The Simplest of all Business Models

If you want to use Wifi at Pete’s Coffee & Tea you will have to buy something first.  At the counter they give you a code to use, that allows you about an hour of surfing time.

In many local coffee stores you technically have to buy something but once you do, you can stay parked in their tables for hours without buying anything. In Pete’s bigger competitor, Starbucks coffee, it is the similar unlimited free access plus access to premium extras like The Wall Street Journal.

Coffee shops complain about those who occupy tables for hours at a stretch, buy little or nothing and mooch on their bandwidth as well as electricity. Customers who do spend money at coffee shop and need good connectivity for an hour or two complain about the poor speed and difficulty in finding tables near outlets. General customers (who hire the coffee shop for, coffee) complain about the crowd and lack of seats to simply sit and enjoy their brew or have a conversation.

Free Wifi became a popular perk for coffee shops, restaurants and hotels to attract customers and keep them in their shops. If the customers chose your business over others because of free Wifi, you win. If the customers stay because of free wifi and continue to spend during their stay, you win. You have successfully used free wifi as lead generation tactic and customer retention  tool. (Freemium?). For instance, Panera bread saw its sales increase by 15% when they introduced free wifi.

On the other hand, what is free to customers, is not so to businesses. There are costs of operation (making sure there is enough capacity) and opportunity costs (both for the money spent on their big pipe broadband and the moochers). When everyone else offers free wifi it becomes difficult for a business to either stop offering it or start charging for it. Add to this customer dissatisfaction from providing poor internet service.

Look at where we are in the discussion. We are not talking about the compelling value proposition a coffee shop (or a restaurant) offers but talking about a perk. Let us not forget the primary job these businesses wanted customers to hire them for. If customers’ choice is made based on secondary and tertiary factors, the primary value proposition has become irrelevant. If a business fears their customers will walk next door for free wifi they are admitting that their product is an easily replaceable commodity.

That is a bigger problem they ignore while fretting about wifi costs. In focusing on free wifi as lead-gen activity they ignored the core customer segment they started with and the customer jobs they hoped to serve. While some may call free wifi (and Freemium?) as business model innovation, this is essentially losing sight of customer needs and your core competence.

If the customers didn’t hire your coffee shop for coffee, should you tie your business model to selling coffee? That is an incongruence between value creation and value capture.

On the other hand your strategy – to serve the most amazing coffee – need not be fixed. You can see the customer shift and decide your strategy is to serve those customers who have a connectivity need and are not satisfied with existing alternatives. You recognize customer issues with poor speeds in free wifi places and provide reliable speeds as differentiated feature. In such a case you cease being a coffee shop and become a workspace provider. And guess what, you now can charge for that value delivered.

The business model is back in sync with value capture matched to value creation.

That is exactly what is happening in Russia’s Clock Cafe.

“You don’t have to pay for coffee or tea or cookies. You should pay for time, and time costs — I hope — [are] not that expensive.”

And their target segment? Students and business folks who hire them for connectivity and hence pay for the value they get.  Nicely done. However, I think they fixed one mistake but introduced another – making coffee free. There really is no reason for them to offer free coffee, especially the premium kind they claim they deliver,

We have cappuccino, latte, espresso, Americano, and our coffee is not the cheap one

They are committing the flip side of free wifi at coffee shop mistake. Sooner or later they will run into the free wifi problem in reverse. Why bother with coffee or why not charge for it? Especially if the customers didn’t hire you for coffee?

When it comes to business strategy, starting with customer needs and choosing the ones that you can serve better than others remains the best approach. And when it comes to business models, charging for value you deliver remains the simplest of all approaches.

What is your strategy? What is your business model?

The Incredible Starbucks Steel Gift Card

To refresh your memory, just before the holidays Starbucks launched a limited edition (5000 only) steel gift card priced at $450. The card carries a value of $400 and comes with some sundry benefits like free refill on brewed coffee and free drink on birthday.

That is correct. It costs you $450 to get $400 because Starbucks said it costs them a lot to make this steel card. While I called this egregious pricing, at least 5000 people did not think so. The card was sold out and worse was sold for much higher prices on eBay.

By last check there were 510 sold listings.

• 70 odd listings were for just the empty card ($0 value) sold from $325 to $650
• Most of the listings were with the full $400 value and sold from  $670 to $1250
• Very few listings with $5 and $25 value and with no other values

What can I say about this?

Pricing on $0 gift card provides great insight on buyer perception. It appears keeping the full $400 value of the card helped increase its value among buyers. That is, when sellers left $400 on the card buyers bid additional $600 for that $400.

We can try to explain away why anyone would pay $650 for an empty card. But nothing in rational economics can explain why someone will bid $1.5 for each additional $1.

But I think the only reasonable point we can make from this data is – the left tail of human civilization has at least 5000 people, the left most has at least 510 people (those who won the auctions) and rightmost has 510 people, those who made a profit.  (Note: Subtract the 510, those who sold, from 5000 and add back those bought and you get 5000 in left tail.)

And you my friend, I know, is in the right tail, simply because you are reading this.

From Effective Pricing to Egregious Pricing – Starbucks

In the past I have only written praiseworthy things about Starbucks pricing. I always admired how they set prices for their drinks, decide to raise prices when everyone else was running price promotions and how they communicated their price increases. This time I think they have crossed over from effective pricing to egregious pricing.

First time I wrote about Starbucks pricing it was on their decision to increase prices when the global economy was going into recession

In the case of Starbucks, how did they arrive at price increase, going against the flow? The simplest calculation here is, when price conscious customers moved out all they are left with are price insensitive customers who prefer their products. Hence it makes sense to charge more for them as long as the loss in profit from further drop in customers is less than the increase in profit from higher price. (Here is an attempt at formal proof on why increasing prices yields better profits).

Later on it was on their price communication,

As you read this multiple times you will find all kinds of reasons except, “We cater to a somewhat higher-income customer and we price our products based on customer willingness to pay. Besides we don’t expect any push back from these high income segment”.

A key attribute of those practicing value based pricing is never explicitly saying that they are practicing value based pricing. There are always other reasons and you never say pricing at customer willingness to pay. A key part of practicing effective pricing is effective pricing communication and managing customer perception.

Even when they announced $7 lattes I only had good things to say. After all they likely have more data on their customers and buying behaviors than any of us do. They likely found a segment willing to pay $7 for lattes and are simply targeting them with a product version at a price those customers are willing to pay (second degree price discrimination).

Even if there is no such segment, a $7 price tag helps to improve the reference price in the minds of rest of their customers and hence will provide Starbucks with a way to increase prices of their other drinks.

All these are effective pricing. No doubt. But now I think they crossed over from effective to egregious, launching a contemptuous attack on their customer’s intelligence.

Starbucks recently introduced its new Steel gift card that is sold only through Gilt.com and costs you $450 but buys you only $400 worth lattes.

If we leave out the last phrase “$400 worth”, everything else about this product is indeed effective.

1. They chose the right customer segment and set a price specific to that segment
2. Set a hard limit on number of units they wanted to sell – a result of their understanding of the size of the segment and a tactic to create artificial scarcity
3. Designed the product to be distinctive (Steel over Plastic) – making it a conspicuous consumption. Imagine flashing this card in your local Starbucks, the baristas and the rest of us mere mortals have no option but submit to your opulence (Disclosure: I go to Starbucks only when someone else is buying)
4. Selling it only through luxury goods website Gilt.com and not at every Starbucks outlet – thereby not only reaching customers with high reference price, high willingness to pay and high wherewithal to pay but also not targeting rest of their customers
5. Guaranteeing profit from a high value gift card that locks up future sales and the possibility to add 10-15% of face value as profit from breakage (customers not using full value of the card)

Had they stopped right there, a $450 card worth $450 lattes, that would’ve been effective pricing. Then they took it one step further.  They decided to extract even more profit by setting the value of the gift card to only $450. And as they were wont to do with giving cost reasons they said,

One reason the card is so pricy is because it isn’t made of plastic — but specially etched steel. That guarantees the heavy metal wedge with the familiar Starbucks logo will stand out in your wallet and at the cash register.

The Starbucks card costs $50 to make,

Even if it is true, why should the cost matter in this case? This is not a true product. This is like the US Treasury asking you to pay $550 in change for a $500 bill because it costs them $50 to print that bill.  While it made perfect sense to use cost argument to push through price increases, cost has no relevance to take away value of the gift card.

What they have demonstrated here is utter disregard for the customer. They probably think, if these customers were willing to pay $5000 for a luxury product that costs $50 make why not take $450 cash from them for $400 worth lattes.

The sad part is they may be right and they likely will sell out all 5000 of their limited edition steel gift card. After all don’t we all pay $100 more for 16GB additional flash that only costs pennies? May be the steel gift card is laser etched and designed to fit so perfectly in your palm and that alone is worth $50 for some.

My outrage is probably misplaced and egregious pricing is likely the new effective pricing.

How are you going to react when you see that startup founder flashing the steel card at Starbucks, especially when his product is free?

You better not bake your costs into pricing

The Atlantic boldly declares, “prices are people”.

“Baked into the price of everything we buy is the rising cost of advertising, accounting, legal services, insurance, real estate, consulting, and the like — jobs performed by the high-wage workers of our modern economy,”

Quoting data on our food spending, they say increasing share of our spending goes to services (wages to people that is) while less and less goes to commodity producers. Hence their case, baked into price is people cost. They explain to us that is why hand-made handbags are more expensive than the mass-made.

Just think about the $629 you just paid for the new iPad 4G, 32 GB.  Was it priced high because it is made one at a time using US labor, costs Apple a lot to pay those high-wage geniuses who work at Apple stores or because of their rising cost of advertising?

You can see how naïve Atlantic’s argument is and that how it completely misses the mark on economics and marketing front.

First the economic point – customers are not going to keep buying products when the manufacturers keeps adding their rising cost to the price. Demand is a function of price. Not only demand moves with price, the entire demand curve may shift (as they do in case of economic shocks). On the flip side, look at the farmer’s share as the price they charge for the products they delivered. Their pricing power keeps going down because of excess supply and practically no product differentiation.

Next the marketing point – customers are not paying to offset your costs. They are paying to fulfill their needs –utilitarian or hedonistic. It does not matter to them what your costs are or how you are allocating them.  When was the last time you were at a coffee store and paid separately  for employee salary or the decorative lighting?

It is not the cost that comes first, it is the price that comes first. Apple and Starbucks don’t bake their cost into pricing. They find the price customers are willing to pay for the value they get and deliver the product at cost that is profitable to them. In case of Apple, insanely profitable prices and costs. There are many customers who are not willing to pay Apple prices, Apple simply chose not to target them.

(Photo credit: Wikipedia)

It is not the salaries of Apple Store Geniuses that is baked into each iPad. To target those customers who are willing to stand in line and hand over $499 to $799, Apple has to hire the Geniuses. The  experience is part of the product. Apple is willing to pay higher wages the Geniuses demand because, one they cannot deliver the same customer experience with someone willing to take lower wages and two it can still make profit at these wages.

Prices are not people. People costs do not determine prices.

Hope you are not taking economic insights or worse pricing advice from such articles.

Other readings:

1. If you think organic produce is priced higher because of costs
2. Why is iPad 3G priced $129 more than Wifi but Kindle 3G is only priced $50 more
3. What is the difference between Apple and a drycleaner? (password: iPad2)

Our pricing decisions are based on … Starbucks Raising Prices

Image via Wikipedia

Two years back we saw the story of Starbucks price increase. Despite widespread criticism in the news media we saw no real ill effect on its sales or brand. You know why from here (elasticity) and here (demand curve shifts). Now they are rolling out price increases to the rest of the country. I want to point out some key points noted in the price increase story that serve to tell us how well they are executing this change.

Here is the link to Reuters story if you want to read it without my interpretations.

Starbucks Corp (SBUX.O) raised prices by an average of about 1 percent in the U.S. Northeast and Sunbelt on Tuesday, making coffee-drinkers spend more in New York, Boston, Washington, Atlanta, Dallas, Albuquerque and other cities.

Average price increase is meaningless. They want us to focus on the small number. Most likely some prices went up much higher then 1%. You won’t find that until you read the story. Most likely they also calculated the average over all their products, even those that did not see price increase, simply to bring down the average.

Starbucks expects high costs for things like coffee, milk and fuel to cut into profits this year. Like other restaurant operators ranging from Chipotle Mexican Grill (CMG.N) to McDonald’s Corp (MCD.N), it is raising prices to help offset some of that cost pressure.

They are giving reason for the price increase. As William Poundstone, author of Priceless wrote in a guest post for this blog, customers are more likely to find the price increase acceptable if associated with a fair reason. Starbucks is going a step further in using examples, “hey others already did it and we are following them”. You should give them credit for both points and extra credit for giving future cost increase as the reason.

the price for 12-ounce “tall” brewed coffees and latte drinks went up 10 cents. Prices on about half a dozen other beverages also were set to increase

This further attests to first point, not all prices are going up. Most likely they are increasing prices of their most popular drinks, those whose demand is relatively inelastic or those with lower contribution margin such that they are okay with lost sales from price increases. For the last point see my past post on how lower contribution margin means okay to lose sales from price increases.

Starbucks’ Olson said the price for a 16-ounce “grande” brewed coffee, the company’s most popular beverage, remained the same across the United States and has not changed since January 2011. The price for grande lattes was unchanged in most markets, he added.

To state the obvious, Starbucks has three sizes, tall, grande and venti. They are increasing prices on their tall while leaving the grande untouched. This is classic case of second degree price discrimination. After the price increase on tall, some customers may find they get more value with grande (higher consumer surplus) than they get from higher priced tall and will instead choose grande. Since the marginal cost of additional coffee in grande is almost negligible this is still an upside for Starbucks. They are able to capture higher consumer surplus without alienating their customers. Because they have done their versioning right.

Lastly this one is the most measured statement of all (I bold texted the key phrases)

The Seattle-based chain said its pricing decisions are based on multiple factors, not just the price of coffee, which has eased lately.

Those considerations include “competitive dynamics” in individual markets as well as costs related to distribution, store operations and commodities, including fuel and ingredients for food and beverages, Olson said.

As you read this multiple times you will find all kinds of reasons except, “We cater to a somewhat higher-income customer and we price our products based on customer willingness to pay. Besides we don’t expect any push back from these high income segment”.

A key attribute of those practicing value based pricing is never explicitly saying that they are practicing value based pricing. There are always other reasons and you never say pricing at customer willingness to pay. A key part of practicing effective pricing is effective pricing communication and managing customer perception. Failing that you will face backlash as some brands recently did.

Overall, great pricing strategy, execution and communication by Starbucks.

Instant Coffee Price Is About Skimming

Update 8/19/2010: Via sales stands at $100 million

Instant coffee may be a $21 billion market but Starbucks’s new instant coffee Via is definitely not about taking a share of the revenue.

A trio of single-serve Via packets will sell for $2.95 in the United States and 12 packets will sell for $9.95. Those prices are significantly higher than Nescafe’s Taster’s Choice single-serve packets that sell in Los Angeles for roughly $1.50 for six and around $4 for 20.

At $1 per serving, Via is  four times the price of the market leader, Nestle. Via is priced for profit, not for capturing market share.

Nestle’s overall margin of 12% tells us the upper bound of overall market profit is $2.4 billion. For Via, the cost per serving cannot be any more than twice the retail price of a serving of Taster’s choice (assumption). Conservatively we can assume Via has 40% margin. Starbucks will be more than happy to get just 3% or so market share. How will Via get  its 3% market share? It comes from two sources. One, there always exist a segment that wants premium instant coffee and is willing to pay premium price. Two, by bringing in new customers who have not tried instant coffee before (some of these will be ex-Starbucks customers who stopped visiting the coffee shops).

If Via gets 3% of the $21 billion market, that is $630 million in revenue and $250 million in profit. That is, at 3% market share Via will gain 10% of the market’s total profit. That is not that different from the strategy of Apple and Blackberry that have 30% of the mobile phone profit share with less than 3% of market share.

Pricing Via is about skimming profits not market share and a very prudent one.