Herfindahl-Hirschman Index or HHI, is a commonly used metric for measuring market concentration.
It is calculated by squaring the market share of each firm competing in the market and then summing the resulting [tweetmeme source=”pricingright”]numbers. For example, for a market consisting of four firms with shares of thirty, thirty, twenty and twenty percent, the HHI is 2600 (302 + 302 + 202 + 202 = 2600).
It serves as a quick reading to see whether the market has few big players or many small players based on their percentage market share. It is based on an observable and easily measurable metric – market share.
It may help the Justice Department, but is this relevant or actionable? Does it say anything about relative success of each player? The problem is reinforces the focus on market share and the almost monomaniacal drive to increase one’s market share.
What would be relevant is a measure of profit concentration of a market. Why isn’t there such a metric? That is because while it is simple and straightforward to compute market share, there isn’t a way to compute the profit share. One way would be to add up the profits of each market player, compute their respective share of the pool and compute an index like HHI. It says something about current pricing and operational efficiency but it says nothing about what is the potential total profit in the market.
What is needed is a way to measure the total possible profit in a market and how it is expected to change. Then a HHI like metric like show who is profit maximizing and who is not.
There isn’t a HHI like metric for market profits because, to repurpose Ford’s statement on costs,
“Profit is always a computed number. Anyone can compute what it is but no one can say what it ought to be”.
One of the income statement metrics that stock analysts obsessively focus on is operating margin expressed as a percentage. Stocks get punished when the operating margin drops or did not meet the goals. So businesses align their marketing and operations to focus on this improving operating margin. To an extent operating margin expressed as a percentage shows the profitability of the operations but the obsessive focus on percentage leads to two errors:
- Information loss – specifically the absolute profit earned. ( I am going to ignore here a more rigorous number, operating cash flow and treat earnings as all cash.) Given two stocks of identical companies in the same market, one with an operating margin of 10% and the other 12%, both with a stated 5 year goal of 4% improvement, can we tell which stock is a better prospect? What about their absolute income level and growth prospects?
- Causation Confusion – percentage margin is incorrectly treated as the driver of overall profit. Higher the operating margin, higher the profit. Margins do not drive your profits it is the other way.
Operating margin percentage is a computed number not an intrinsic metric that needs to be actively managed and definitely not a driver for your marketing decisions like pricing the products. Let us take the case of Mattel just because it was in the news recently.
Recently Mattel anounced blow out earnings, with 86% increase in profits with only a single digit increase in sales. This is extraordinary but there is a concern on what they are focusing on. The WSJ news story’s title reads “Earnings Up 86% As Margins, Barbie Sales Jump“. Margins did not drive the profits up. Profits went up because of price improvement on their Barbie line. In its earnings call Mattel CEO, Mr. Robert Eckert, made the following statement
“We will price our products consistent with our goals of long-term operating margin of 15% to 20%,”
Determining the price to sell based on the stated operating margin goals is cost based pricing. Pricing the products to meet a derived metric is like putting the cart before the horse. Price is not driven by a businesses need for meeting its operating margin targets set by stock analysts but by the customer’s willingness to pay. Based that price the business must either try to make the products at costs that are profitable (price driven costing) or choose not to compete in the market. I want to believe that Mr. Eckert meant here choosing only those products that can help Mattel meet its margin goals and not set prices regardless of the customers.
What drives shareholder value is absolute profits. Not percentages. As Ford said about costs, operating margin is always a computed number.
What drives products prices is value to customers and their willingness to pay, not stock analysts.
What sets prices and drives profitability is effective price management not meeting operating margins.
The Sunday edition of the print version of The Times is priced $6, 3 times the price of daily edition. But the Sunday edition comes packed with many extras. According to Ad it would take someone the whole day to finish it. The Sunday edition is actually a type of bundling that combined many different specialized offerings that are valued differently by different segments. Note that even weekday edition of newspaper pricing follows bundled pricing model (See for more on bundling).
But I saw a different case of weekend edition pricing for business newspapers in India (The Economic Times, Business Standard, The Financial Express). The weekend editions are actually much thinner and sparser than the weekday editions and priced almost twice the weekday editions. The regular newsstand that I bought the weekday edition did not even carry them. The news vendor said there aren’t many buyers for the weekend edition because it was priced so high. The vendor at the other newsstand I walked to said he carries fewer copies than the weekday edition.
So why is the weekend edition that carries fewer stories (and fewer Ads) priced higher and sold fewer copies? This is just another case of effective pricing.
Fewer people bought the weekend edition than the weekday edition. Due to fewer readers the advertisers weren’t willing to buy Ads for on the weekend edition and hence the newspapers are also losing Ad revenue. But those who bought the weekend edition valued the paper more and hence were willing to pay more. The price is simply set to sell just to these high value customers and maximize profit.
If we were to dig deeper the Ad prices would also be higher for the weekend edition, despite fewer copies sold because of the targeted reach.
That’s effective pricing.
[tweetmeme source=”pricingright”] Cost based pricing is tacking on a % margin to the cost of the unit instead of pricing your product/service based on the value it adds to your customers. Costs does not matter to your customers and nor should it matter to pricing your product. Costs matter only to the extent that it makes no economic sense to sell a product below its marginal cost. I am dismayed to see the extent to which people go to compute costs, allocating a share of every cost incurred to every unit sold.
Let me try to explain how ridiculous cost based pricing is by taking it to the extreme.
Suppose you ran a coffee shop that sold just one SKU (as I said I am taking this to the extreme to prove the point). As your customers buy their cup of coffee they see a row of jars in front of them. Each neatly labeled with
- a short definition of what it is for
- a dollar value
There is a jar for
- coffee beans
- bathroom cleaners
- depreciation on coffee machine
- salary for employee 1 &2
- childcare (for your child while you work)
Each jar is also marked with a respective dollar amount.
You ask your customers to drop exact amount marked on every one of those jars.
Every time the price of coffee beans, milk etc goes up you re-lable your jars.
What do you think your customers will do?
Ask your self what your customer is paying for? Did they walk into your store to get their daily caffeine fix, experience the great ambiance you provide or to help you offset your costs?
Do you practice effective price management?