Passing on Obama Care Costs to Pizza Lovers

CEO of Papa John’s pizza chain, Mr. John Schnatter, has raised his concerns about the impact of Obama Care on his business. He has consistently stated that to comply with the policies of President Obama’s health care reform he will have to pass on the added costs to his customers. To be precise he has said he will have to increase prices by 10-14 cents per pie.

Recently I tweeted this about his position on passing on costs to customers,

Which led to two very valid questions from two different inquisitive readers about what read like a generalization about pricing, costs and margins.

Let me address Carrie’s comments – she is absolutely correct. If you had right pricing (profit maximizing based on the demand curve and your marginal costs) and if a new cost is introduced due to an externality (like regulation) your business may become unprofitable at current prices. And yes that does not mean your original pricing is wrong.

The question then is whether or not the business can pass on those costs as price increases to customers which is raised by both Carrie Mantha and Ron Shevlin.

I want to address this in three parts

  1. Raising Prices and Elasticity
  2. Marginal Vs. Fixed Cost
  3. Pricing for Value

Raising Prices and Elasticity:

If a business can carry out 10 to 14 cents price increase without impact in their sales volume, then they better do it now. In this case it is clear that their original pricing is wrong because they are not profit maximizing by leaving too much consumer surplus. To see this in perspective I point you to my previous analysis of IKEA stores asking customers to leave empty shopping carts in their allocated bays to keep prices low,

if they can indeed raise prices because we are not stowing shopping carts properly without affecting sales/profit they would have already done that – shopping cart or not.

On the other hand if we give that they indeed have set the price optimally then any price increase will result in  drop in volume (elasticity). As long as the increase in gross margin from this price increase is more than the loss from lost sales and the health care cost then they should do this price increase.

N2 times 14 cents >  (N2-N1) times current gross margin + $5- $7 million Obamacare cost

What they are doing here is not passing on costs but merely raising prices so let customers self-select themselves to whether or not buy the pizza at current prices. This is not passing on costs because customers have the choice of not buying.

Marginal Vs. Fixed Cost:

Is the health care cost fixed cost (cost of running the business regardless of sales volume) or marginal cost (cost incurrent per unit)? The cost varies per employee but that does not make it a variable cost. If you try to allocate fixed cost to every unit sold (based on your current sales volume) you are setting yourself for death spiral.

First you compute  12 cent (average) cost increase per pizza. But as stated before your volume drops so you have to recompute the cost per pizza which likely comes to 15 cents which leads to even more volume loss and so on and so forth.

In other words it does not make sense to allocate share of fixed costs on a per unit basis and hence wrong to say they will have no option but to pass on the cost increase to customers.

Pricing for Value:

Finally, price of a product is not s sum of its cost components with manufacturer margin tacked on. Price is the manufacturer’s fair share of the value they create for their customers. For instance consider this extreme scenario of pizza pricing. You walk into Papa John’s and you see several different jars on the counter. They are all labeled with a dollar value marked next to each

  1. Yeast
  2. Water
  3. Flour
  4. Cheese
  5. Pepperoni
  6. Sausage
  7. Onion
  8. Obama Care
  9. Profit

After buying your pizza you are asked to drop appropriate money in each jar as marked. How is that for your pizza experience? Are you buying pizza to offset the cost of Papa John’s?

Your costs are just that, your costs. They have nothing to do with your customer who buy your product for the value they deliver. Stated another way, your customers hire your products to get a job done, be it satisfying hunger or satisfying their emotional need. As long as your product can do the job better than alternatives at the price customers are willing to pay they will keep hiring it. See what Henry Ford said about prices and costs.

we first reduce the price to a point where we believe more sales will result. Then we go ahead and try to make the price

So if you are talking about passing on your costs to your customers your pricing is wrong.

All that said, in fact Papa John’s may be using the Obama Care as a valid reason to pass on price increases. See here and here for discussions on using cost argument for price increases.

Do not use pricing to address operational problems

You see long lines at ski lifts or at amusement parks. One common conclusion most go for is, “Demand exceeds supply, let us increase prices until the lines go away”.  Quite possible, if you have done the due diligence and eliminated operational inefficiencies as the reason for your lines.

Pricing is a marketing lever. While it will help a firm address marketing issues related to managing demand

and capturing consumer surpluses, it will not help with solving operational issues.

In his book Blunder, Zachary Shore talks about cognitive traps that could lead a firm to commit blunders. The two key ones I want to quote here are “Causefusion” – confusing the causes of complex events and  “Cure-allism – thinking that one-size solutions can solve all problems”.

It is true that any congestion can be addressed by increasing prices until congestion goes away. There is a very good discussion of congestion pricing in the Freakonomics blog. But before applying a pricing solution the firm must exhaust all other reasons. For example, the long lines at ski lifts could be due to slippery loading and landing zones,  too many single skiers choosing to sit alone,  mixing kids and novices in the lift line for others etc.  These are all operational issues and require operational solutions. Changing the pricing  will not address the root cause.

If you are going to increase prices then you should understand the elasticity and customer segments and do the numbers on how much your profits will change. If you have not done that for setting your original price, it is likely you will not do that for this price increase and hence mostly likely will end up with sub-optimal profits.

Sometimes just a simple operational change is better than a pricing strategy overhaul.