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Like many farmers I know, I’ve always struggled with setting prices. I want to charge a “fair” price for my customers, and I want to make sure those prices will allow me to continue farming. My thinking on pricing has evolved quite a bit over the last decade as I’ve been exposed to more useful concepts from the business world, and those concepts have proven to be useful tools when considering how to price my produce.
The first tool I use is variable costing. Instead of trying to account for all of the costs of the entire farm, I only look at the variable costs for producing each individual crop. Variable are the ones that relate directly and obviously to the amount of the particular crop I’m growing.
For example, when I look at the variable costs for growing head lettuce, the cost of the seedlings depends on how many I plant, the cost of bed preparation depends on how much I plant, the cost of cultivation depends on how much I plant and so on, right on through the steps of harvesting, washing and packing. These are all variable costs.
Selling does depend a little on how much I plant, but because lettuce is lumped in with lots of other crops at the time of selling the way it varies with the quantity I grow isn’t obvious so I leave that number out. Likewise, things like growing the cover crop that precedes the lettuce is something I’d probably do even if I wasn’t growing lettuce specifically, so I leave that out.
Many expenses are not accounted for and those all fall into a big bucket of “fixed” expenses. “Fixed” doesn’t mean they never change, it just means they don’t change in direct proportion to the amount of lettuce I’m growing as long as I don’t change my scale significantly. The fixed costs may change if I change the scale of my farm, or some of my other practices. As long as that change is not directly proportional to size of a planting of an individual crop those expenses are still lumped into fixed costs.
In general I’m trying to find the average variable cost and I am not looking at one specific planting that had some extreme weather or weed or other event. I might look at different varieties differently if I suspect they are significantly different in their variable costs.
We used to grow baby heads of lettuce as well as full sized heads. Many of the costs are the same with baby heads, but there are also differences so I separate those out. Likewise, if I grow a crop in summer and the same crop in the late fall the yield differences and harvest times can be different on average so I might look at summer lettuce separately from fall lettuce.
The contribution margin formula. When setting prices, consider the total contribution margin the price will be able to return, not the contribution margin per unit.
This process gives me a variable cost per unit. For example, lettuce might cost me $1 per head to grow. With this method I’m only looking at the costs to grow, harvest and pack, so if I sell it for $1 per head I’m not losing money, but I also don’t have anything left over to pay for all of my fixed expenses, like general marketing, office time, tools used across the farm, etc.
If I were to sell lettuce for less than $1 per head, I’d lose money on every head I sold, but as long as I sell it for more than $1 per head I’ll have something to contribute to my fixed expenses. The amount that I have to contribute to fixed expenses is called my contribution margin.
Ultimately, I need enough total contribution margin from all the crops I sell to cover my fixed costs if I want to stay in business, and it’s nice if there’s a little extra for profit. Variable costing doesn’t tell me the price to charge to make sure this happens, but it gives me a floor for my price on individual items, and it can also give me a basis for comparing crops once I set the prices for my crops using the second tool.
Price elasticity of demand
The second tool I use is something called the “price elasticity of demand.” To oversimplify, this is saying that you’ll sell more if you set your prices lower, and less as you raise your prices. What you want to do is to find the price for each crop you grow where you maximize its total contribution margin – the total amount of money that a crop brings into the farm minus the variable costs to produce that crop. It is important to note that you are not trying to maximize your contribution margin per unit, you’re only looking at the total contribution margin.
Going back to my lettuce example, if I do a little research and estimating and I set my head lettuce price at $1.50 per head expecting I’ll be able to sell 100 heads at that price, I’ll bring in $150; my variable costs are $100 (100 heads x $1 per head in variable costs), and my contribution margin is $50. If I think I could only sell 80 heads if I were to raise the price to $2 per head, my contribution margin at that price would be $80.
At some point the curve will reverse. If I think I’d only be able to sell 20 heads at $3 per head then my contribution margin would only be $40. Based on these projections, growing 80 heads to sell at $2 per head is my best option.
The contribution margin for lettuce at a few price points. There are a lot of considerations that go into setting prices, but your ultimate goal is to find a balance that keeps your customers coming back and allows you to stay in business long-term.
The reasoning here also depends on when I’m making the decision on what price to set. Often I’m reevaluating the price at the time of sale, after I’ve already grown the lettuce. If I’ve already grown and harvested 100 heads my total variable costs are already incurred and are $100 no matter what price I sell at.
If I sell all of them at $1.50 that feels good; I’ve sold out and I have a contribution margin of $50. If I raise my price to $2 per head and I only sell 80 of the heads that still brings in $160, which gives me a $60 contribution margin and leaves me with 20 heads unsold which I can do whatever I want with (donate, eat them myself, sell them at a cut rate…) Again, if I keep pushing my luck I might try $2.50 per head and only sell 60 heads, which gives a contribution margin of only $50, so now I know that my best price is closer to $2 per head.
If you’re paying attention to the math, you’ll see that I would have been best off growing just 50 heads in the first place, something to note for the future. The other factor that might change in the price elasticity of demand equation is the variable cost. By growing more or less of an individual crop you may find or lose efficiencies which change how much it’s costing you to produce, so keep an eye on that, too.
It is impossible to collect exact data that will let you set a price to the penny that maximizes your contribution margin every time so if you’re looking for that, give up. You can and should pay attention to your customers to understand how they react to price changes. Also pay attention to how other people are pricing similar products in your area which in turn will impact your customers’ perception of the value of your products.
Get a sense of how large your pool of potential customers is – and specifically the people who are looking for what you are selling or who could be easily swayed. If you’re already selling everything you grow you don’t need more customers right now. If you’re not, figure out where the people are that are looking for your product at your price and let them know you exist and want to work with them. If you can’t find them, maybe your price or product mix isn’t the right one.
Why I stopped using full costing
Full costing is a method where you take both the variable costs and the fixed costs into account to calculate a “full cost” per unit of crop. Agricultural economists and others frequently create just such formulas for crops. What I’ve come to understand is that when they do it’s often for a specific reason and there are numerous assumptions they’re making to get that number. Those assumptions don’t necessarily translate well when I try to use that number to set prices on my farm.
A big problem with full costing for farms that grow more than one crop, and almost all market farms fall into this category including mine, is how to “fairly” allocate the fixed costs. Some people allocate those costs by space, creating a per acre, or per square foot charge; others allocate them by revenue, creating a formula for a percentage over variable cost (costs that do vary directly with the amount of individual crops that are grown) to set a price that will ultimately pay for all the fixed costs in addition to the variable costs.
The allocation is essentially an estimate of the amount of contribution margin each crop needs to generate. Allocation methods can work to give a target contribution margin, but the result is somewhat arbitrary and if one or more crops won’t quite make what the allocation indicates it should that can work fine, as long as one or more other crops is able make enough above the allocation to make up for it.
If those allocations get unitized so that they’re not just looking at the total contribution margin needed, but the contribution margin per unit, that is often called a “breakeven” price. Beware that there is no one breakeven price for an individual item that ensures. Breakeven prices are calculated on the assumption that your customers buy all the produce you grow at the price your chosen allocation method gives you. If the quantities of the crops you grow and sell change at all, that will change the allocation per unit and thus the price.
I’ve given up on full costing because it’s more complicated to calculate than variable costing, and ultimately it doesn’t give me better information. I can arrive at prices that are more in line with what my customers are happy with, and that allow me to make sure I’m not growing crops that are losing me money by using the combination of variable costing and the concept of the price elasticity of demand. This doesn’t mean I don’t look at all of my costs of doing business, I just don’t use any of the fixed costs when deciding about the price to charge for any particular crop.
The best price
In a sense, the best price for you to charge is one that enough of your particular customers feel is fair. Changing your prices may change who your customers are over time, and that may or may not be a good thing. Prices are different in different places because costs and expectations are different in different places. We can influence our customers’ perception of what the fair price is for our products using a variety of methods, but there is a limit and we each need to look at our prices within the contexts of our own farms and customer bases.
This is a broad overview of a topic that can quickly start to feel overwhelmingly complex when you first start looking into the details. To use the tools well does take some data collection, but it doesn’t have to be an overwhelming amount. It also gets easier with better understanding of the moving pieces.
Even better, the same data you collect for understanding the variable cost of crops can be used in other ways to help analyze and make improvements to your systems. If this article sparks questions I’d love to hear them and respond either directly or in follow up articles here. Please email any questions to [email protected] and I’ll do my best to reply.
Josh Volk farms in Portland, Oregon, and does consulting and education under the name Slow Hand Farm. He is the author of the book Build Your Own Farm Tools and Compact Farms: 15 Proven Plans for Market Farms on 5 Acres or Less, both available from Growing for Market. He can be found at SlowHandFarm.com.