Aligning Price With Value Received

There is huge outcry in the media – MSM and social media alike – on the imminent end to net neutrality. The recent tiff between Level 3 and Comcast kicked off this new round. There are a few neutral parties that make support Comcast’s pricing but mostly we see  the opposite.

Given that infrastructure is already there, its costs are already sunk and the pipes (or is it tubes?) already laid, should the carrier price differently for different customers and different traffic they place on the network?  Level3 accused Comcast of practicing price discrimination, as if it is an unlawful act.

Our Global economy depends on practicing price discrimination, in fact it is arguable that without price discrimination some of us won’t be able to avail ourselves of certain products, including life-saving prescription drugs.

One way to look at this differential pricing is using classes of service in a railroad. But that does not do enough justice since the benefits from each class differ. To look at Level3 vs. Comcast tiff, let us go all the way back to 1831 when the first Manchester railroad helped drive trade. As a faster  mode of transportation, railroads made it possible to transport fresh food and farm animals to distances that were impossible with previous slower modes.

Manchester railroad’s first consignment was a batch of 49 “squealing Irish pigs” . The railroad charged the farmers 18 pence a pig.  Soon sheep were transported but at half the cost of 9p per sheep. Why the price difference? After all this is not a case of different classes of service.

One could argue that the pigs weighed close to twice as much as the sheep. In reality that was not the argument. At that time there were other alternatives available to transport sheep and the value from faster mode of transporting them was not significantly higher than that from alternatives. So different cargo, transported under same conditions, were charged differently based on economic value add to the customers.

So why shouldn’t the precious cargo of movies transported over data pipes be priced differently?

Why shouldn’t Level3 pay a different price than the others if the value it derives from using the carrier network is higher?

If you have trouble seeing the fairness, here are other examples of everyday price discrimination that we accept and  embrace:

  1. As an educated high-tech customer who uses latest browser like Chrome, you get cheaper rate on your credit card compared to those unfortunate who still use the browser that is pre-installed on their computers.
  2. You are most others are happy to pay $129 more for iPad 3G while Kindle 3G only costs $50 more for  the same radio parts.

Banning price discrimination is banning product  innovation.

If one price is good, two are better – both to the marketers and the customers.

Next up, since the value of electricity delivered to home is more to a customer using it to charge her plug-in electric car, should that customer be charged a different price than the rest of us?

Why isn’t there an index for profit concentration of a market?

Herfindahl-Hirschman Index or HHI, is a commonly used metric for measuring market concentration.

It is calculated by squaring the market share of each firm competing in the market and then summing the resulting  numbers. For example, for a market consisting of four firms with shares of thirty, thirty, twenty and twenty percent, the HHI is 2600 (302 + 302 + 202 + 202 = 2600).

It serves as a quick reading to see whether the market has few big players or many small players based on their percentage market share. It is based on an observable and easily measurable metric – market share.

It may help the Justice Department, but is this relevant or actionable? Does it say anything about relative success of each player? The problem is reinforces the focus on market share and the almost monomaniacal drive to increase one’s market share.

What would be relevant is a measure of profit concentration of a market.  Why isn’t there such a metric? That is because while it is simple and straightforward to compute market share, there isn’t a way to compute the profit share.  One way would be to add up the profits of each market player, compute their respective share of the pool and compute an index like HHI.  It says something about current pricing and operational efficiency  but it says nothing about what is the potential total profit in the market.
What is needed is a way to measure the total possible profit in a market and how it is expected to change. Then a HHI like metric like show who is profit maximizing and who is not.

There isn’t a HHI like metric for market profits because, to repurpose Ford’s statement on costs,

“Profit is always a computed number. Anyone can compute what it is but no one can say what it ought to be”.

Cost Allocation Trap

Businesses, small and big are almost obsessively focused on allocating a portion of every cost incurred to every unit produced. The distinction between sunk costs and  marginal cost is lost on them. Costs that are incurred regardless of volume produced are spread over units produced. For example, a Cupcake business allocates a portion of the mortgage, insurance and other fixed charges to each cupcake.

The problem is complicated by the way these businesses set pricing, they simply tack on an artificial margin to come up with unit price

Cost Based Pricing: Unit Price = Unit Cost * (1+ % Unit Margin ) (WRONG!)

There is no logic behind the % Unit margin, it is either based on what competitors are reporting or a magic number someone comes up with. An arbitrary number that has no meaning and no indicator of absolute profit becomes the number everyone in the organization works towards. No effort is spared to protect  (and increase)  % Unit Margin leading to drop in absolute profit.

The net result is the business has no way of knowing what the market demand is and how the market will react if they were to change prices. Due to their fixation on protecting he % margin they end up selling at the wrong price and losing out on the absolute profit. Since the unit cost is wrong to start with the % margin leads to higher prices. In addition, in this method of cost allocation, any increase in volume will reduce unit cost and any decrease in volume will increae unit costs (because fixed costs are spread over more units).

Increasing market share requires them to produce more unit and it also helps with reducing unit cost. So they produce more, flood the market and end up discounting heavily, destroying the very margin they were trying to protect.

Businesses are reluctant to give up market share in favor of profit because producing less “eats into % margin”. When business have high market share and operating at near full capacity, the unit cost is at its lowest. Due to the incorrect cost allocation, higher market share is wrongly associated with higher % margin. So businesses spend all energy in defending market share.

If the demand shifts down (due to recession), businesses are reluctant to  reduce volume produced because the decrease in volume increases unit cost and hence “eats into % margin”.

This is the same reason businesses are reluctant to increase prices because any price increase leads to lower volume which affects unit cost and % margin.

What starts as cost allocation mistake leads businesses down the wrong path of protecting market share and % margin.

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.

Price Increase When Demand Shifts – Semi Rigorous Proof

Previously I have written about pricing for recessionary times and how CPGs and other businesses are realizing increase in profits despite drop in revenues. As more and more price sensitive customers switched to private labels and other low cost options, premium brands responded by raising prices. The claim is this price increase delivers higher profit than a price cut to gain back customers because once the price sensitive customers moved out those that continue to prefer the brand are less price sensitive. The claim is just that if it is not formally proved. With the recent changes in bottled water prices I made an attempt at proof. But it was one example based on one data point and is not really a proof.  Here is another attempt.

Let us take the Starbucks as example. I recently made the same claim on price sensitivity of Starbucks customers. Let us assume there are only two types of Starbucks customers one is price sensitive and the other is relatively less price sensitive. Each with linear demand curve:

q1 =  a  – b * p   (demand curve for price sensitive customers)

q2 = c  – d * p  (demand curve for  brand conscious customers)

Mathematically it is easy to show that the latter curve is steeper than the previous. Each demand curve yields a different profit maximizing price p*, the second curve’s is higher than that of the first (again proof exists in textbooks). Any price higher or lower than p* will yield lower profit (hence the name profit maximizing price). Let us call the p* for demand curves 1 and 2 as p1 and p2.

If Starbucks can find out who is who and can separate them then they can charge different prices. This is called Third degree price discrimination. But when a customer walks into one of their stores Starbucks has no way of finding whether she is of type 1 or 2. They are also attracted by the higher volume by combining the customer segments so to them the combined demand curve will be

q = q1 + q2 =  (a+c) -(b+d)p

This has its own profit maximizing price which is between the profit maximizing prices of the two demand curves.  Let us call this p3. For this demand curve any price different from p3 will yield lower profit than p3.

In other words, p1<p3<p2

With the down economy the price sensitive customers simply stopped coming to Starbucks, thereby revealing who the brand conscious customers are. In other words, the demand curve became

q = c – d*p

If Starbucks continued to price at the previous profit maximizing price of p3 (which is lower than  p2), its profit will be ower than what would it have been if it were to price at p2 (the profit maximizing price for the demand curve).

This proof can be extended to account for many different demand curves and non-linear demand curves.

Hence it makes sense for Starbucks to increase its price when the demand curve shifts.

Pricing For Profit Maximization

I want to discuss a great example of profit maximization pricing strategy I saw. There is a main parking lot right in front of the Boardwalk, Santa Cruz that charges $10 for an all day parking. Parking right in front of Boardwalk and crossing the street to enter the beaches is a great convenience to customers. Is $10 the price for the convenience? I am not fully sure, it could be more. Definitely it is not less than $10 judging by the occupancy rate of this lot.

As you drive into the town and drive towards Boardwalk, you see several signs advertising $5 for  all day parking. Those parking lot owners know their lot is of less value to a customer because of the walk (however short) from the lot to the beach. So they price their offering to reflect the “negative differentiation value”. Those with lower willingness to pay and do not mind the walk will pick this option.

But the most interesting pricing is the one practiced by a hotel on the street that parallels Beach st and on the other side of the $10 parking lot. Clearly their lot is no way near the size of the commercial lot that charged $10. They only had handful of spots. They advertise a price of $30 per day and clearly one can see that the sign they had outside is not hard-coded, it allowed changing the price figure at their will. They are practicing dynamic pricing, based on the demand.

Their advantage is, by 2 PM the main parking lot is all full and the hundreds  of cars are routed through the street the hotel is located. As one can judge from the traffic backed up miles away from the exit to Santa Cruz, there was practically unlimited supply of cars coming in. The traffic on the Beach street was inching its way around the block, as people kept driving in with the hope of finding a nearby spot.  After spending 30 -60 minutes inching around the Beach st, some of the drivers are bound to feel their time and convenience is worth the additional  $20.

Clearly the hotel’s pricing is based on the observation of years of traffic pattern  and pricing based on customer demand. Note that the marginal cost for each spot is $0 and if they had priced the spot for $15 almost everyone would have taken it. But they only have limited supply of parking spaces. Clearly they did not want to reach the wider market and targeting only those with a high willingness to pay so they can spend time on the beach instead of driving around for a $10 spot. The dynamic pricing option allows them to drop prices as they see traffic slow or when they still have empty spots near the end of the day.

That is pricing for profit maximization!