Answer to Pricing Puzzles – Restaurants Charging Fee for Sharing

I tweeted a series of pricing puzzles. This series is my interpretation of what the answers could be. Do not treat them as absolute answers. Alternative explanations are possible.

There are two parts to this question.

  1. Why do restaurants charge a fee for sharing?
  2. Why do they charge two different prices based on what is shared?

It is safe to say that those willing to share are most likely couples and they likely pay for it from the same shared budget. For everyone else, those not sharing budgets, the question of sharing does not even come into play.

A restaurant’s goal is to maximize spend per table.  Their wait-staff are essentially the sales team trying to generate more sales per table during the period it was occupied.

So when customers share, it cuts (almost in half) the spend (and hence profit) per table. To discourage customers from doing so, they make the price of the single entree look a little more unattractive by adding the split fee. This is second degree price discrimination. With the split fee, customers may see higher value (consumer surplus) when they order two vs. one.

For those who still want to share for any number of reasons including limiting portions, even with added fee sharing will provide higher consumer surplus and the restaurant gets to recoup profit.

Why charge different split fees? Price discrimination done right. If you charge one split fee, you might as well charge two.

Should they do it? What about customer backlash?

To repeat my earlier point, this is a limited segment that will share food. The rest won’t even notice the split fee.  So by all means do it as this is money that flows straight to bottom line. However they should consider their customer mix and capacity utilization.

What does this mean to you as a Tech Product Manager?

I do not recommend you following in the restaurant’s footsteps. Start with the customers and their needs. Consider how your webapp is being used by your customers.

  1. Do they share login?
  2. From what budget are they paying for it?
  3.  Is there value for them in keeping separate logins?
  4. Do they want to keep their Netflix video queue/history or Evernote clip archive separate?
  5. Do they consume your limited capacity without adding to revenue?

My recommendation: Instead of trying to tack on split fees, make the price of adding second (or third) user attractive that most will do it.  (Like SurveyGizmo did)

 

Metered Price Discrimination, Customer Margin or in the Vernacular of Social Media – Freemium

Consider these real life pricing scenarios that you see everyday:

  1. Six Flags Discovery kingdom sells its annual season pass for $49.99. According to its website, “Buy your Season Pass for $49.99, just $5 more than a one-day admission.”  Now why would they give away an unlimited entry annual pass for “just $5 more than a one-day admission”.
  2. Movie theaters charge extremely high prices, 4 to 5 times what we usually pay outside, for popcorn.
  3. Gas stations sell gas almost at cost and sometimes they even lose money due to credit card interchange

What is common in all these pricing scenarios? All these businesses are practicing what the economists would call as,  “Metered Price Discrimination“, or what marketers describe as, “Customer Margin“. There is nothing new, it starts with, “price discrimination” – charging different customers different prices.  Customers differ in the value they get from a product/service and in how much they are willing to pay for it.

Let us start with a simple case where the only way to monetize a customer is the price they pay. Let us keep it really simple and assume all costs are sunk and the marginal cost to serve a customer is $0.

For each price point you set, there will be different number of customers willing to pay that price. That is your demand curve. Your job is to find the price that maximizes profit – if you increase the price you will lose some customers but gain more from the remaining ones,  if you decrease the price you will gain new customers but lose revenue.

Total profit ∏1 = p times N ; price is the only lever you can control

Now consider the case where there are many different ways to monetize the customer (let us still keep costs as $0). For example, amusement parks charge parking, sell you lunch etc. Then you have several different levers to control,

Total profit ∏2 = p times N + R1 * n1 + R2 * n2 + ….

where R1, R2 etc are average revenue from each additional service you sell or ways you monetize the customer and n1, n2 are the subset of customers that generate that revenue stream. It is trivial to see that n1, n2 etc are directly a function of N.

Your goal now is find the entry price p that maximizes total profit and not just the profit from price paid. For example, movie theaters may set the ticket price lower such that they bring in lot more people but make up for it from the subset who are willing to pay higher price for popcorn. Similarly gas stations attract more customers with lower gas price and sell high priced snacks and drinks in their stores.

This is Metered Price Discrimination – some customers get away with paying the low “entry fee” while others pay more by consuming additional services at different prices.

Now consider the special case where the entry fee, p =$0. You have what is described as “Future of pricing”, freemium. You give up on monetizing entry fee and focus only on profit from other revenue sources.

Total profit ∏3 =   R1 * n1 + R2 * n2 + ….

There is nothing new, radical or futuristic about it.

If you have done the analysis, know your customers and find that ∏3 is better than ∏2, then by all means set the price to $0. You need to know ex ante, what the different revenue streams are going to be and how many customers will generate that. You cannot go in with a free model assuming that once you get customers in you  can monetize them later.

If all you have is hope, or promises of a marketing guru quoting some extreme examples that show higher ∏3, you have have your work cut out for you.

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.

Is Ann Taylor’s Pricing Paying Off?

Ann Taylor reported their Q3-2009 went up despite drop in sales. Their gross margin went up by $7.7 million while their sales fell by $64.8 compared to same  Q3-2008. Kay Krill, President and Chief Executive Officer, commented,

Our results for the quarter were a direct result of our strategy to maximize gross margin performance by tightly managing inventories, focusing on full-price selling and controlling costs. I am pleased that our performance also reflects the cumulative benefits of our ongoing restructuring program initiatives.

I have been writing all along about the need to cut promotions, focus on protecting pricing and practice effective price management to deliver profit growth. But I am not fully convinced that price increase contributed to Ann Taylor’s profit growth. In fact they may have lost more than they gained from price realization and any profit growth was a result of their cost cutting. I will focus on the gross margin number when I say profit in this discussion.

Ann Taylor cut down on promotions and focused on charging full-price with the net result of increase in average prices. Another measure is inventory control. Total inventory per square foot at the end of the third quarter of 2009 was down 20.7% versus year-ago. If we assume (see note below) that this reduction can be equated with drop in volume of the same level, from the revenue change and volume change assumption we can compute that the average price increased by 10.6% (See end of this post). In other words 1% increase in price resulted in 2% drop in volume (price elasticity 2).

Their percentage gross margin  was 48.8% the previous year.

Loss of profit from drop in volume (due to increase in prices) = 20.7%*48.8% =  10.1% of  Q3-2008 revenue

Increase in profit from 10.6% price increase = (100%-20.7%)*10.6%   =        8.4%  of Q3-2008 revenue

This is a net loss due to drop in volume. Since their profit in Q3 2009 increased YoY, the profit increase is entirely due to cost control and other effectiveness measures in merchandising.

So did Ann Taylor make the right decision to improve prices? Could they have delivered higher profit by keeping their promotions and price levels? Unless there is a strategic reason to preserve brand premium and long term profit, this price increase was not a profit maximization move.

Footnotes:

On the volume drop  assumption, this could be wrong because sales volume is a flow metric while inventory was a point metric. But this  is inventory per square foot of store, so it is a good stand in for volume. Another possibility is that a portion of the 20% reduction is to respond to volume that is already lost due to recession (demand curve shift). If the price elasticity drops to 1 or low, then yes the price increase makes perfect sense.

Calculating price increase :

R = P * Q;       (P2/P1) = (R2/R1)*(Q1/Q2)  (R2=$527, R1=$462, Q2 = (100%-20.7%)*Q1)

Effective Price Management

Lindt’s Bitter Profit Drop

Lindt reported almost 90% drop in its profit, while cost overruns was a contributor the main reason quoted by The Wall Street Journal is the failure to increase prices.

Swiss chocolate maker Chocoladefabriken Lindt & Spruengli AG has suffered from a failure to raise prices late last year to offset higher cocoa prices, underperforming rivals with an 88% drop in first-half net profit and lower overall sales.

The lead line from the WSJ article does not tell the full story. Lindt’s profit dropped from 22.9 million Swiss francs to 2.7 million Swiss francs.  There was a a one time charge 22.2 million Swiss francs in that expenses. Their operating profit, excluding these charges and taxes, is a better measure but still it includes factors unrelated to marginal costs, like currency fluctuations and depreciation.  So let us look at their gross margin numbers and compare the number for this six months against the same period last year (note we cannot simply use the previous six month period because of seasonality variations).

Compared to previous year same six months  their gross margin was 64% from sales of 1.03 billion Swiss francs  and this six months gross margin is  62% from sales of 0.985 billion Swiss francs. Their cost of revenue is almost identical to YoY numbers while their sales  fell 4.3% from its year over year numbers. This does support the theory that failure to pass on cost increases to customers as price increases resulted in loss.

To retain the same gross margin as YoY number, Lindt should have raised its prices by 8%, assuming its sales will not fall any farther than the 4.3% drop. They were concerned whether the sales would have dropped steeply if they had increased prices, a valid concern that can only be answered by looking at their market data on customer preference and price elasticity of demand at different price points. Their sales had to drop additional 7% (email me for the math) to make the price increase unattractive.

While costs are irrelevant to pricing (especially at 64% margin and for the premium product) the commodity price increase of last year should have been used as a pretext to increase prices. Customers are more willing to accept price increases when there is a reason (however trivial or irrelevant) than unexplained increases.  There are also other methods that would have increased margin without a direct price increase, one of which is using creative packaging that reduces amount sold for the same price saving marginal cost. Cadbury explicitly stated this in their annual report, and Nestle’s size reduction of Haagen Dazs was popularized by none other than Ben and Jerry’s (Unilever).

The net is, Lindt should have taken steps for better price realization (price increase , reduction in promotions and creative packaging) using the commodity price increase as a pretext.