I am doing an about turn on a statement I made 18 months ago on iPad price elasticity. Then I presented this graphic below and stated the existence of linear demand curve,
Looking at the unit volumes and average selling price (ASP) over three most recent quarters it appeared iPad sales were price elastic. That is, volume changed with price changes.
This time I expanded the time frame and included data from the first month iPad was launched to latest quarter. Over this nearly six year period here is how the chart for Units vs. ASP looks like,
We can step back and squint all we want, this does not say much. So I ran linear regression analysis on this data, trying to test the hypothesis if changes in volume can be explained by changes in price. It turns out there is absolutely no correlation between unit volume and price.
The linear model Units = Constant + Coefficient X Price, has an R-square of 0.0017, that is absolutely no predictability. Changes in unit volume is independent of price.
Here is how the scatter plot looks like, almost horizontal curve with points scattered above and below the line.
Which means demand for iPad is driven by completely different factors – use cases, product fit, features, customer preferences etc. So if Apple wants to spur value growth it has to pull different levers than price. That is why you are seeing newer product innovations like the iPad Pro.
On the other extreme of price spectrum is Amazon’s $50 Kindle tablet. If iPad is not price elastic can we say anything about volume for $50 Kindle. Unfortunately we cannot extend the model to a different product category at such a low price point. It is highly likely a price point like that can drive impulse purchases that can drive up volume significantly.
Finally on changing my stand on price elasticity of iPad,
When new data come in I change my mind. What do you do?
Two years back we saw the story of Starbucks price increase. Despite widespread criticism in the news media we saw no real ill effect on its sales or brand. You know why from here (elasticity) and here (demand curve shifts). Now they are rolling out price increases to the rest of the country. I want to point out some key points noted in the price increase story that serve to tell us how well they are executing this change.
Starbucks Corp (SBUX.O) raised prices by an average of about 1 percent in the U.S. Northeast and Sunbelt on Tuesday, making coffee-drinkers spend more in New York, Boston, Washington, Atlanta, Dallas, Albuquerque and other cities.
Average price increase is meaningless. They want us to focus on the small number. Most likely some prices went up much higher then 1%. You won’t find that until you read the story. Most likely they also calculated the average over all their products, even those that did not see price increase, simply to bring down the average.
Starbucks expects high costs for things like coffee, milk and fuel to cut into profits this year. Like other restaurant operators ranging from Chipotle Mexican Grill (CMG.N) to McDonald’s Corp (MCD.N), it is raising prices to help offset some of that cost pressure.
They are giving reason for the price increase. As William Poundstone, author of Priceless wrote in a guest post for this blog, customers are more likely to find the price increase acceptable if associated with a fair reason. Starbucks is going a step further in using examples, “hey others already did it and we are following them”. You should give them credit for both points and extra credit for giving future cost increase as the reason.
the price for 12-ounce “tall” brewed coffees and latte drinks went up 10 cents. Prices on about half a dozen other beverages also were set to increase
This further attests to first point, not all prices are going up. Most likely they are increasing prices of their most popular drinks, those whose demand is relatively inelastic or those with lower contribution margin such that they are okay with lost sales from price increases. For the last point see my past post on how lower contribution margin means okay to lose sales from price increases.
Starbucks’ Olson said the price for a 16-ounce “grande” brewed coffee, the company’s most popular beverage, remained the same across the United States and has not changed since January 2011. The price for grande lattes was unchanged in most markets, he added.
To state the obvious, Starbucks has three sizes, tall, grande and venti. They are increasing prices on their tall while leaving the grande untouched. This is classic case of second degree price discrimination. After the price increase on tall, some customers may find they get more value with grande (higher consumer surplus) than they get from higher priced tall and will instead choose grande. Since the marginal cost of additional coffee in grande is almost negligible this is still an upside for Starbucks. They are able to capture higher consumer surplus without alienating their customers. Because they have done their versioning right.
Lastly this one is the most measured statement of all (I bold texted the key phrases)
The Seattle-based chain said its pricing decisions are based on multiple factors, not just the price of coffee, which has eased lately.
Those considerations include “competitive dynamics” in individual markets as well as costs related to distribution, store operations and commodities, including fuel and ingredients for food and beverages, Olson said.
As you read this multiple times you will find all kinds of reasons except, “We cater to a somewhat higher-income customer and we price our products based on customer willingness to pay. Besides we don’t expect any push back from these high income segment”.
A key attribute of those practicing value based pricing is never explicitly saying that they are practicing value based pricing. There are always other reasons and you never say pricing at customer willingness to pay. A key part of practicing effective pricing is effective pricing communication and managing customer perception. Failing that you will face backlash as some brands recently did.
Overall, great pricing strategy, execution and communication by Starbucks.
Ann Taylor reported their Q3-2009 went up despite drop in sales. Their gross margin went up by $7.7 million while their sales fell by $64.8 compared to same Q3-2008. Kay Krill, President and Chief Executive Officer, commented,
Our results for the quarter were a direct result of our strategy to maximize gross margin performance by tightly managing inventories, focusing on full-price selling and controlling costs. I am pleased that our performance also reflects the cumulative benefits of our ongoing restructuring program initiatives.
I have been writing all along about the need to cut promotions, focus on protecting pricing and practice effective price management to deliver profit growth. But I am not fully convinced that price increase contributed to Ann Taylor’s profit growth. In fact they may have lost more than they gained from price realization and any profit growth was a result of their cost cutting. I will focus on the gross margin number when I say profit in this discussion.
Ann Taylor cut down on promotions and focused on charging full-price with the net result of increase in average prices. Another measure is inventory control. Total inventory per square foot at the end of the third quarter of 2009 was down 20.7% versus year-ago. If we assume (see note below) that this reduction can be equated with drop in volume of the same level, from the revenue change and volume change assumption we can compute that the average price increased by 10.6% (See end of this post). In other words 1% increase in price resulted in 2% drop in volume (price elasticity 2).
Their percentage gross margin was 48.8% the previous year.
Loss of profit from drop in volume (due to increase in prices) = 20.7%*48.8% = 10.1% of Q3-2008 revenue
Increase in profit from 10.6% price increase = (100%-20.7%)*10.6% = 8.4% of Q3-2008 revenue
This is a net loss due to drop in volume. Since their profit in Q3 2009 increased YoY, the profit increase is entirely due to cost control and other effectiveness measures in merchandising.
So did Ann Taylor make the right decision to improve prices? Could they have delivered higher profit by keeping their promotions and price levels? Unless there is a strategic reason to preserve brand premium and long term profit, this price increase was not a profit maximization move.
Footnotes:
On the volume drop assumption, this could be wrong because sales volume is a flow metric while inventory was a point metric. But this is inventory per square foot of store, so it is a good stand in for volume. Another possibility is that a portion of the 20% reduction is to respond to volume that is already lost due to recession (demand curve shift). If the price elasticity drops to 1 or low, then yes the price increase makes perfect sense.
Calculating price increase :
R = P * Q; (P2/P1) = (R2/R1)*(Q1/Q2) (R2=$527, R1=$462, Q2 = (100%-20.7%)*Q1)
Previously I have written about pricing for recessionary times and how CPGs and other businesses are realizing increase in profits despite drop in revenues. As more and more price sensitive customers switched to private labels and other low cost options, premium brands responded by raising prices. The claim is this price increase delivers higher profit than a price cut to gain back customers because once the price sensitive customers moved out those that continue to prefer the brand are less price sensitive. The claim is just that if it is not formally proved. With the recent changes in bottled water prices I made an attempt at proof. But it was one example based on one data point and is not really a proof. Here is another attempt.
Let us take the Starbucks as example. I recently made the same claim on price sensitivity of Starbucks customers. Let us assume there are only two types of Starbucks customers one is price sensitive and the other is relatively less price sensitive. Each with linear demand curve:
q1 = a – b * p (demand curve for price sensitive customers)
q2 = c – d * p (demand curve for brand conscious customers)
Mathematically it is easy to show that the latter curve is steeper than the previous. Each demand curve yields a different profit maximizing price p*, the second curve’s is higher than that of the first (again proof exists in textbooks). Any price higher or lower than p* will yield lower profit (hence the name profit maximizing price). Let us call the p* for demand curves 1 and 2 as p1 and p2.
If Starbucks can find out who is who and can separate them then they can charge different prices. This is called Third degree price discrimination. But when a customer walks into one of their stores Starbucks has no way of finding whether she is of type 1 or 2. They are also attracted by the higher volume by combining the customer segments so to them the combined demand curve will be
q = q1 + q2 = (a+c) -(b+d)p
This has its own profit maximizing price which is between the profit maximizing prices of the two demand curves. Let us call this p3. For this demand curve any price different from p3 will yield lower profit than p3.
In other words, p1<p3<p2
With the down economy the price sensitive customers simply stopped coming to Starbucks, thereby revealing who the brand conscious customers are. In other words, the demand curve became
q = c – d*p
If Starbucks continued to price at the previous profit maximizing price of p3 (which is lower than p2), its profit will be ower than what would it have been if it were to price at p2 (the profit maximizing price for the demand curve).
This proof can be extended to account for many different demand curves and non-linear demand curves.
Hence it makes sense for Starbucks to increase its price when the demand curve shifts.
All last year, the common theme among the CPG companies was higher profit despite decreasing sales because they had better price realization. CPGs delivered higher profits by increasing prices, reducing promotions and with creative packaging. But that trend is coming to an end for at least one of the companies – P&G. In the recent investor conference call they announced plan to cut prices, add promotions – all in efforts to regain market share. P&G was losing sales for the past two quarters and they are now determined to turn this around, especially in the fabric care sector. As some of its customers turned to cheaper store brands, P&G tried to hold on to them with multi-version pricing. They not only introduced Tide Basic to appeal to price sensitive customers but also introduced high margin super-premium Tide Total Care to keep the customers within the brand family.
The tide has turned now, as they so no cheer in continuing drop in market share, especially in fabric care segment. P&G announced a 13% price cut on its Cheer brand detergent. Is that a move that will help with market share? Probably. But in the key and the only relevant metric of profit they may be giving away too much with a 13% price cut.
P&G’s 10-K states their average gross margin is 50%. With a 13% price cut their margins will drop and the sales have to increase 36% to make up for the lost margin. That is an extremely tall order in the highly competitive and saturated fabric care market. As a comparison, their historical sales growth was in the region of 3% to 8% per year.
Unless they are looking at the total customer margin and not just gross margin on one product. Customer margin is the total margin from many different P&G brands a customer buys. This will reduce the required increase in sales but not near the 8% number (you can do the math on required customer margin for that). There is one more risk with lowering prices, lowering customer reference price and thereby reducing chances of future price increases.
The net is P&G, the inventor of marketing research and customer driven product strategy, is going to trade profits for market share. I will be watching next quarter sales numbers with great interest.
I saw a commercial for PUR water purifier that makes a value proposition on savings from bottled water. There was another commercial by Wal Mart that showed people buying their private label bottled water and taking it with their brown bag lunch. There is yet another commercial by Brita that takes a green approach by showcasing the ill effects of plastic bottles. The net is bottled water sales are down due to a variety of reasons.
How should the marketers handle the shift in consumer preference?
Should they drive down prices to keep their customers from switching to tap water?
How much will the sales volume increase with price change? i.e., what is the price elasticity of demand?
Is raising prices an option?
It is almost out of luck there is data on all these (from WSJ) that one can find without searching too hard. It is as if do all of us a favor, one of the biggest brands, Coke, did not change its prices and another biggest brand, Pepsi, lowered its prices. For all practical purposes we can treat that there is no differentiation between these brand for bottled water and they represent the overall market.
Coke, kept its prices stead and saw its sales drop by 26%. Note that this is sales in dollars not units, but at constant prices we can assume that this represents volume drop. I am no Greg Mankiw or Andy Rose, but to me this drop in demand at constant prices seems like a shift in the demand curve. So let us treat this as the shift in the demand curve due to income effect (people switching to tap water or store brands as part of their cost cutting). See Figure 1 and 2 for the shift in demand curve.
Figure-1 Demand Curve Figure-2 Demand Curve Shift
Figure-1 were the demand curve before recession, Figure-2 shows the shift. It is an approximation and not an accurate drawing.
Next, Pepsi cut its prices by 5%, and its sales (dollars) fell only by 13.8%. This is shown in Figure-3. But that is based on the previous demand curve. Since we assumed the demand shifted down, the 13.8% drop is actually 12.2% (26% – 13.8% = 12.2%) increase in volume. That is the price elasticity of demand on the new curve at the same price point before the price cut is 12.2/5 = 2.44.
Figure-3 Price drop results in sales increase (along shifted demand curve)
Not all of this 12.2% sales increase translate into profit. Pepsi and Coke do not break out their earnings to show revenues and profit from bottled water. Luckily, Nestle does. If use their numbers EBDITA numbers, the margin as a percentage of sales is 7.3%. This seems on the lower side. In 2003, MorganStanley reported that the margin is around 20% for US bottlers. So we can take the margin to be in-between these two estimates, say 15%. So Pepsi earned a gross profit of 12.2%*15% = 1.83% of the total sales.
Not a bad move, better than Coke which did not change its prices. But could they have done better? What if they had raised priced by 5%? That is a 5% of sales added to profit. But their sales volume would fall. If we take the price elasticity of demand to be the same (2.44) in the other direction, then their volume would have fallen 12.2% with a profit loss of 12.2% * 15% = 1.83%. This translates to a incremental gross profit of 2.6% from price increase despite a 12.2% drop in sales. If Coke or Pepsi were to reduce capacity and operational expenses to account for this 38.2% (26%+12.2%) drop in volume, the cost savings will add to the gross profit from price increase for a higher operational profit.
This leads us to conclude, that price increase at lower volume would have delivered higher profits than sales increase from lower prices. But recommending price increase when the sales just fell 26% is going against the “conventional wisdom” – one needs data, conviction to act on it and limitless courage to go against “conventional wisdom”.
Iterative Path 
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