production and labor costs, and much more. For even more on this topic, it’s really worth checking out the excellent Farm Flows posts at www.littleseedfarm.com. Also, be sure to take a look at the links at the end of the article on marketing and price, as well as our Business Planning Page. Thanks to Scrapple for sharing his extensive knowledge on this topic!
As beginning farmers we’ve found it very helpful to interact with other beginners and share our cumulative knowledge as we all learn together. Starting a farming business is a daunting task and it helps to learn from others as we proceed down this path. One of the questions that comes up most frequently when chatting with other beginning farmers is how to price your farm products. This can be a very confusing proposition for someone with limited business experience and little financial background. Even for those with experience it can be a confounding problem. Having a background in business and economics and the experience of operating two profitable (although very small) businesses in the past, I thought it would be helpful to share an overview of some of our thoughts about pricing strategy.
What is your vision for the farm?
One of the first questions to ask is, what type of farm are you looking to operate? Typically two types of businesses find long-term success. One is a lower volume, higher margin producer and the other is a high volume, low-cost producer. A good example from the auto industry is Porsche vs. Toyota. Porsche focuses on creating an aspirational brand, producing top quality products and commanding a higher average selling price. Toyota, on the other hand, sells a much higher volume of pretty good cars at a much lower price and doesn’t really differentiate itself from the other high volume producers. Toyota’s introduction of the Lexus brand was Toyota’s way of trying to get a little piece of the higher margin, lower volume industry. Frequently, the higher margin strategy will require higher than average prices and a greater focus on marketing and product differentiation. In general, I think most people reading this site and looking to start a farm will fall on the lower volume, higher margin side of things, so I’ll focus more on using that strategy.
What are your costs of production?
The most critical step in the pricing process is to determine your costs of production. If you don’t know your costs you shouldn’t be pricing anything. Far too many businesses don’t take the time to truly understand their costs of production. By not understanding your costs and pricing too low (or too high) you will eventually run yourself out of business. If you price below your true costs you will not only go out of business, but you will also make enemies with your fellow farmers, not a great proposition for a newbie farmer. This step is by far the most critical, do not to ignore it.
So, how do you determine your costs of production? Start by breaking down all of the expenses required to produce your product. There are many ways to do this, but I like two ways the best: Direct/Indirect and Fixed/Variable. I think Direct and Indirect is a little more straight-forward so I’ll stick with that for this article. You can read this article on Fixed and Variable expenses if you’re interested in learning more about that.
Direct expenses are the expenses that relate specifically to the production of your goods. Indirect expenses are expenses that do not relate specifically to the production of your goods.
Let’s go in reverse and start with Indirect. These are costs that are not directly related to the production of your goods, but that you will need to cover regardless of your volume of production. Indirect costs generally include items such as your mortgage, insurance, taxes, interest expense, marketing expense, and, for the most part, fuel expense and depreciation of equipment. Your rent/mortgage will not be lower if you have a bad sales month. The insurance company won’t care if you can’t sell all your produce, they still want their premium payment. Your marketing cost will be the same whether it drives one person to buy your product or a thousand. Did you borrow money to buy land, equipment, or other necessary items? If so, the interest expense on that debt should be included in your calculation of indirect expenses. Do you already own land outright? If so you should include an estimated value for use of the land similar to what you would charge to rent your land, or what you would pay in interest if you didn’t own your land. You should relatively easily be able to add up all the Indirect expenses and come to a rough annual/monthly estimate. Keep that figure aside. You can think of Indirect expenses as the amount you will need to cover AFTER covering your Direct expenses. In a lot of respects Indirect expenses are similar to Fixed expenses in the Fixed/Variable analysis.
So what are the Direct expenses? These are the expenses that relate directly to the production of your goods. For farmers the biggest Direct expenses are typically labor (including your own), feed, seed, slaughter/butcher fees, and utilities/electricity. Fuel expense can also fall into this category (not all expenses can neatly be ascribed to one category or the other). It’s very important to understand how much it costs to directly produce your goods. Walk through the life-cycle of your product(s) from start to finish. What is directly required to produce each product?
Once you get a good idea for the Direct costs you can break them down for each unit you are producing. This will give you an idea for how much it directly costs you to produce each item you’re taking to market. If you know that figure you can apply an additional margin above that cost that will get you to a number that also covers your indirect expenses calculated above. Once all of your expenses are covered that should be your MINIMUM price. It’s advisable to put some extra margin in to cover unforeseen events (losses) and to account for inefficiencies, errors and unsold inventory. This is a version of what’s called the “cost-plus” method of pricing.
Your expenses are highly dependent on the type of operation you run. Selling wholesale, retail or to restaurants are very different business models with very different expense dynamics. If you’re selling at farmer’s markets all over your state then fuel will be a huge expense and you’ll need to do some serious number crunching around how much it costs you to transport all your goods back and forth each day. If you’re buying in a lot of feed for your animals then you’ll need to understand the feed conversion rate of each animal and how much it will cost to get your animals up to market weight. Slaughtering and butchering fees are another very big variable expense for livestock producers and should be adequately accounted for. Labor costs can be a very large portion of expenses, especially for produce farmers. Electricity can be an enormous expense if you’re chilling/freezing large amounts of food over long periods of time.
Ultimately, you’ll need to produce at a sufficient volume and at a sufficient margin to cover your direct and indirect expenses. The only ways to cover your costs are to produce more, sell at a higher price or reduce your costs. Once you understand your costs you’ll be able to determine which tactic works best for you. Sit down and run the numbers, you’ll be very thankful you did. Who knows, you may enjoy knowing the details, it can be quite enlightening.
Make sure to account for your own labor
What do you do about personal living expenses and your own “salary”? You should include a labor rate in your figures that is high enough to cover your living expenses and a normal amount of savings. If you aren’t pricing your products high enough to cover your own day-to-day living expenses how do you expect to stay in business? Since you’re now self-employed you have to take into consideration your living expenses when you price your goods and plan your business’ profitability. Don’t sell yourself short. For the amount of risk you’re taking and the hard work that’s involved you deserve to make a decent living. One additional note, it’s not appropriate to subsidize your farm business with outside income and operate at a price level that doesn’t reflect your true costs of production. Your business should be able to stand on its own as a profitable and sustainable entity.
Don’t forget about capital expenditures
Depreciation of property, plant and equipment is a very real expense. If you spend $10,000 on a tractor on Day One of starting your farm you need to account for that expense over the estimated useful life of that tractor. If you think the tractor will last ten years (and your accountant agrees) then you should allocate $1,000 in depreciation expense to your indirect (or direct in some instances) costs over the next ten years. If you do not account for depreciation of the equipment (and save funds for future equipment replacement) you will not be able to replace your equipment when it eventually reaches the end of its life.
At this point you should be able to determine what price you need to charge to cover your bills and stay profitable. It’s really all about knowing your expenses. You could stop there, but there are still a few more considerations that I like to take into account…
Does your price fit your marketing strategy?
If you’re marketing your products as a high-value or differentiated product then you’ll want to price at a level that communicates that to your customer. You want to attract the customers that are willing and looking to pay that kind of price for a superior product. Selling a differentiated, high-value product at a low price will confuse the customers you’re hoping to target and attract the customers you’re hoping to avoid. If you know your costs of production you can confidently adjust your price up or down as necessary to hit the right demographic and also assure your business’ sustainability. If you find that your price is too high for the demographic you’re targeting then you either need to change your target market, scale-up or find a way to cut costs.
What is the supply and demand dynamic for the products you’re selling?
Once you’ve determined the necessary price and production volume to cover your costs you’ll need to determine if there is enough market demand to sustain another producer of your size. If demand is waning lower prices may be required to drive further demand. Each situation is completely different and there’s no easy answer. Talking to existing farmers, visiting with customers and understanding your target market should lead to a better understanding for whether you could sell at a similar or higher price to what’s being sold already.
If demand for your product is strong enough you may be able to enter the market at an equal or higher price than your competition. If demand is not strong enough then you may need to charge a lower price or pursue a different marketing/sales strategy. If you know your costs of production you’ll be able to decide which option is best for you.
It helps to think about the supply/demand dynamics of your market while you’re formulating your production strategy above, the two are not mutually exclusive. If your price is just too high think about adjusting your marketing strategy and targeting a different demographic. If that’s not an option, find ways to be more efficient and lower costs of production so that you can also lower your price. If demand is weak, or the market is already over-supplied, you won’t want to scale-up your production volume.
What about what the competitors are charging?
In my mind this question is not absolutely necessary if you follow all of the steps above in determining your price. What competitors charge is interesting for you to gauge and measure yourself against, but it should not determine what you charge. If you have adequate knowledge of your true costs of production and the supply/demand dynamics of your target market then your competitors’ price is interesting information, but not much more.
Don’t get me wrong, it’s very important to be aware of competitors’ prices and it should help shape much of your business strategy, but it should not be the primary factor in determining your price. It should be a benchmark you use in assessing your own viability and whether you can operate sustainably given your costs of production and the price/volume at which you’re selling. It’s generally been my observation that farmers too frequently under-price their goods and don’t earn an income reflective of the risk they’re taking and work they’re putting in.
If you calculate that you can sell at a lower price than competitors then it’s up to you to determine whether you want to disrupt the market by charging a lower price and potentially driving your competitors out of business or whether you want to charge an equal or higher price and be rewarded with higher profit margins. If your business is viable at a lower price than competition that’s their problem, not yours. It often doesn’t make sense to pursue a lower price strategy just because it’s theoretically possible (why leave money on the table unnecessarily?), but that’s your choice to make. If you are trying to sell to a lower income bracket or make local and sustainable food more affordable and your business is profitable and sustainable at a lower price then it might make sense. At the end of the day if you know your costs you have the luxury to determine what you’ll charge. If you don’t know your costs you’re flying blind and will hit a wall at some point.
If I don’t sell at a lower price how will I get customers?
Creative marketing and/or having a differentiated product are excellent strategies for acquiring new customers. Your goal should be to acquire long-term, dedicated customers. If you pursue a strategy of acquiring customers by selling at a low price and thinking that you’ll just raise the price at a later date you may be setting yourself up for a rude awakening. Competitors will likely try to match or beat your lower price to retain their customers. If competitors have been in business for a long time they may be much more prepared to withstand longer periods of unprofitability than you are. Customers are also very fickle; many will leave when you eventually raise your prices. Besides, do you really want to attract customers that are only looking for the lowest price? If so, maybe you should consider a higher volume, lower cost strategy.
I figured out the appropriate price based on your suggestions and I still won’t be making a decent living
Then you haven’t been honest about taking into account all of your expenses. Most likely you haven’t considered ALL of your living expenses when determining your prices and required production volume. From a ‘cost accounting’ perspective you should not (and in fact from a tax perspective cannot) include your personal expenses when determining your business’ profitability, but the real-life situation of being self-employed dictates that your business must be profitable enough to cover your cost of living otherwise you won’t be able to stay in business. Include a respectable living wage for yourself, you deserve it.
- by Scrapple
For additional financial tips and observations keep an eye on our Farm Flows posts at www.littleseedfarm.com
Additional resources on the web:
UVM Pricing Information: http://www.uvm.edu/newfarmer/?Page=marketing/price/pricing_index.html&SM=marketing/sub-menu.html
Breakeven Pricing: http://www.extension.iastate.edu/agdm/wholefarm/html/c5-202.html
Direct Marketing: https://attra.ncat.org/attra-pub/summaries/summary.php?pub=263