Using Cost Argument In Pricing

Pricing is about capturing a fair share of the value you add to your customers.  This method of pricing is called value based pricing. The opposite of this is called cost based pricing that is  internally focused and ignores  customers.  Your costs are irrelevant to pricing, as long as you are not selling below marginal cost and beyond break even point. After all if you are making a loss on every sale or on the whole operation then it makes no sense to be in that line business.

That said, a marketer can use costs signals to introduce price increases while assuaging customer concerns about fairness. I do want to stress that this is a pricing tactic and not a strategy. In their paper titled, Perceptions of Price Fairness, researchers Gielissen, Dutilh,and Graafland  validated their hypothesis,

Hypothesis 2: Options to pass on production costs are perceived to be fair.

When customers see the price increase is a result of cost increases, they are  willing to accept the new prices. Once the high prices become established, these become the new reference price and can remain sticky even when the original cause (production cost increase) is no longer valid.  We see that in the earnings results of CPG brands that used commodity price increase in 2008 to push through their price increases. Since they hit their peak in 2008, prices of food and utilities have come down but the CPG price increases remain.

Brands, despite their current pricing strategy, should implement tactics that take advantage of short-term market conditions. While we saw how P&G, Nestle, Cadbury, Heinz and Unilever taking  advantage of cost increases we also saw Lindt’s not using the increase in cocoa prices to increase its prices. The result is a 90% drop in their profits.

The net of this is, your costs are immaterial to your pricing strategy but short term price increases can be used as effective signals to fix faults in your pricing.

Retailer Going After CPG Price Increases

While the leading CPG brands (Heinz, Nestle, Unilever, Del Monte) are reporting increase in profits from price increases, the retailers are not happy with the price increase. Safeway is asking the brands to  rollback their prices and is using their private label leverage. Safeway executive Steve Burd, told analysts,

I say wait and see, because we’re going to chew  up on corporate brands

Mr. Burd makes his case based on falling input costs and hence the brands must pass on the savings to the customers. Again to repeat for the umpteenth time, costs are not relevant to pricing. These food brands were able to retain their price increase and grow their profits despite the drop in sales volume. This is because of the change in customer mix, the price sensitive segment has already moved on to private labels. The brands are doing the most rational thing, price products at what customers are willing to pay.

The retailers have a higher gross margin on the private labels and most private label products are produced by the same corporate brands Mr. Burd was talking about. The retailer margins are so thin that they need the large volume to make up for their high fixed costs. The retail operations are measured by dollars per cubic (or square) inch.  The fall in volume of name brands due to their  price increase is starting to affect retailers despite the increase in sales of private labels.

One questions we should ask is if a retailer can “chew the corporate brands” with their private labels, why not do just that? Why threaten to do this? I believe the loss to retailers with this move will be larger than it would be from a negotiated price agreement with the brands. Retailers depend on the same brands for supplying private labels, they need to spend more on promotion and stand to lose customer traffic if brands are pulled out of their stores.

What is the likely outcome? Brands are happy with their price increase and know that those who are buying now are their brand loyal customers. If a retailer pulls the brand off the shelves most customers will seek another store. But the risk exists that the brands will lose out in the long term. The most likely scenarios to happen are

  1. Brands will allow retailers to keep more of the price increase in the form of trade promotion
  2. Brands cut a better price deal with retailers on the wholesale price of private labels manufactured in their factories.

In any case it is time for retailers to start thinking about reducing their operational costs.

Another CPG Reporting Profit Rise From Price Increase

Last week three major CPG brands (Unilever, Nestle and Heinz) reported big jump in their profits fueled by price increases. Now another big brand, Del Monte reported its quarterly profit increased by 14% due to its price increases. Their sales revenue increased despite the weakness in volume due to the price increase. Once again another  marketer is giving up its quest for market share and “stomach share” and going for the core business objective, “profit”.

It shows again that they were pricing lower than they should have and that their brand does command a premium. The customer mix also changed with the price sensitive customers switching to private labels but the rest remaining loyal to the brand. Another factor is the sustained revenues at higher profit from Del Monte’s pet food division.

Price increases in the company’s pet-food segment will likely remain a good business choice for Del Monte, according to Morningstar analyst Ann Gilpin, because consumers tend not to trade down to private-label products when it comes to their pets.

“I don’t think anybody wants to buy private-label dog food, just because there were so many issues with recalls,” she said.

Is this the begining of the end of the quest for Market Share at all costs mantra?