Restaurant Pricing Strategies and Elasticity
A lot goes into maximizing sales and profit in the restaurant business. We have operations systems around driving down food waste, software to help us cut our labor costs, and undoubtedly spreadsheet files tracking our operations supplies. These are all crucial parts of running a successful restaurant and take a lot of work. One thing less discussed, and something that takes a lot less work, is understanding how to use different pricing strategies to maximize sales and profits.
Pricing Strategies
There are three basic strategies I will discuss, which can be used separately or in conjunction with each other. Then I will touch on a topic economics geeks like me find exciting: price elasticity.
Pricing strategy one: Cost based pricing
Cost based pricing requires calculating the cost of your menu items and pricing them out to a fixed percentage range. For example, let's say your famous lasagna cost a total of $2.38. We have chosen a target food cost percentage of 30%. We take our $2.38 and divide it by .30, for a price of $7.93. This can just be rounded up to $8.
The benefits of this strategy are that it a) ensures you hit cost targets, and b) it is objective. This method can be challenging for small independent concepts that do not have inventory management software. Such software requires creating and managing an inventory database, which is too time consuming for most small operators.
Pricing strategy two: Market based pricing
Market based pricing means you price your menu items in relation to other like items in your local restaurant scene. For example, let's say we want to price out our famous lasagna, but do not have exact costing information. We identify other local restaurants in the area that serve lasagna and find a price range for lasagna in the area. We price our lasagna within this price range.
Where in this price range? It depends. There are some discretionary decisions to be made regarding your price. Are you trying to drive traffic with low price points? Are you offering a unique lasagna your guests can't find anywhere else? These two questions could drive your price to different ends of the price range.The pricing decision needs to consider your marketing strategy and the confidence in how well you have differentiated your product.
One of the challenges with this method is finding items that are apples to apples. You do not know the ingredient quality, costs, or recipes of your competitors. There are also concept concerns to consider. Guests that go to a fine dining Italian restaurant are paying for more than the lasagna. How else are you adding value to the guest experience?
One of the advantages of this strategy is that you can always maintain competitive pricing. This needs to be an active process, and can sometimes be time consuming. A common mistake is to price menu items based on what you think is a market price. Get menus, get on the phone, and collect real prices.
Pricing strategy three: Loss leader pricing
Pricing a loss leader means minimizing your profit, or even taking a small loss on a menu item to push volume. This should only be used sparingly as a marketing tool. The primary purpose of this strategy is to drive guests into the restaurant with an aggressive price in the hopes they buy something else. This is essentially the happy hour strategy. Your guest buys a cheap drink, but buys food in the process so that you make money.
Although loss leader strategies are typically utilized so that guests buy more menu items in the same visit, this can also be used across day parts. As an example, you can promote an aggressive lunch special in the hopes of convincing your guests to come back for dinner where you have higher prices.
This pricing strategy should be tracked closely, and from a marketing standpoint should not be your first move. The most appropriate time to use a loss leader is during day parts that your restaurant is empty, for example between lunch and dinner, or dinner and a late night bar crowd. If this strategy is used too aggressively it will potentially lead to losses.
Strategies come together
How do we use these pricing strategies in practice? The best pricing method for your menu is to combine cost based and market based strategies. Start with a cost based method. To do this you will need menu costing information, and a cost range that will create a profitable business model. In our lasagna example, we costed our lasagna at 2.38 and set a price of $8. This is your starting point.
Next you apply the $8 to our market based strategy. Where does $8 fit in our market price range? Let us say the lasagna price range is $7 to $11 for lasagna in your immediate area. You are in range, so you can keep your price at $8. You also have some wiggle room to raise the price if demand allows it.
What if you price an item using a cost based strategy, and then find that the price is above the market price range? You have three options: 1) Keep your price as is. This makes sense if you have added value to the menu item. For example, you are using high end ingredients your competitors are not. 2) Keep your price as is, and accept it will have a low profit margin. 3) Adjust the recipe or lower the portion size to decrease the cost and get the price within market range.
Loss leader pricing should only be used as a market tool, and not very often. Your guests will come to expect the lower prices and only come when there is an aggressive price offer. Brands such as Applebees, TGIFriday’s, and Olive Garden all got locked into a low price trap by overusing this strategy. During the 2007/8 recession, these brands used aggressive pricing to maintain traffic levels, but when the economy improved they had a challenging time pivoting away from using price points to drive sales.
Price Elasticity
Price elasticity refers to how your guests will respond to price changes. There is a formula for this, but the formula is not necessary to understand the concept and use it to your advantage. There are two basic rules of thumb depending on if you are increasing or decreasing prices.
When decreasing prices you must have more order incidences (demand) than your price decrease, in percentage terms. For example, let’s say you lower prices from $10 to $9. That is a ten percent drop. You need to sell 10% more menu items to increase sales.
When increasing prices, your order incidences (demand) can drop by up to as much as the price increase in percentage terms. For example, you increase prices from $10 to $11. That is a 10 percent increase. You can sell up to ten percent less of this menu item and still make more money.
How do you know how much demand changes when you change prices? You can't predict this. You have to monitor sales when prices change and adjust accordingly.
Strategically, price changes should be planned. You can minimize the change in demand by changing prices slowly. For example, if you would like to change prices from $10 to $12, there would likely be severe sticker shock if you did that in one menu change. If you change your prices 50 cents every 6 months, you can reach your target without as much demand shock.
Don't try to out work analysis
Using effective pricing strategies and tracking changes in demand will improve your sales and profit margins. It is hard work trying to save money in operations. So hard, that restaurant managers often don't take the time to optimize their menus. This is a critical mistake. Menu pricing should be regularly evaluated and changed.
Looking for more information on tackling your costs? Check out my online course on Restaurant Inventory Management. Find more information about pricing for profitability in these additional blog posts:
Incremental Price Increases: A Strategic Approach for Small Businesses
Menu Updates: Streamlining Your Restaurant Offerings for Maximum Profit
Menu Design: How Images, Graphics, Font Sizes, and Placement Influence Buyer Decisions
