Hormel Chili Prices Going To Get Hot

Hormel Chili reported increase in profit despite drop in revenues. Unlike all previous CPG cases we saw last quarter, Hormel’s profit came exclusively from cost reduction. In fact they failed to capture larger profit because of the price cuts.

Their revenue declined 10% on a volume decline of 3%. This means their prices dropped on the average by  7.2%. That is pure profit given away in he form of promotions and lower prices while the customers really were not looking for it. Their frozen food line saw 8% price erosion (revenue fell 9% on a 1% volume drop).

The good news is Hormel knows it and definitely is going to fix it. Hormel Chairman and Chief Executive Jeffrey M. Ettinger said,

Although we are pleased with our earnings, we experienced disappointing sales in the fourth quarter,” he said, citing in part lower pricing for its pork and turkey products and planned production reductions at its Jennie-O Turkey business, which is in the middle of a turnaround.

They can only go so far with cost reduction, but their current lower price offers bigger headroom for profit growth. If Hormel improved its prices by 5% and if their volume fell by about the same amount, their revenue may not grow as much but their profits will increase by  $64 million, that is 60% net income growth from 5% price improvement!

If the stock  market really follows profits over market share, we should expect Hormel stock to heat up.

People Who Read WSJ Are 75% More Likely To …

Does reading The Wall Street Journal makes one more likely to get better jobs and bigger salaries?

The Saturday edition had a half page Ad for student subscription. You can find the claims made in that Ad here.

wsj_student_survey

The problem with these claims is correlation does not imply causation. Regarding these claims:

  1. This is a survey, not a controlled experiment where they randomly assigned people to a control group and treatment group and followed them over years to see if there are statistically significant differences in their GPA, salary etc.
  2. There is omitted variable bias here. The same trait that made the students and others read the WSJ is possibly the driver behind their success. Self motivated and driven people are going to equip themselves with every possible tool and training to get ahead in life. If it is not WSJ they would have read other journals and newspapers to get ahead.  While the claim that “Journal helps the student get ahead with a robust set of career preparation resources”  is valid the following statement “Did you know students who read The Journal are 140% more likely to be starting a full-time job upon graduation?” is misleading because it implies causation.

Few  years back there was a TV commercial for WSJ that showed a man going up in career because of WSJ. The commercial starts with a man, walking in rain, stopping to pick a copy of WSJ from a news vendor to protect himself from the rain. He later runs into an executive of his company in the elevator, who upon seeing the newspaper in his hand offers him instant promotion.  It is one thing to use humor to imply causation, no one will take it seriously. It is however not factually correct when they use survey data and make a causation claim based on correlation.

Other reads: There was also an article on Fantasy Football that implies causation from correlation.

PS3 Price Drop Not A Game Changer

Sony was used to being the market leader in gaming consoles prior to PS3. Their previous model, PS2 sold 138 millions units worldwide, far ahead of Microsoft’s XBox and Nintendo’s Gamecube. That all changed in the next generation of gaming consoles. Now Nintendo, with its Wii and its  innovative wireless controller is the leader with 50 million units sold in the three years since its introduction. Sony managed to sell only 24 million units so far.

In an effort to drive up its market share, Sony cut the price of PS3 by $100. Technically it is on a different model they introduced called PS3 Slim.  Is this a good profit maximizing move?Is low market share a concern that requires such drastic price cuts?

I have written before the need to focus on profit share over market-share. In the case of gaming consoles, it is a platform market. The sale does not end with the console rather starts with it. There are many revenue opportunities from sale of games and accessories over the lifetime of the console. Now there is also a new opportunity for subscription revenue from online gaming. It is not enough to just look at gross margin on the hardware, we should include margins from all the complements. In other words, the customer margin.

Larger the market share, larger is the number of games available for it as more developers will commit to developing games for that platform. With marker leadership comes exclusivity. A console maker can convince the game developers to  make certain popular games available only for their platform, at least for a limited time. But this has not been the case lately as Financial Times reports

With many third-party game developers no longer willing to make games exclusive to PlayStation, Sony has also suffered from a lack of hits by its in-house games division compared to Microsoft’s success with its Halo franchise, Mr Baker said.

Suppose we assume the gross margin on the new PS3 is $120 per console. Assume that at current market share and growth rate the incremental margin from sale of games and accessories over the lifetime of the console is $150.  So the total customer margin today is $270. With the price cut of $100  and the expected increase in market share from it, let us assume that the incremental margin per unit goes from $150 to $200. There is however  no reason or data to believe this, given the point made by Mr.Baker in  the FT.com story.  So the total customer margin in the new case is ($120-100+$200) $220.

Sony will be  losing $50 in customer lifetime value per unit sold with its price cut. To make up for it, its sales have to increase (over its current sales rate) by  50/220 = 23%.

The price cut would have given them competitive sales advantage only if Microsoft and Nintendo could not do the same. But it is not the case. Microsoft cut its prices by $100 and Nintendo might do the same (although doubtful).

Microsoft acted to consolidate its lead over Sony in the current generation of games consoles as it cut the price of its top-end Xbox 360 on Thursday to counter a similar move last week by its Japanese rival.

It is now questionable whether Sony can deliver a sales increase of 23% from its price cut. Note that this number will be much higher if the customer margin numbers we used are lower.

The net is, price cut is not going to be a game changer for PS3 sales.

Small Business Pricing – 5 Steps To Effective Price Management

Linda runs a sewing business that does works like alterations and hemming.  Unlike most small business owners, Linda writes a blog that is about “Sewing for profit” in which she shares her ideas and practices to help others like her to run an alterations business.

In the down economy when people postpone purchases, alterations should be good business. But the barriers to entry are low, there are many individuals and businesses offering this service and the market alters (pun intended) with the economy. There are also challenges in reaching the right customer segments. All these make this a highly competitive market with challenges in communicating differentiation and price list becomes the main piece of any messaging.

Linda is thinking about pricing and wrote about it recently. A very well written article that considers factors like opportunity cost of the business owner’s time, competitive analysis and a pricing model for someone starting new in this business. Linda recommends a pricing that is based on the time it takes the individual to do the work and based on pricing from other competitors in the area.

If I were to suggest changes, it is avoiding what Mr. James Mason described as the 8 deadly pricing sins and practicing what I described in Effective Price Management. Pricing a product or service based on what it takes to produce and deliver it is cost based pricing. The risk is that in any undifferentiated market there will always be someone willing to price it lower and quickly prices will spiral down.

What can a small business, like an alterations or any such business, can do to practice effective price management in a highly competitive environment? Here are five steps to get there:

  1. Recognize that cost to produce is not relevant to your customers. Your costs are relevant only to see if you can run a profitable business given the addresable market and prices you can charge.
  2. Recognize that price is not differentiation. Competing on price does not let you have a conversation about the value you add.
  3. Identify the different customer segments and the economic value to them from your service.In the case of alterations the segmentation is based on usage scenarios, sometimes a customer would want to get their work pants altered and other times their expensive evening wear. The economic value is different for each case. Practice a pricing model that is based on this value add.
  4. What is “ownable”? When many other competitors are in the same market, what sets you apart from the rest? Is that defensible and unique and no one else can claim the same? In other words is that “ownable”? Identify that and make the marketing conversations about this and not lower prices. On the last point, salons excel in offering multiple prices based for the same service based on who does the work.
  5. Offer multiple versions of your product/service, be it based on material that is worked on, raw materials you use, convenience or based on person who is doing the work in your business.

Defusing Customer Backlash From Price Increases

My previous consumer behavior experiment led me to conclude that customer backlash to pricing changes stem from the reference price, the price they used to pay or a service despite the value they get. Recently I saw a blog post about Frontier Airlines by Mr. Andrew Hyde regarding its changes to standby policy. Frontier now charges a fee for going standby on an earlier flight. Before they did that they did not allow standby on earlier flights, this had caused Mr. Hyde to revolt and even say that he would never travel by that airline.

Mr.Hyde, as he points out in the comment, did not object to price increase per se and contrary to what I wrote earlier his objection was to change in policy without notice.  The net is customers will be less than willing to pay for services that used to be free because their reference price is $0.

This situation is no different from the customer backlash faced by US Airways before it decided to drop its $1.99 drink fee. It makes perfect business sense for Frontier to charge for this service regardless of the  costs associated with admitting a standby passenger on a partially empty flight. Frontier should have recognized the reference price effect if they were were planning to charge for the standby before they denied it to some. They should have  first worked to improve this from $0 to a positive value before introducing the price changes.

For instance, it could have sent all its travellers (anyone whose email address it has, past, present and future) a coupon or two for “Free standby”. Stated clearly in that coupon is the price of the standby and the value those customers get by using the coupon for a standby. This would have cost them nothing more than the cost of sending out the coupon but the effect is to improve the reference price of the standby service from $0 to the dollar amount marked in the coupon.

A business simply cannot ignore the effects of reference price and should actively work to manage it.

Reversal of Irrational Consumption

Have we been buying things that are worth less to us that the price we paid for them? If we all are rational we should not pay more than our willingness to pay which is a function of  what the product is worth and our reference price.  A recent Financial Times article on changing consumer preferences in recessionary times had quotes from several marketing professionals and academics. One of the quote was from Mr. Seth Godin, author of several marketing books,

Seth Godin, a marketing trendspotter, calls this the “affordable premium” product, which, like a McDonald’s coffee, is deemed to be worth more than it costs.

If we are rational (left image) we should only be buying products that leaves us a positive consumer surplus. What Mr.Godin suggests (or to be specific the FT’s quote states) is that we have been behaving like the right image.consumption

Does that mean we have been buying goods that are not worth the price  we paid for them? Perhaps. There are two possible explanations:

  1. Our consumptions were hedonistic and we convinced ourselves that the products are really worth more than the price we paid for them.
  2. Our consumptions were conspicuous – that is we have been doing them for keeping up with appearances and with the Joneses.

Availability of easy credit and high home prices drove us to behave like the right image and buy things that we were not getting the value for the price we paid. Now with bad economy we see the reversal to the expected rational behavior.

The bigger question is how do consumers value the products they buy? Even consumers do not know the exact dollar figure of value. A marketer can tease out this value and make a reasonable estimate of the relative weights we assign to the components of a product like is utility, hedonistic value, brand and luxury. Next up I will discuss the factors that go into the valuation and the current shift in consumer valuation.