Adaptive Price Management

When the downturn started in 2008 and retail sales started dropping, the department stores started dropping prices from fear of being left with inventories. There were big sales, with 50% to 70% drop in prices even in high end retailers like Saks. There was one exception, Abercrombie & Fitch, which steadfastly refused to drop prices.

They knew they were not a product for the mass market and there was a small segment they served. For a long time that segment was not worried about price. They were more concerned about the brand and the long term effects of sales on their brand and future pricing power. They were worried about setting low reference price in the minds of their customers and did not want to train their customers to wait for sales. There was more to lose from price decrease than to gain.

However, things got worse for Abercrombie & Fitch. Their operating margin shrank from 20% to barely 4% in less than a year. Their sales fell 30%. Whatever happened to Effective Price Management  that recommends pricing for profit and protecting  price premium to deliver higher profit.

They  correctly following and religiously implementing two of the three components of Effective price management:

  1. Pricing based on value add to segments
  2. Pricing based on incremental analysis

Unfortunately there are two problems that led to profit erosion.

First  problem is effective price management requires the marketer to manage all three components and selectively choose one or two and implement just those. When a marketer optimizes a subset they end up missing the true optimal solution.They were focused on margins from individual items and not on maximizing total margin from the customer. They ignored the third component of effective price management – Focus on customer margin not product margin.

Second problem is the model is not static – you do not decide  your segment, their value proposition, their demand curve once and forget about it. The segments, their taste, value proposition and willigness to pay all change and change drastically due to external events. The New York Times  reports on a market research that found just this shift:

Aéropostale and Wal-Mart, the discount chain, are among teenagers’ go-to stores this season, while more expensive stores — like Hollister and Abercrombie & Fitch — are not, according to a survey of students ages 12 to 17 by Majestic Research.

“Rather than get one top at a Hollister, they can get two or three at Aéropostale,” said Brian J. Tunick, a retail analyst at J. P. Morgan Securities.

When this shift happens then all the previous models on segmentation, targeting and incremental analysis on sales drop and lost profit must all be reevaluated. When the model does not evolve and remains static, it results in decisions that does not deliver under changed conditions.

Effective price management is not about picking and choosing a subset of the three components but implementing all three with right balance to maximize profits. It cannot be done in a, “set it and forget it mode”,  it is a dynamic model that requires continuous tuning to adapt to changing inputs.  Failure to do so will result in sub-optimal results regardless of how optimized the partial model is or how accurate and complete the initial model is.

Pricing Strategy and Stock Prospects

Procter and Gamble   and Kraft, the two Consumer Packaged Goods (CPG) leaders, reported identical revenues and earnings growth in their last quarter. Analysts interviewed by Barrons magazine prefer  Kraft over P&G for one major reason: Kraft’s pricing strategy that is focused on reducing discounting and solidifying pricing power in the face of competition from low priced private label.

Kraft Chief Executive Officer Irene Rosenfeld seemed confident that the days of branded foods being nibbled to death by cheaper private-label goods have come to an end. Rosenfeld says the company has expanded operating margins and plans to continue increasing its “pricing power.”

What about P&G pricing? According to Jason Gere of RBC Capital Markets, discounting and price cuts are not guaranteed to drive volume.

Although the company will likely spend heartily on price cuts, advertising and brand-building in the coming year, it’s unclear whether the strategy will work, says Gere, who rates the company at Market Perform.

Does P&G practice effective price management? Mostly it does, but analyst comments raises questions on some of the components.

  1. Value add to segments: Does P&G has multiple brands that appeal to different segments and keep the customers within their brand family as they trade down?  I believe so. Mr.Lafley, Ex-CEO of P&G, made it clear that P&G will expand product portfolio to cater to changing consumer behavior.
  2. Incremental analysis: What is the incremental profit from price cuts and increased advertising spend? Jason Gere’s comments above seem to indicate there is uncertainty on this aspect.
  3. Customer Margin: Can P&G capture a larger share of customer spend? The decline in organic sals growth indicates challenges in capturing larger share of customer spend at the stores.

Ultimately it comes down to effective price management to drive profit growth and stock prospects.

Lowering Prices To Generate Sales?

Here is another CEO who clearly believes lowering prices does not automatically guarantee  sales increase: Macy’s Terry J. Lundgren.  In his inteview with The Wall Street Journal, Mr. Lundgren  said,

WSJ: Do you think about lowering your average selling price or changing your product blend, as some of your competitors have done?

Mr. Lundgren: Here’s the challenge. We have [a men’s pants brand], and they typically go out the door between $29.50 and $32.50, with all the coupons and everything.

What Mr.Lundgren refers to as “out the door price” is the “pocket price“, the net price after all discounts. The net effect of the discounts and coupons is price leakage that erodes profit, clearly Mr. Lundgren is driving Macy’s to focus on its price waterfall.

Mr.Lundgren’s management serve as the best case study so for on the three components of effective price management:

Knowing the value add to segments:

Our purchasers are women. She’s spending the same amounts but just shopping with a great deal of discretion. Value is the word, even if it’s at regular price. The intrinsic value of what she’s buying is very important.

Incremental analysis: How much should sales rise to compensate for loss in profit from price cuts? (Lundgren is on the direction but he is comparing top-line while he should be doing incremental math on lost profit. There is also numbers error as pointed out by the commenter.)

So we were getting tremendous sell-through at low price points and no margins. And I am not making my pants sales for last year, because my average sale dropped by 30%. It’s really hard to make the math work. I have to have 30% more transactions on this product to break even.

Customer Margin: Understanding that loss leaders are effective only if they help generate incremental profit from customers who are attracted to the stores by low prices of loss leaders.

We and the manufacturer together agreed to mark them (pants) down to $21.99 or something like that. Selling like hotcakes. Every other pants around them stopped selling.

Does your business practice effective price management?

Effective Pricing In Downturn – Pricing Luxury Wines

In the down economy, wine makers are struggling to sell luxury wines, those that are priced $25 or more. The Wall Street Journal reports the slump in sales and how the winemakers are cutting prices to clear inventory. The sales of wines priced $25 or more fell 12%. These wines are priced at 10% to 30% discount to woo customers whose buying behavior changed since the beginning of the recession. Revenues in one of the California winery slipped almost 40% due to drop in volume and the price cuts to entice price sensitive customers. The danger with all the price cuts is whether the winemakers will be able to raise prices because of the low reference price they set now in the minds of customers. Trained to see price cuts and low prices, customers will balk at any future price increases.

How else could the winemakers have handled this?  The lessons come from the playbook of CPG companies – increase prices, sacrifice sales and market share but deliver profit growth despite drop in revenues. The top-line number (revenue) is immaterial, it is the bottom-line (profit) that matters. This is especially true in a downturn when the customer mix change and there is only so much cost cutting a business can do. When the price sensitive customers switch or hold back, all you are left with are those who prefer your wine over others – hence you should charge them a price that matches their higher willingness to pay.

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!

Best Buy Price Waterfall

Best Buy announced its fiscal Q1 earnings yesterday. The story is the opposite of what we saw for CPG earnings. The CPGs reported increase in profit despite losing market share but Best Buy reported decrease in profit despite an increase in market share. The main contributor to the drop in profits – price leakage. In its press release the company said

The company noted that comparable store sales in flat-panel televisions were essentially flat versus the prior year as unit increases offset declines in the average selling price.”

Despite selling more units the company brought is less revenue – the reason is the many discounts it made available to induce sales during the down economy. The price waterfall for flat panel TV tells the general story behind Best Buy’s statement regarding decline in selling price. From a list price of $1299 the pocket price, after all discounts and cost of capital to extend free credit to customers, drops by almost 40% to $781. bestbuy_price_waterfall

It is a good sign that the company realized the price leakage. We should expect to see drop in inventories, further drop in revenues but increase in profit  from better price realization in the coming months.