Chasing Loyalty at All Cost

[tweetmeme source=”pricingright”] When customers are not willing to buy branded products at premium prices, should the marketers  go after those customers with price cuts, discounts and promotions? Heinz, facing drop in sales and change in customer buying behavior, said it is doing exactly that:

Heinz warned analysts that it will likely have to lean heavily on promotions, discounts and advertising to stop the defection of consumers to cheaper, private-label brands. “This is a tough environment, there’s no doubt about it,” said Art Winkleblack, Heinz’s chief financial officer.

It is a surprise that Heinz that  reported increase in profits for the past four quarters is reverting to the conventional wisdom of maintaining loyalty. The expectation for any marketer holding on to customers through enticements is that:

  1. These will stay loyal when the price eventually improves . But, data shows that buying loyalty leads to profit destruction in the long run.
  2. Loyal customers are less price sensitive, based on a study which is a contradiction since marketers first have to buy loyalty with price cuts. There is no proof in the data that loyalty leads to price insensitivity.

In their 2002 book, Trading-Up, authors Silverstein and Fiske, talk about a behavioral shift in consumers – seeking New Luxury and willing to treat themselves to premium priced products. These are the customers who bought emotionally and justified rationally. Marketers chased these new breed of customers with price points that were high but attractive enough to this Trading-Up segment. (Note: If not for this segment, the prices would have been even higher. )When marketers got used to the volume and market share, they built capacity and made projections based on continued growth in the Trading-Up segment. But all that changed when the economy took a turn for the worse.

In the early days of the Great Recession, The Times profiled how customer’s buying behaviors started to change – from buying premium priced name brand food items to cheaper store brand items. A woman profiled in the story said she convinced her brand conscious husband he was getting A1 steak sauce by refilling empty A1 sauce bottles with store brand sauce.

Recession came as a shock, people losing jobs, seeing their friends and families lose their jobs and a fear for their own caused some to cut back on what used to be essentials. Economists call this the income effect. What the recession started was not just a blip but a behavior change that led  many customers to permanently trade down to cheaper private labels. Arguably these are the “Trading-Up” customers who sought New Luxury.

Instead of trying to hold on to these price sensitive customers  and buying their loyalty at all costs, marketers  must treat this as an opportunity to identify their truly brand loyal and price insensitive customers. When the price sensitive customers all take one step back, those who are left in the front row must be the brand loyal ones. Which means instead of discounting or dropping prices, marketers can actually  increase prices (See Starbucks case study).

What is your cost of loyalty?

Behind Crest White Strips Multi-Version Strategy

P&G practically created the teeth whitening white Strips category. Introduced under the powerful Crest brand it helped create new revenue stream  after all  it is not easy to grow 10% YoY when each brand bring in $1 billion revenue. The part that interests and impresses me the most is their multi-version pricing for the White Strips category. While I expressed concern about P&G’s other brand Downy’s horizontal product line extensions, Crest White Strips serve as an example of effective pricing  strategy, tactics and execution.

Take a look at the Crest White Strips page from P&G and here are some insights on their versioning strategy:

Side bar – Value Tag: For brand managers from Colgate-Palmolive and Unilever this article is worth $9999 to you.

  1. If one price is good two are better and four are even better if designed and positioned correctly. Crest offers four different versions of the product, offering increasing benefits from low to high end version.  This is vertical product line extension.
  2. Versions are designed in such a way that customers self-select  themselves to the right one (Second degree price discrimination).
  3. The lowest priced version is the Classic at $24.99 and the super premium version ($44.99) is the Crest Advanced Seal, introduced in early 2009.  That is a $20 price differential between the lowest and highest product creating great profit opportunity from up-selling.
  4. The price jump is non linear and reflects customer’s diminishing utility. From Classic to Premium it is a $10 jump indicating customers assign most value in this upgrade. Between other versions it is $5 jump indicating customer utility flattens out or grows slowly as they move up the versions.
  5. Note that the listings are benefits and not product features. Customers care about benefits  and not about the features – compare this to many of the technology offerings that simply list feature differences across versions.
  6. Look at  the images showing the packages. These are designed to visibly show that not only are these versions different but also  help “tangibilize the intangible” (Ted Levitt).
  7. In behavioral economics, the effect of  presence of high priced versions has been extensively studied. The netof those findings is that while these may not sell much, the  presence of high priced versions help improve customer willingness to pay for the other versions. But that is not the case with Crest Advanced Seal. I make this claim based on the number of reviews and rating for this product.
    Versions Reviews Rating (on a scale of 5)
    Classic 58 4
    Premium 34 3.75
    Pro Effects 17 3.5
    Advanced Seal 77 4

    If we use the number of reviews as a stand-in for the market share, Advanced Seal, despite being the super premium version, is their most popular seller. The ratings also indicate that customers are happier with their super premium version. At $20 price premium and arguably not much cost difference this is a big contribution to their profits.

  8. Their Pro Effects, scored the least both in terms of number of reviews and rating. Until P&G introduced Advanced Seal an year ago, this was their most expensive version. We can hypothesize that it served then as the expensive decoy but did not add as much value to the customers and hence did not get market share. Going forward we should expect to see P&G allocating fewer marketing resources to this version and keeping its price levels.
  9. All their prices end in 99, as seen again in behavioral pricing literature this is a good tactic. It is easy for everyone to have prices end with 99 but it takes marketing strategy and a clear understanding of customers to maximize profits.

Overall Crest White Strips serve as a great example of marketing strategy, versioning and pricing for profit maximization done right!

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.

Profitability of Product Proliferation – The Case of Downy Simple Pleasures

Update 3/26/2013: P&G recently discontinued Downy Simple Pleasures and relaunched it as Infusions

Recently P&G has been promoting a new line of Downy fabric softener called Simple Pleasures. This is a premium product compared to their regular Downy line and it offers at least five different scent choices. On top of that Downy brand is running a contest to generate more scents.

How many Downy scents does the market need or can support?

downy_simple_pleasures Brands have been competing for the shelf space and wallet share of customers by expanding their product line both vertically and horizontally. The reasoning is finding every niche and filling it with a version at a price customers are willing to pay. That is the reason a typical supermarket stocks 30,000 to 40,000 SKUs. That is the reason you see raspberry, strawberry, key lime pie, vanilla and all sorts of yogurts. While conventional wisdom may say to the brand managers to keep expanding, data show otherwise:

  1. Customers do not value different variations  (colors, scent, flavors)within the same product line differently
  2. Retailers cannot set the prices differently for strawberry flavored vs. raspberry flavored yogurts
  3. Increasing products horizontally (color, scent, flavors) do not result in increase in market share or profits

In an NPR story on Walmart earnings report, they interviewed a few customers shopping at a Walmart. One of them said,

Ms. HAVENER: Do we really need to carry 19 different tackle boxes, or do we need to carry six different tackle boxes? And were so really looking at clarity of offering.

This is one data point, but the broader story line is Walmart has been systematically reducing SKUs, decluttering shelves and pushing back on manufacturers on number of SKUs they want to stock. Walmart is the leader in retail market share and it is by no means alone in pruning shelves. Retailers like Walgreens and those in UK are doing exactly the same.  Retailers, especially Walmart, are known for religiously tracking revenue per square feet (it is actually per cubic feet) of retail space. All the retails space and shelf space may be sunk cost, but there is an opportunity cost associated with every SKU they decide to stock. Retailers are finding that customers value fewer options more than proliferation and the reduced inventory helps with profits when sales are down. So why are we seeing increase not decrease in SKUs from brands?

When P&G’s customers were trading down to private labels, P&G responded by vertical extension of its product lines like Tide Basic and Tide Ultra. As a multi price point   strategy to keep customers within the brand family that is the right approach. But I am not convinced with their horizontal line extension.

When a brand is already $1 billion in annual revenue (P&G has at least dozen of them) is product proliferation the only way to find growth? Given the  pressure from channels and the data showing otherwise why is P&G flooding the market with a product that differs only in the scent but otherwise has no functional utility to the customer?

P&G is arguably the best in class data driven and customer driven marketer, not just in CPG space but across the entire brand space. May be Google edges them out but that is another story. What are they seeing that the academic researchers and retailers are not?

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.

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.