Value Pricing:

Can The effectiveness of value pricing for some food-service operations is

unquestionable, but not for others. Here's a simple technique that

operators can use to determine whether value pricing might increase

their profits.

by David K. Hayes and Lynn M. Huffman

David K. Hayes, Ph.D., is vice president of bro'adcast/videofor the Educational Institute of the-AH&MA. Lynn M. Huffman, Ph.D., is the chairperson of the department of educa- tion, nutrition, and restaurant~hotel management at Texas Tech University.

© 1995. Cornell University

Q u i c k - s e r v i c e restaurants oper- ate in one of the industry's most tur- bulent segments. That turbulence has been augmented by value pricing-- the effort to increase profits by deeply discounting menu prices. 1 Fueled by the initial aggressive ef- forts of industry leaders such as Taco Bell and McDonald's, value pricing appears to be a long-term competi- tive strategy. 2 Currently more than 20 percent of large chains' business volume may come from their value- priced menus. The result is a down- ward price spiral that consumers love but some operations executives find worrisome)

In its simplest form, value pricing is an attempt to use product price to satisfy consumers' increasing de- mand for value, although value pric- ing is not a substitute for product quality, consistency, and cleanli-

Charles Bernstein, "V-Menu Strategy:Value, Veggies,Variety," Restaurants and Institutions, July 15, 1993, p. 54.

2 Cleveland Horton, "Taco Bell Expands Price Strategy," Advertising Age, Vol. 61, No. 46 (November 5, 1991), p. 20.

3 Theresa Howard, "Wendy's Goes for Gold in New Olympics Campaign," Nation's Restaurant '.News, February 7, 1994, p. 12.

February 1995 • 51

NT A RLY

• Special value pricing: The price is reduced on selected menu items for a predetermined period of time; coupons or other forms of advertising may be used. Each of those approaches can be

useful.Which one will be the most effective depends on the needs and menu offerings of a particular op- eration. As special value pricing is best studied as a common form of retail discounting, this article con- cerns itself with the first two tech- niques, everyday value pricing and bundling.

Both strategies offer the promise of increased profits through in- creased sales volume. Everyday value pricing increases volume if customers entering the door buy more items than they otherwise would and if more customers enter the door. 1~ Bundling can increase per-person spending by encourag- ing consumers to buy complete meals) 2 The promise of profits, however, can be false if the value- pricing techniques do not produce the expected consumer-spending patterns. 13

Most businesspeople dislike the idea of reducing selling prices. There is good reason for their con- cern.Yet the effectiveness of value pricing for some organizations is unquestionable. TM Operators consid- ering a move to value pricing can use a simple technique to deter- mine the buyer response necessary for value pricing to increase profits.

Goal -Value Analysis

Several authors have addressed the menu-analysis problem in detail, is However, complex mathematical formulas are inconvenient and in- timidating. A simple and effective approach to the issue is goal-value analysis, which we introduced and explained several years ago. 16 Using this approach, the relative profitabil- ity of a menu item can be deter- mined by the formula

A x B x C x D = G where

A = (1 - food-cost percentage), B = average number sold per day, C = selling price, D = 1 - (food-cost percentage +

variable-cost percentage), and G = goal value. Goal-value analysis is unique in

that it combines both food-cost percentage (portion cost divided by selling price) and contribution mar- gin, balancing and weighing both factors to arrive at a useful figure.

For example, an operator selling a daily average of 250 hamburgers at $1.29 per burger, with a $.60 por- tion cost and a 30-percent variable cost, would find the goal value for that menu item (rounded off to the nearest whole percentage) to be

(1 - .47) x 250 x 1.29 × (1 - [ .47 + .30]) = 39.

A menu item with a goal value equal to 39 would generate a profit equal to that of the hamburger. An item with a goal value less than 39 would be less profitable; one with a

H Richard Gibson, "Super-cheap and Midpriced Eateries Bite Fast Food from Both Sides," The Wall Street lournal, June 22, 1990, pp. B1, B4.

,2 Susie Stevensen and Karen Strauss,"Making Green from Blue Plate Specials," Restaurants and Institutions, August 26, 1992, pp. 69, 72, 74.

~3 Steve Weiss, "Ten Promotional Principles," Restaurants and Institutions, June 10, 1992, pp. 84, 88, 92, 97.

I4 Lev, pp. D1, D9. *~ See: Jack E. Miller, Menu Pricing and Strategy (NewYork: John Wiley & Sons, 1993), pp. 98-101;

Thomas J. Kelly, Nicholas M. Kiefer, and Kenneth Burdett, "A Demand-Based Approach to Menu Pricing," Cornell Hotel and Restaurant Administration Quarterly, Vol. 33, No. 1 (February 1994), pp. 48-52; Lendal Kotschevar, Management by Menu (New York: John Wiley & Sons, 1987), pp. 172-192; and Mohamed E. Bayou and Lee B. Bennett, "Profitability Analysis for Table-Service Restaurants," Cornell Hotel and Restaurant Administration Quarterly, Vol. 33, No. 2 (April I992), pp. 49-55.

16 David K. Hayes and Lynn Huffman, "Menu Analysis: A Better Way," Cornell Hotel and Restaurant Administration Quarterly, Vol. 25, No. 4 (February 1985), pp. 64-70.

February 1995 • 53

Exhibit 1 An average day at Broiler-Tech Burgers

Food-cost percentage

Burger .47 Fries .28 Large drink .18 Small drink .19

Selling price ($)

1.29 1.09 1.19 0.89

Portion cost ($)

0.60 0:30 0.22 0.17

Number sold

250 225 150 125

Exhibit 2 Profit and loss at Broiler-Tech Burgers

Total sales Expenses

Food Variable Fixed

Total expenses

Pretax profit

Dollars Percentage

858 100

32 30 23

729 85

129 15

272 257 200

Exhibit 3 A day at Broiler-Tech Burgers with value pricing

Food -cost percentage

Burger .61 Fries .30 Drink .22

Selling price ($)

.99

.99

.99

Portion cost ($)

0.60 0.30 0.22

Number sold

300 300 300

Exhibit 4 Profit and loss at Broiler-Tech Burgers with value pricing

Total sales Expenses

Food Variable Fixed

Total expenses Pretax profit

Dollars Percentage

891 1 O0

38 30 22

803 90 88 10

336 267 200

Goal value

39 74 76 46

Goal value

10 83 111

higher value, more profitable. The goal-value figure, while not a dollar amount or a percentage, provides a standard or benchmark that allows for comparisons of various menu- pricing options.

W h e n using goal-value analysis, some operators use one variable-cost figure (an average) for all menu items. However, the operator can use any level o f variable cost that he or she feels is appropriate for any given menu item. 17

Goal-value analysis works well when comparing individual menu items, and it also works nicely for entire menus. To determine the goal value of an entire menu, the opera- tor uses the average portion cost (total food cost divided by number of items sold) in place of the portion cost, the average selling price (total daily sales divided by number of items sold) in place o f the selling price, and the total number of items sold in place of the number sold of a single item.

The formula trades a small amount of accuracy for its simplicity, but it has been found to be superior to many other menu-analysis sys- tems. j8 Goal-value analysis is espe- cially useful as a means of observing the dynamics involved in value pricing.

A Case Study To examine the impact o f value pricing using goal-value analysis, imagine that a single quick-service restaurant is operating as Broiler- Tech Burgers. For our purposes, let's assume it currently serves only four items: quarter-pound hamburgers, french fries, large soft drinks, and small soft drinks (see Exhibit 1).

17 For various ways to calculate variable cost, see: R a y m o n d Schmidgall, Hospitality Industry Managerial Accounting (East Lansing, MI: Educational Institute of the AH&MA, 1990), pp. 203-204.

18 Lendal Kotschevar, "Menu Analysis: R e v i e w and Evaluation," Florida International University Review, Vol. 5, No. 2 (Fall 1987), pp. 19-25.

54 CflRNELL HOTEL AND RESTAURANT ADMINISTRATION QUARTERLY

On an average day Broiler-Tech serves 750 items to 300 customers, the total cost of food is $272, and the total sales are $858. Therefore the average selling price is $1.14 ($858 divided by 750), and the average food cost is 32 percent ($272 divided by $858). Given those numbers, and a variable cost of 30 percent, we can use the formula

A X B × C × D = G to determine the goal value of the entire menu:

(1 - .32) x 750 × 1.14 × (1 - [.32 + 0.30]) = 221.

Comput ing the goal value of the individual items, we find that the hamburger has a goal value of 39; the french fries, 74; the large drink, 76; and the small drink, 46 (see Exhibit 1).The menu generates a 15-percent profit (see Exhibit 2).

Everyday value pricing. The owners of Broiler-Tech are consider- ing a change to a menu with 99-cent everyday value pricing that would include three items rather than the current four (by eliminating the small drink). I f they made the change, and if all their current cus- tomers were so attracted to the lower prices that they bought one each of all three menu items, they would sell 900 items to 300 customers, the total food cost would be $336, and the total sales would be $891.Working through the numbers again, we find that the entire menu would have a goal value of 179. The burger would have a goal value of 11; the fries, 82; and the drink, 110 (see Exhibit 3). The menu would generate a profit of 10 percent (see Exhibit 4).

Even though the number of items sold would increase 20 percent, from 750 to 900 items, pretax profits would decline 32 percent, from $129 to $88.

Increasing customer counts. Value pricing for Broiler-Tech's cur- rent customer base, using the prices suggested here, would not be a good idea, even if all customers were

highly attracted to the value-priced items. That is not unexpected. The strength of value pricing lies not only in its influence on the spending patterns of current customers but in its ability to generate more custom- ers. The question to be answered, of course, is exactly how many new customers must be generated to make value pricing worthwhile. The answer can be easily found with the goal-value formula. If we know the selling price and the portion cost, we can determine how many items have to be sold to maintain the goal valu e:

B = G/ (A x C x D) In our 99-cent example, if we

continue to assume that each cus- tomer buys all three items, the aver- age food cost is 38 percent, and the average selling price is, of course, $.99.We can use those numbers to determine how many items must be sold:

B = 221/{(1 - . 3 8 x 0.99 x (1 - [ . 3 8 + . 3 0 ] ) }

B = 1,128 If each customer bought all three

items, the store would need 376 customers, or 76 new customers, to maintain the goal value of the menu. The total sales would be $1,117 and the expenses would be $960. There- fore the profit would be $157, or 14 percent.

Additional customers do not ma- terialize from thin air. They are the result of word-of-mouth and paid advertising. Simply put, it does little good to introduce value-price menu items without an extensive and well- planned advertising program that results in additional customers.

In some cases a value-pricing strategy has failed because it was not supported heavily enough by adver- tising dollars. The advertising dollars, however, must come from the operation's revenues. That makes the needed volume increases from value pricing even higher, to offset those additional advertising costs. If the

operator allocates 4 percent of total sales to advertising, increasing the variable cost to 34 percent, we can recompute the number of items that must be sold:

B = 221/{(1 - 0.38) x 0.99 x (1 - [0.38 + 0.34)]}

B = 1,285 That means the store needs 428

customers, or 128 new customers-- more than a 42-percent increase--to maintain the goal value of the menu while also paying for expanded ad- vertising. The total sales would be $1,272, and the expenses would be $1,116. Therefore the profit would be $156, or 12 percent of sales. As can be seen, the advertising expense comes directly from bottom-line profits. Advertising is both the ve- hicle that drives value pricing and an expense required by it. Perhaps that is why value pricing is so highly praised by those in advertising.

Profit Percentage versus Profit Dollars One need not be in the hospitality industry long before hearing the phrase "You bank dollars, not per- centage points." It is usually meant as an admonishment to those who emphasize cost percentages rather than bankable dollars. The phrase takes on new meaning, however, with value pricing. We believe that where value pricing is concerned, percentages are indeed important.

Re turn on sales is about more than pretax dollars. Pretax dollars are the result of the efficient use of an organization's people, equipment, and facilities. If an organization pursues a marketing strategy to increase bottom-line dollars but in doing so overtaxes the output of its people, equipment, and facilities, the long-run prognosis is not good. Overcrowded dining rooms, long lines, and dirty, rapidly aging facili- ties do not bode well for any operation. 19

19 Howard, January 17, 1994, pp. 29-30.

February 1995 • 55

If value pricing is to bring long- term success, increases in bot tom-line profit should result from the decreased fixed-cost percentages that offset the increased food-cost per- centages brought about by value pric- ing (and de- spite the need to allocate more funds for advertising). In addition, serious operators should consider an in- creased charge to variable expense for accelerated facility wear and tear. While wear and tear is included among the expenses covered by the variable-cost percentage, estimates of anticipated wear and tear are based initially on a known volume. The greater levels o f traffic resulting from value pricing may require a reevalua- tion of that original assumption and a revision o f the variable-cost percentage.

The issues of guest service and employee morale are less easily ad- dressed. In cases where workers are underused to begin with, value pric- ing results in labor-cost efficiencies. But in an industry segment that re- lies heavily on entry-level and part- time workers, quality, consistency, and cleanliness may suffer from the stresses produced by value pricing. The operator must carefully evaluate the likely repercussions of value pric- ing before implementing it.

How Low Should You Go? Operators need to know whether value pricing can be an effective strategy in their operations. That question can be looked at in two ways:

(1) With a given price structure, how many items must be sold to achieve desired profits? (2) With a given num- ber of items sold, what must the selling price be to achieve desired profits?

To use goal-value analysis to find the an- swers to such questions, follow these steps: • Establish values for A,

B, C, and D used in the goal-value formula. Take them from cur- rent operating results

or by setting target goals for performance.

• Compute the current goal value using those figures.

• To determine how many items must be sold, plug in the figure for the average selling price (C) and solve for the number of items that must be sold (B).

• Or to determine the selling price, make a projection of the number of items that will be sold (B) and solve for average selling price (C).

Summary Value pricing is a powerful market- ing technique. Its merits will no doubt continue to be debated, and we believe goal-value analysis can help clarify portions of the debate.

Value pricing can help operators to increase customer counts and total sales. It is also possible that in the long term advertising costs can be reduced, as a single value theme is a simpler message to convey than a more-varied theme and the price strategy is easier to implement than a changing market strategy. Fixed- cost percentages and some variable- cost percentages, such as labor, may decline as volume increases.When value pricing is combined with bun- dling, ordering speed for both walk- up and drive-through customers

may be increased as consumer deci- sions become easier. The result may be an increase in worker productiv- ity with no increase in labor costs.

O n the other hand, value pricing must be driven by extensive adver- tising, at least initially. It is not a strategy for a cash-poor organization hoping for a rapid turnaround.Value pricing is also damaging to organi- zations that are unable to deliver quality products in large volumes, since poor quality is a sure way to reduce the customer count. Some operations are unable to handle large volume increases overnight. Long lines, poor quality, and dirty facili- ties indicate a workforce or facilities that are stretched to the limit. Most risky of all is the possibility that the price reduction may be irreversible; once customers associate a menu item with a particular price, an in- crease is difficult.

We believe that value-pricing strategies must maintain profit mar- gins, not just pretax profit dollars. Because of the real operational chal- lenges presented by value pricing, individuals in the operational divi- sions of quick service need to de- mand marketing strategies that will maintain profit margins. Such pro- grams can be developed. Creative pricing strategies that increase some menu-i tem prices while reducing others can help. Customers should be encouraged to trade up to larger sizes, not just bundled packages. The McDonald's "Supersize It" campaign does just that.

Menu offerings and their prices must be carefully monitored to en- sure profit margins. Goal-value analysis can be a valuable tool in that process by providing a shorthand method to quickly analyze an item or an entire menu. If any segment of the food-service industry can stop the downward price spiral that has begun, it will be the quick-service segment, where creativity and inno- vation are the order of the day. CO

5, NNELL HOTEL AND RESTAURANT ADMINISTRATION QUARTERLY