Our pricing decisions are based on … Starbucks Raising Prices

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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.

Is Groupon a tool for price discrimination

NPR’s  Robert Smith claims Groupon’s success comes from simple economics, “Different people are willing to pay different prices for the same product”.

Since some people are not willing to pay $18 for burgers but are willing to pay $9, Groupon makes it possible to bring these customers and sell them the same burger for lower price.

Smith misses the point and even Groupon will strongly disagree with Smith’s claim. His argument is an extension from regular price promotion coupons which are a way to achieve price discrimination.

None of what Smith describes about price discrimination is incorrect it is simply irrelevant to the new world of Group Buying.

The basic question to ask is whether Groupon and the Groupies are Sales Channels or Marketing Channels.

Groupon positions itself as the marketing channel. Their messaging is about finding new customers who come in for 50% off, fall in love and become a regular paying full price. They do not want businesses to look at contribution margin at individual customer level.

Groupon does not want to be seen as a tool for off-loading excess inventory or just another way to reach sell to new customers. That is the job of a sales channel.

A sales channel  can be a tool for practicing price discrimination. You sell your product through different channels to different target segments and can charge different prices.

As a tool for achieving price discrimination,  Groupon will be effective only if

1. There are no opportunity costs to selling at lower price
2. There is no possibility of arbitrage – customers buy through one channel at low price and sell in different market at higher price
3. It is targeted and does not cannibalize current sales – full price customers continue to pay full price and do not take advantage of 50% Groupon promotion

The secret to success of Groupon is not price discrimination and is no secret at all. It is because we lack the appetite to do the math on long term value of giving away 75% of our revenue for short term long lines.

Knowing Your True Marginal Cost

From big businesses to home based businesses there is an uncontrollable desire to allocate a share of the total cost to every unit of product sold. It is actually surprising that some of the small businesses do elaborate calculations just so they can allocate a share of the mortgage, insurance, delivery vehicle etc. This is from the NYTimes story on the new entrepreneurial craze – Cupcake stores:

For each cupcake she sells, Ms. Lovely figures she spends 60 cents on ingredients, 57 cents on mortgage payments and utilities, 48 cents on labor, 18 cents on packaging and merchant fees, 16 cents on loan repayment, 24 cents for marketing, 18 cents for miscellaneous expenses and 4 cents for insurance. That totals $2.45, leaving a potential profit of 55 cents on each $3 cupcake.

It is not difficult to see that Ms.Lovely’s elaborate calculations are based on volume sold, so any changes in number of cupcakes sold will affect her cost allocations.  Only the ingredients and labor costs are true marginal costs (you could argue even those don’t count as MC).  For a cupcake priced at $3, that gives a contribution margin of  $1.92 which all add up to defray the fixed costs of mortgage, insurance taxes etc.

So when volume drops and the margin drops below 55 cents will Ms.Lovely increase price of her cupcakes? Will the market pay for it? The problem with cost driven decision making is it ignores the customers.

Padding marginal costs with cost allocation combined with the percentage margin obsession will lead to incorrect pricing that is unrelated to what the market is willing to pay and lost profits or even the end of your business.

Here is five step process for cupcake cost economics:

1. First find out how many cupcakes you can sell different prices, then find the price that maximizes your profit given the true marginal cost for a cupcake.
2. The difference between price and the marginal cost is what each cupcake contributes to defray your fixed cost and eventually contributes to your profit. This is called the contribution margin.
3. The number of cupcakes you need to sell so that the total contribution margin can cover fixed costs is your breakeven volume.
4. Don’t look at % margin on each cupcake, this is irrelevant to your business decision. Not every cupcake you sell needs to contribute to profit, only those that you sell beyond the break even point contribute to profit. Trying to allocate fixed cost and profit to every cupcake leads to bad decisions.
5. If you cannot sell the cupcake for more than its marginal cost, there is no business case. If the total contribution margin   cannot cover the fixed costs, there is no business case.