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these become the new reference price and can remain sticky even when the original cause (production cost increase) is no longer valid.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.