Pedal to the Pricing
Lessons in wholesale vs retail pricing and total product cost from JHS Pedals
One of the things that I love about pricing is that in order to do a good job of managing pricing, you need to learn so much about a company: what customers value about its products, how the products are made and what they cost, how the sales and distribution channel works, etc.
I love learning, I love teaching, and I love solving problems. And it’s because of that Venn Diagram of interests that I love working in pricing.
Because of that, and despite the fact I am not a guitar player, I loved this video by Josh Scott, founder and owner of JHS Pedals.
In the video, Josh watches and responds to a video from a customer who is taking apart several guitar pedals and discussing how much he thinks they must cost, in order to answer the question “Are pedal makers ripping us off?”
The customer clearly thinks the answer might be “yes”, but Josh explains how pedal makers are not raking in as much revenue as the customer imagines, because the pedal makers sell their products to guitar stores at a wholesale price so that the retailers can in turn make a profit. He also explains how the cost of a product is more than just of the cost of some key parts.
Sales Channel is a Real Cost
The inciting incident for Josh’s unhappy customer is that Josh’s company had made a guitar pedal which was a reproduction of a Ross guitar pedal, and when the pedal was not a success, sold off the remainder on their website at a price near cost. That cost was $76 and so they were selling them for $79.
This got the customer wondering: If the pedal’s normal price was $189 before it was put on clearance, then is the manufacturer normally making huge profits?
The answer, as Josh points out, is that the vast majority of his guitar pedals are sold through retail stores. That means that JHS Pedals sells a pedal for an average wholesale price of $110 to a retailer, who then turns around and sells the pedal for $189.
When Josh did his clearance sale on the discontinued Ross pedals, he had first bought back at full wholesale price the remaining inventory from all his retail dealers. It was only then that he sold the pedals at clearance prices on his website to recover his manufacturing cost.
Why does the retailer get to make $79 in profit on each pedal while the manufacturer only makes $34? The answer is that in reality, neither is making that much.
Let’s think about why the retailer needs that markup from $110 to $189.
The retailer is paying rent for a retail space in which customers can come in and see and touch a selection of guitar pedals and other gear. They’re paying for all the things that go with that space (taxes, cleaning, utilities, etc.) And they’re also paying the wages of employees who can show customers the products, discuss them, make recommendations, etc.
Retailers also need good wholesale discounts because they have to buy all the inventory for their store and hold that inventory until it sells.
Picture, if you will: a music store decides to carry Josh’s guitar pedals. They order 20 pedals for $110 each: $2,200 in inventory. During the first month, they sell four pedals for $189 each. That means they brought in $756 in revenue. Right now the retailer is still ($1444) in the hole.
The next month, the retailer buys four more pedals for $110 each ($440 in additional cost) and sells four more pedals for $189 each. He’s making $79 on each pedal, but in terms of total investment he’s still down ($1128).
It’s not until eight months in that the retailer has actually sold more total dollars of JHS Pedals than he has spent on buying and replenishing inventory. You can see why, when the Ross pedals were not selling well, Josh’s dealers wanted him to buy the inventory back!
So the retailer provides a valuable service: letting people see and touch the products, providing in-person marketing, and delivering the product into the customer’s hands. But in return, the retailer needs to make decent margins on each product so that they can pay for their inventory, their retail space, their staff, etc.
The retail channel is particularly valuable to new brands — assuming they can get retailers to stock their products in the first place. Once a brand is established, there are people who will actively seek out their products and buy directly from the manufacturer’s online store. But no one is looking for an unknown brand. If a new brand doesn’t get their products sold through retailers who will put actual work into selling their products to customers, the brand will have to invest much more in advertising and marketing.
It sounds like JHS does now have enough visibility that it can sell some of its products directly, and that helps their overall margins. Josh is making a return on producing great video content (and has half a million YouTube subscribers to prove it.) But the trade-off always remains: if a company wants to mostly make direct sales, it has to invest about as much in marketing as it would otherwise have invested in the retail channel.
But even though that’s enough for him to now start to make significant direct sales, there must still be a large majority of guitar players who have a local music store but have never stumbled across Josh’s YouTube channel.
Even for a brand that can do some significant direct sales, the retail channel is still doing a valuable service. And because it’s important for companies like JHS to let their retailers make money, it’s important that JHS not undercut their retailer’s pricing when they sell direct. Josh would make some great money if he routinely sold his pedals for $139 online, but in the process, he’d undercut his retailers and take away their ability to charge full price and make their stores work. They might well decide not to sell his products if he undercut them that way.
If a brand is going to maintain their relationship with the retail channel, they need to make sure they don’t compete with their own retailers aggressively. They can sell different products (special products not available in stores and clearance items) but on items available in stores, a wise company will not undercut their retailers when selling direct.
Product Cost is Not the Only Cost
As I described, there’s a good reason why the retailers selling JHS Pedals need the $79 per pedal markup — and it’s not because they want to buy a yacht. However, even the $34 in gross profit which JHS is making when selling a pedal at wholesale is not all going to the bank as profit. In fact, very little of it is.
In the video, Josh explains that this pedal has about $55 in parts, and then $20 in labor cost. Within those costs are certain choices: Printed Circuit Boards from the US rather than China. Custom body design and powder coating rather than off the shelf parts. US labor at a living wage rather than overseas labor. Other companies might make other choices, but those other choices would result in other products with other characteristics. If the customer in question doesn’t value the difference provided by Josh’s choices, he may find the other product a better value for him. But what he can’t reasonably do is expect JHS’s product at the price of a different company which makes different value choices.
So while there might be cheaply made similar products, you can’t have a product like Josh’s product without spending the $76 which Josh is spending.
But that’s not the end of his cost. Product cost represents the cost of the parts themselves and the cost of the labor to put those parts together, package them, and ship them off to the customer (in this case, the retailer.)
As I described in a previous post, those are the variable costs, the costs for making and selling one additional unit.
But there are also costs which Josh has which aren’t connected to manufacturing a specific product: He has to pay for the costs of his building, his non-manufacturing staff like bookkeeping and customer service. He has to pay someone to clean the bathrooms. He has to pay utilities and taxes. All of those costs come out of his $34 per pedal in contribution margin.
By the time he’s done paying all those, Josh is making only about $5 per pedal (or 5%) in actual net profit.
Threshold Pricing and Cost Inflation
There’s one last thing that Josh brings up near the end of the video which, as a pricer, I just can’t leave alone. He talks about how he’s kept his pedals at the same price points for years. A number of his pedals retail for $179 to $199, which means they are right up against the $200 threshold price point.
A threshold price point is like a red line which people will react to companies crossing. The difference between $199 and $209 is only ten dollars, but the fact that $209 is over $200 makes the product seem much more expensive. Our subjective impressions are often ruled by the first digit in a price, so any price beginning $1xx we read to some extent at “one hundred dollars” even though $199 is virtually two hundred dollars.
That psychological effect is why so many prices end in -9: You get 90% of the dollars without crossing the threshold represented by rolling over that number in the tens column. As you move to the left, the effect becomes more pronounced. Companies try hard not to roll over the next digit in the hundreds column or the thousands column, and customers sometimes punish them when they do.
The problem is, as Josh explains, that his vendors are not similarly constrained. The companies that sell him circuit boards and fasteners and cases and packaging have been increasing their prices — especially, I would imagine, over the last three years.
His employees also don’t want to see their wages frozen even if JHS’s prices aren’t going up. When there’s inflation, employees need their raises each year just so they can still afford their housing and their groceries.
The result is that Josh has seen his profit rate squeezed over the years.
I deal with this kind of situation all the time as a pricer. Crossing a threshold price is painful, and companies rightly fear losing customers. At the same time, when Josh’s net margins after fixed costs are down to around 5%, think of what would happen if he took a 10% price increase to catch up on the inflation over the last five years.
Josh has a good relationship with his customers. He would want to start by saying very openly that his costs have gone up, especially the cost of paying his employees a living wage, and that although he has absorbed that for years, he’s reaching the point where it will be necessary for him to take a price increase. Tell people when it will happen, and assure them that he does not do this lightly and will remain at these new prices for as long as possible.
If his net margins are currently 5%, that 10% price increase would take them to 15%. JHS would see their total profit dollars go up unless they lost more than 66% of their unit volume.
In pricing, we measure how responsive customers are to price changes with a metric called price elasticity, which is the change in volume divided by the change in price.
If you increase the price by 10% and as a result you sell 5% less units, that’s an elasticity of 0.5.
If you increase the price by 10% and you sell 20% less units, that’s an elasticity of 2.
If JHS takes a 10% price increase, they would have to have a price elasticity over 6 for them to lose money, and that’s extremely unlikely. I have seen a few cases where products showed a price elasticity as high as 10, but it’s extremely unusual.
Why not take a smaller price increase?
Most of their products are priced around the $200 price point. If it’s going over $200 that they are hesitant to do, and which has held them back, slowly losing margin, for the last few years, they should probably break the $200 barrier good and hard.
The very smallest price increase they should consider would be a 5% increase. This would take a $199 item up to $209. (Obviously, that is the change in the MSRP. The wholesale price JHS charged the retailer would not move by $10 but rather by 5%, from $110 to $115.)
However, if they are worried that there will be some customer backlash, that backlash will probably not be much bigger at $219 than at $209, and the extra 5% in increased margins would help cover the cost of any lost business.
Taking the larger price increase would also set JHS up to be able to go longer without taking another price increase. I imagine that Josh would like to be able to go another 4-5 years without having to go through the pain of a price increase again.
I don’t know if Josh is likely to read this column, but if he does I hope he’ll seriously consider this pricing advice. It sounds like he’s built a great business and a lot of trust with his customers through his transparency. He’s right not to want to get greedy with price increases, and to take advantage of increasing scale and efficiency to avoid taking a price increase too soon.
However, no company can fight inflation forever. Unless he’s seeing his actual cost of doing business and manufacturing cost per unit go down over time due to efficiency and scale (which does not sound to be the case) he will need to bite the bullet and take that price increase at some point. As a respected company in his industry, taking pricing leadership in this way will even help to lead the way for companies which are less established and have less pricing power. If other companies move price as well, there will be less danger of customers abandoning JHS due to their price move.
And in the end, charging a fair price (which eventually means moving with inflation) is what will allow him to continue to buy all American-made parts and to pay his workers a living wage.