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).

What effective pricing can do for your business

Take a look at this image courtesy of Planet Money

Revenue difference between MegaBloks and Lego

What you see are the annual revenue numbers for MegaBloks and Lego. Since Lego does not have (any more) exclusive rights to make the bricks, anyone can make them. And MegaBloks does. Its bricks are perfect replacement (as for as I know) for Lego bricks only cheaper.

How cheaper? 50% cheaper. Yet Lego makes 9 times more than what MegaBloks does in a year. Not only in revenue numbers Lego also beats MegaBloks on its margins as well

Gross Margin       70.5% Lego to  40% Mega (source below)

Operating Margin  30.1% Lego to 17.6% Mega.

A little bit of math will convince you Lego has no cost advantage. At 30% cost, even if it halved its price to match Mega’s prices, its margin will be 40%. In other words any (percentage) margin advantage Lego has comes purely from its pricing and not because of cost advantage.

What is going on here? In the words of Jeff Bezos, isn’t MegaBloks working hard to charge customers less and Lego working hard to charge more? Why aren’t customers overwhelmingly picking MegaBloks based purely on price?

If lower prices are designed to drive market share how come Mega has just 10% of market share despite being priced at 50% of Lego?

The Planet Money story says it is because of Lego’s attention to detail and because of their licensing deals for Starwars. But they miss the point. The answer, as in all pricing questions, begins with customers.

Think about the loyal customers who already have spent hundreds if not thousands building their Lego bricks collection and bought into the Lego brand and its messaging. Include the newbies who are getting inducted. Toss in those who are buying Lego as gift for someone else. Do you think any of these customers would make buying decisions based on price? What job do you think these customers are buying Lego for? I bet it is just not as a building blocks toy.

If such customers perceive value at its current prices and are willing to pay such prices there is no reason whatsoever for Lego to give its product away at lower prices. Pricing low because of cost, competition or in the hope of gaining market share is simply not effective pricing.

Lego’s effective pricing driven by customer segments helps it achieve 70% gross margin and 90% of the market.

Finally I should not dismiss MegaBloks or call its pricing bad. MegaBloks likely knows its target customers as well -a tiny fraction that is price sensitive but isn’t likely to grow. They likely found the optimal segment size and the price these customers are willing to pay that will help Mega deliver 17.6% operating margin (nothing to be sneezed at).

But if it really wants to put big numbers on the board it needs to get its own customers who are will hire it for its compelling value proposition and not because it is a cheaper substitute.