About that McDonald’s Minimum Wage and Prices Competing Maths

Leave the kid (ok, Finance Research Assistant, Arnobio Morelix, from University of Kansas ) alone for his math on effect of wage increase on McDonald’s prices. He did his math based on labor costs reported by McD in its SEC filings and said,

7.1 percent of the fast-food giant’s revenue goes toward salaries and benefits. … Thus, if McDonald’s executives wanted to double the salaries of all of its employees and keep profits and other expenses the same, it would need to increase prices by just 17 cents per dollar, according to Morelix.

But he is blamed for not considering the fact most of labor is in the books of franchisees,

By contrast, the small business owners that actually operate McDonald’s locations are spending about a third of their income on employees. Using Morelix’s own methodology, this means prices would actually increase by 32 cents on the dollar if labor costs doubled, or an extra $1.28 for your Big Mac.

And this article goes on to say,

Morelix’s estimate also ignores the fact that price increases reduce restaurant sales–requiring even higher prices on the remaining customers to maintain the assumed profit line

Actually both the methods are wrong. They are wrong on two fronts – costing and pricing.

Cost Analysis Errors

Let us not forget that the numbers reported in financial statements are for investor purposes as mandated by SEC. These are reported in aggregates, truthfully (mostly), but done in a way not to make it easy for competition to understand the cost structure. Do not expect the cost per unit number (marginal cost) for each product to be broken down and reported for competition to see.

McD has a large product mix that spans the spectrum from premium to basic. Its margins (gross and contribution) on premium priced products are most likely higher than that from basic products. A moment’s reflection will convince you that labor cost does not change with product mix or number of units sold. So it should be treated as a fixed cost of operating the franchise vs. marginal cost on each unit sold.

Price Analysis Errors

Both these analyses assume and do math using cost based pricing. That is you add up all your costs, distribute the costs among units sold, tack on a markup and voila you have price. Customers are not buying your products to defray your costs. See this article on ridiculousness of cost based pricing.

Had McD set prices thusly then it is true that increasing prices will result in lower sales (demand schedule), hence fewer units to distribute the costs on, hence higher per unit cost allocation, hence even higher price, …. death spiral.

Pricing comes before costs. A marketer will first find out what the different customers are willing to pay and set a price that maximizes their profit at given cost structure. If innovations or off loading cost components help reduce costs they will lower prices as long as the incremental profit from new sales is more than the lost profit from decreased per unit profit.

McD wants to get its products into the hands of as many customers as possible. They as the brand owner gets to set prices. They set prices (using whatever demand schedule they uncovered) and try to make those prices at costs that deliver profits. With franchise model it works a bit more in their favor – they set prices and let the franchisees worry about making a profit at those prices after covering their total costs.

If the franchisees see their current sales is not enough to make a profit, after paying McD its due (franchise service fee , rent, marketing expenses and materials cost to McD), labor costs, investment costs and all other operating costs they may decide to either quit and do something else or look for ways to squeeze other costs. For instance they could force McD to reduce the service fee, rent or materials costs.

If McD sees drop in gross sales because franchisees see an unprofitable business they may either set higher price point thereby catering to fewer customers or change product mix. Note that I did not say price increase but said, “set higher price point“. There is a huge difference. The former means passing on cost to customer while later means deciding to let go some customers who are not willing to pay the higher prices.

If McD should change the product mix they may choose to opt for premium products, different service and better experience. That product strategy will require a different labor that demands higher wages but franchisees may willingly pay those wages because of better profit from new product mix.

A marketer decides to drive down prices to reach as many customers as possible because they can still maximize profits at those prices by driving down costs. If they were not allowed to drive down costs (by artificially passing on to others) they will choose to set higher price points and serve a different segment vs. serving all.

Finally an important point Ron Shevlin makes about businesses and price increases,

Yes they would have as I wrote previously on this topic.

There you have it. Costs have nothing to do with pricing and paying living wages does not mean costs are being passed on to customers.

On the same note when a business says they are passing on Obama care costs in each slice of pizza you buy you should question it.

Markup is just plain gross, not Gross Margin

An anonymous commenter on my previous post wrote,

maybe you need a refresher in the most basic tenets of finance and accounting because gross margin is a percentage, not an absolute dollar figure. you’re referring to GROSS PROFIT, but calling it gross margin.

First correction on this comment is – Gross Margin can be expressed as either absolute dollar value or as percentage. In most situations it is understood by context – especially by the practitioners. Gross Profit and Gross Margin are used interchangeably as well. See for example Apple’s earnings release

apple-gross-marginBut when Google Finance shows Apple’s financials they refer to it as Gross Profit.

Sometimes we see Gross Margin Percentage explicitly used to indicate percentage margin. Again practitioners are not confused by any of the terms even when two of them are used interchangeably.

What is Gross Margin? (or Gross Profit)

Expressed as dollar value it  revenue less cost of goods sold. Expressed as a percentage it is this difference divided by revenue.

The anonymous commenter (who seem to have inexplicably routed his IP traffic through Fool.com, because I know MotleyFool is not afraid of making comments) added,

gross margin is the percentage that a company nets on the sale of a good after dividing it by its cost of goods sold.

That is not true. What this person is confusing with is  Markup. While Gross Margin (etc.) are financial accounting terms Markup is not. Its origins are in cost based pricing. You compute the cost to make a widget, add your preset margin you want to extract and call it the price.

Which you, my right tail readers, know is simply gross way to set prices. It would serve us all well if we banish the  “Mark Brothers” – Mark Up and Mark Down.

Another note on Gross Margin – it is a financial accounting term used for financial reporting purposes. The intended audience are investors and regulators. Since competitors can also see this companies do not want to signal their exact cost structure. So they  confound this number with a share of fixed cost allocation from manufacturing.

If you as a product manager or marketer going to worry about margin, worry about customer margin.

The Lego Pricing Puzzle

In a recent Wired blog post, physicist Rhett Allain asks

Why Are LEGO Sets Expensive?

and answers his own question by stating,

I’m not sure I would say LEGO blocks are that expensive, but the statement is that they are expensive because they are so well made.

To his credit he immediately qualifies his claim by adding

Really, this has to at least be partially true.

Then professor Allain goes on to make his case based on size variances in Lego pieces and compares it with variances in other blocks used for “play constructions”. Finding no statistically significant difference with other plastic blocks he adds,

but the LEGO blocks appear to be created from harder plastic. Maybe this would lead them to maintain their size over a long period of time. (but no data)

Finally he builds a regression model of price of Lego sets  to number of pieces in each set.

In essence, Allain made up his mind that Lego is expensive because of the intricacies in manufacturing, its cost of materials and number of pieces. He then collects data that would support his claim but quickly discards them with alternative explanation when data doesn’t fit his claim.

But lost in all this are some published hard numbers from Lego. They have 70% gross margin and 30% operating margin. Note that I am using gross margin reported in financial statements that usually include other fixed cost allocations to confound the numbers. That is Lego’s real contribution margin (price less true marginal cost) could be higher than 70%.

Even if Lego were to cut is price in half they would make as much gross margin as MegaBloks that makes Lego compatible pieces. Intricacies in manufacturing and cost of hard plastic do not contribute to Lego’s costs (or prices as Allain claims). That is Lego does not incur any additional costs because, “they are so very well made”.

Lego is priced thusly because they identified customers who value its offering and are willing to pay the price premium despite the presence of cheaper alternatives. All the reasons about details of pieces and their size variance are post purchase rationalizations we tell ourselves to justify the price we paid.

Your costs are just that, your costs. Costs are not something you pass on to your customers (unless you use that as ploy to pass on price increases).

Pricing Flash Storage in Tablets – Don’t Call This As Markup

The New York Times Bits blog laments about the giant markup Apple and Amazon charge on flash storage. Bits blog not only complains about the price vs. cost difference but also caught on to the price difference between Kindle and iPad for the same storage.

Kindle: 16 gigabytes for $300 and 32GB for $370; to enjoy 16 extra gigabytes of storage, a customer pays $70 more. For its smaller 7-inch tablets, Amazon charges $50 more for an extra 16 gigabytes.

iPad: You can get a 16GB model for $500, a 32GB model for $600 or a 64GB one for $700. That’s $100 extra for that first 16GB bump, then a relatively cheap $100 to get from there to 64GB.

At the outset let me point out I have lamented on the same topic as well but mostly admired it and only lamented it a bit as a consumer. Let me point out how the flash storage prices vary even within Apple’s different product lines,

Apple Pricing

Yes both Kindle and iPad are able to extract lot more consumer surplus with their flash pricing. That is because they figured out their customers value the additional capacity lot more and are willing to pay the additional $100 (or $70) for doubling capacity. This is not markup and the fact that flash costs 50 cents per gigabyte should not matter.

Using words like markup comes from cost based pricing (add up all the costs then mark it up to get the price, hence markup), as is shown by this text in the same Bits blog post,

Of course, when you buy a new gadget, you’re not just paying for a slab of components. The maker of the product is trying to get you to cover the cost of research and development, manufacturing and advertising, and still rake in some profit.

Note how sure the author is – “Of course, you understand the price you pay is …”.

Let me do my own convincing and point out that – of course  customers are not concerned about your costs. They are not paying the price to defray your costs. Besides R&D, Manufacturing and Advertising costs are sunk and are not attributed on a per unit basis.

Customers pay for what they value and marketers charge for that value. If marketers figured out a way to deliver the value at  the lowest possible price it does not mean they have to pass on the savings as lower prices unless they are forced (by market forces) to do so.

Call this effective pricing and don’t call it as markup.

As a customer do I lament alongside Bits blog? I do. But as a product guy I admire their pricing.

For extra credit see my articles on

  1. Nexus 7 flash pricing
  2. Second degree price discrimination infographic
  3. Why Apple does not include earphones with iPad?

Pricing Beer in Ballparks

Think of the last time you were at a ballpark and paid for beer. You likely remember paying at least twice as much as what you pay in a restaurant and four times as much what you pay in retail stores.

Which ballpark in the country has the most expensive beer? According to the NPR story it is the Marlin’s ballpark.

According to an analysis by TheStreet.com, the most expensive beer of any baseball stadium is sold at the new Marlins Park, where baseball fans pay $8 for a Bud Light draft.

Why do baseball parks charge you a “small fortune” for a beer?

If you asked the Marlin’s officials, their company line is

“Well, when you look at it, the pricing reflects basically the total cost of the operations including our players,”

Well said. Don’t mistake this statement for pricing naiveté of Marlin’ pricing managers. They understand pricing at customer’s willingness to pay and not based on cost. They simply are using cost argument to justify the pricing. Seriously, no pricing manager worth his salt will believe for a moment the cost of ball players is included in the price of beer. So will the price go up when they sign an expensive player or go down when they fire one? (See here for an example)

The cost based argument is to justify the higher prices and nothing more (like we saw with Starbucks story).

If you read my Groupon book, there is a chapter on how different customers are willing to pay different prices for the same product. One of the example I used is the price of beer at ballparks. Some are willing to pay the set price to enjoy the beer and some aren’t. Ballparks, with so much data about their customers in their hands, can easily find the price at which their profit from beer is maximized. They don’t have to sell beer to most number of people, they only have to maximize their profit.

Take for example, one of the baseball fans interviewed for the story,

“I’m used to, like, $3 pitcher nights and, like, dollar beers and stuff. But I have no choice.”

Marinelli works a part-time job at a sporting goods store where an $8 beer is “an hour of work, on average,” he says. “It’s expensive, man!”

This fan may not buy all the time but does a few times. From the ballpark’s perspective people like Marinelli don’t have to buy beer on every visit, because there are lot more fans like him and there are lot others who are willing to pay every time. An additional thing going for the ballparks is there are no alternatives. You cannot bring beer from outside.

This is the reason why even at the peak of recession, beer prices at ballparks went up. See here for a detailed explanation of demand curve shifts.

Still not convinced how Marlins price beer? Here is a clear indication that they get pricing – Marlin’s EVP of operations says,

the Marlins could be charging a lot more — customers in Miami have been trained to expect expensive drinks. You go to a nightclub and the markup on a bottle of vodka might be 4,000 percent. In that sense, the 800 percent markup on Bud Light at Marlins Park could be much worse

They understand reference price of their customers (remember the famous willingness to pay for beer experiment by Richard Thaler). Customers have been trained to expect higher prices in such public venues and Marlins is merely building on it.

How do you price your products? And how do you communicate how you price your products to your customers?

How can I offer $140 shirt for only $39.50?

I received an Ad insert for Charles Tyrwhitt shirts with Saturday’s WSJ. Yes, as a matter of fact I still get the real paper newspaper, but we digress.

The Ad offered all kinds of dress shirts for a single price of $39.50 (normally $140 to $160). The Ad, speaking in the voice of the shirt company founder, then poses the question you see in the post title and answers it for us.

As expected the answer starts with cost, “because our buyers are great, we deal direct and no middlemen”

You can see at play some of the behavioral pricing tactics – price anchoring  with stated high price and signaling great value with marked down prices. Besides the  tactics the explanation does not answer the original question. In fact that is not the right question at all.

If the cost argument is accurate, then the question a customer should ask is,

How is it a shirt that likely costs less than $39.50 to make is normally priced at $140-$160?

As a regular reader of this blog and a fellow practitioner of value based pricing you may be tempted to answer this pricing question  with,

“because there exist a customer segment that is willing to pay that price for whatever job they are hiring the shirt for”

Unfortunately it is not the case with apparel pricing.  Pricing is not as sophisticated as you believe it is. It is steadfastly stuck in the land of cost based pricing with standard markups.

The data for this comes from an article in WSJ that analyzes pricing of $155 polo shirts. Almost the same, down to the sub-category level and price point.

The article does a marvelous job of marginal cost analysis. Most articles on cost analysis commit cost allocation error – allocating a share of all fixed costs to every unit made. This analysis gives us a true marginal cost of $29.57 for a polo shirt. We won’t be far off to assume that Tyrwhitt shirts have the same cost structure.

Then we see how they arrive at $155 price tag,

Using standard industry markups, the MacLanes set the wholesale price for the women’s polo at $65 and the retail price at $155. (Retailers in the U.S. mark up wholesale prices of ready-to-wear by roughly 2.2 to 2.5 times.)

Here are your answers for both the original wrong question and the right question.

How can a producer offer a $140 shirt for only $39.50?
Because it likely  costs them less than $39.50 to make one so they can still make  profit per unit and the $140 price is based on wholesale and retail markups.

How is it a shirt that likely costs less than $39.50 to make is normally priced at $140-$160?
Because of the antiquated way of setting wholesale and retail prices of apparels.

It is one thing to charge four  or forty times the marginal cost based on customer willingness to pay (Apple) but to charge four times the marginal cost based on standard markups  is …