Pricing Strategy and Stock Prospects

Procter and Gamble   and Kraft, the two Consumer Packaged Goods (CPG) leaders, reported identical revenues and earnings growth in their last quarter. Analysts interviewed by Barrons magazine prefer  Kraft over P&G for one major reason: Kraft’s pricing strategy that is focused on reducing discounting and solidifying pricing power in the face of competition from low priced private label.

Kraft Chief Executive Officer Irene Rosenfeld seemed confident that the days of branded foods being nibbled to death by cheaper private-label goods have come to an end. Rosenfeld says the company has expanded operating margins and plans to continue increasing its “pricing power.”

What about P&G pricing? According to Jason Gere of RBC Capital Markets, discounting and price cuts are not guaranteed to drive volume.

Although the company will likely spend heartily on price cuts, advertising and brand-building in the coming year, it’s unclear whether the strategy will work, says Gere, who rates the company at Market Perform.

Does P&G practice effective price management? Mostly it does, but analyst comments raises questions on some of the components.

  1. Value add to segments: Does P&G has multiple brands that appeal to different segments and keep the customers within their brand family as they trade down?  I believe so. Mr.Lafley, Ex-CEO of P&G, made it clear that P&G will expand product portfolio to cater to changing consumer behavior.
  2. Incremental analysis: What is the incremental profit from price cuts and increased advertising spend? Jason Gere’s comments above seem to indicate there is uncertainty on this aspect.
  3. Customer Margin: Can P&G capture a larger share of customer spend? The decline in organic sals growth indicates challenges in capturing larger share of customer spend at the stores.

Ultimately it comes down to effective price management to drive profit growth and stock prospects.

Lowering Prices To Generate Sales?

Here is another CEO who clearly believes lowering prices does not automatically guarantee  sales increase: Macy’s Terry J. Lundgren.  In his inteview with The Wall Street Journal, Mr. Lundgren  said,

WSJ: Do you think about lowering your average selling price or changing your product blend, as some of your competitors have done?

Mr. Lundgren: Here’s the challenge. We have [a men’s pants brand], and they typically go out the door between $29.50 and $32.50, with all the coupons and everything.

What Mr.Lundgren refers to as “out the door price” is the “pocket price“, the net price after all discounts. The net effect of the discounts and coupons is price leakage that erodes profit, clearly Mr. Lundgren is driving Macy’s to focus on its price waterfall.

Mr.Lundgren’s management serve as the best case study so for on the three components of effective price management:

Knowing the value add to segments:

Our purchasers are women. She’s spending the same amounts but just shopping with a great deal of discretion. Value is the word, even if it’s at regular price. The intrinsic value of what she’s buying is very important.

Incremental analysis: How much should sales rise to compensate for loss in profit from price cuts? (Lundgren is on the direction but he is comparing top-line while he should be doing incremental math on lost profit. There is also numbers error as pointed out by the commenter.)

So we were getting tremendous sell-through at low price points and no margins. And I am not making my pants sales for last year, because my average sale dropped by 30%. It’s really hard to make the math work. I have to have 30% more transactions on this product to break even.

Customer Margin: Understanding that loss leaders are effective only if they help generate incremental profit from customers who are attracted to the stores by low prices of loss leaders.

We and the manufacturer together agreed to mark them (pants) down to $21.99 or something like that. Selling like hotcakes. Every other pants around them stopped selling.

Does your business practice effective price management?

Ryan Air Going For No Checkin Bags

Ryan Air arguably the first to practice airline unbundled pricing used to charge a per bag checkin fee. In the next round of unbundling they decided to completely remove checked bags. It is understandable if a business decides to reduce service instead of practicing unbundled pricing to better manage customer perceptions. Ryan Air was already charging separately for the bags and its customers were already trained to pay for bags. So why drop a revenue generating service?

This is a great case study of one of the three components of Effective Price Management – Incremental Analysis. It is conceivable that the true marginal cost (without fixed cost allocation) is $0 per bag, so an fee they charge is pure profit. But they are looking at the total cost to offer the baggage service, and whether or not the service as a whole generates profit. Since they were charging separately for bags it is conceivable that people were trained to carry less to reduce or avoid what they pay for bags. With fewer people using the service the revenue generated is most probably not be enough to support the fixed costs associated with the service.

That explains the service reduction. This move could actually be generating more profits from cost savings.

Do you practice Effective Price Management?

What is Price Realization?

[tweetmeme source=”pricingright”]

JCPenney Pricing Waterfall
JCPenney Pricing Waterfall

It is time to give some definitions of pricing terminologies, specifically definitions of Price Realization, Price Leakage, Pocket Price and Pricing water fall.  I will explain these concepts in the B2C context (a retailer), for a B2B explanation see this. Seen above is a picture that shows the pricing for a queen mattress at a JCPenney store. The prices and discounts are taken from a store visit. (Note that I did not consider interest income earned from credit card balance.)

List Price: Price is the method to capture value added by a product. The most common way to indicate prices to customer is the list price, be it price tags in retail or invoice price in B2B transactions.

Price Leakage: Unfortunately, both in B2B and B2C scenarios, a business is unable to get the customer to pay the list price. Due to sales pressures, competitive offerings and other macro-economic factors, the prices are marked down. Different discounts applied to the list price are referred to as Price Leakage. In the figure above, price leakages are show in color red. Last week JCPenney was running a 50% off sale with an additional 15% customer appreciation coupon. On top of these if a customer were to open a store credit card they gave an additional 10% off. JCPenney is also running a frequent shopper program called JCPRewards that gives back $10 for every $250 spent.

Pocket Price: The pocket price, the price finally collected after all applicable discounts, is significantly less than the list price. This is still not profit, because it does not include sales commission (if any) and marginal cost of the item sold.

Pricing Waterfall: The picture says it all.

Price Realization: Price realization is about decreasing price leakage, increasing pocket price  and hence keeping a higher proportion of the list price that flows directly to the bottom line (profit).   Price realization can be in the form of  higher list price, fewer discounts, additional charges or decrease in service offered (see Cadbury’s methods on this).

Effective price management is about moving away from price leakage to increasing the pocket price through price realization.

But is JCPenney leaving money on the table or is there more to this than it meets the eye?

Before you cut prices

In 3 components of effective price management I talked about the need for doing an incremental analysis before making changes to pricing. For instance:

  1. What is the sales change expected for a given price cut?
  2. What is the minimum  increase in sales required to keep profit at levels before the price cut?

In other words  what is the price elasticity of demand for your product and does it justify the price cut?

Here is a real business example of such an analysis for the proposed $10 price cut by at&t for its iPhone subscribers.

3 Components of Effective Price Management

[tweetmeme source=”pricingright”]As the economy continues to remain slow and businesses struggle to keep afloat many may be tempted to focus on volume and market share  and dedicate all their resources to keep these numbers high at the expense of profit. Unless the business is in the  early stage of its life cycle or relies on network effects the focus should be on profit.

We learn a valuable lesson from  CPG companies that are relentlessly focused on profits at the expense of market share as they face cost conscious customers and renewed threat from private labels. Despite the recession, most CPG companies  reported 10-14% profit growth. What these companies are practicing is Effective Price Management. Their methods apply not only to B2C but also to B2B companies.

I see three components that support effective price management. This article is somewhat inspired by Peter Drucker’s Five Deadly Business Sins and influenced by a recent article on pricing titled Eight Deadly Sins by James Mason in ICIS. I am very reluctant to use adjectives like ‘deadly’ or moralistic language like ‘sin’. So  I decided to focus this article on what businesses need to change to practice effective price management.

See a deck version of this here.

Understand and quantify the value added to  different customer segments: Costs do not matter, both for pricing and to the customers. Customers are driven by the value added by the product and this value-add differs for each segment. Businesses need to realize that their product lines, despite being homogeneous, add different value to different customers. They not only need to understand but also quantify  customer value for different segments. Quantifying the value helps capture some of the value created – typically a business can capture only 10-20% of value created because of reference price and alternatives available to customers.

Every change needs an incremental analysis: Be it changes to pricing, adding capacity, changes to marketing budget or to sales team – do the analysis to find what it would do the current profit? How much incremental new sales is needed to just get back to current profit levels? (this is called incremental break even). Sales team is more than likely to push for price reductions but by how much will the sales go up, what is the price elasticity of the product?  The operations team may push for adding capacity, the usual mistake is to treat this new investment as part of the rest of the cost structure, but you should exercise care in finding the true incremental profit from additional units sold from this newly added capacity.

Focus on the total margin per customer: A business should not just look at margins per product line – it needs to look at what is the total revenue including complementary sales and the total cost per customer. A product line may not by itself drive profits but can generate complementary sales that can all add up. The other factor in the profit equation is cost, the cost of serving the customers is not all the same – the costs cannot be clumped together as an average. Knowing the cost to serve a customer will help the business decide the level of service to provide and determine whether or not that customer is profitable. Classify the customer into Gold, Silver, Bronze etc based on their customer margin – keeping the top customers (i.e., those that generate more profit because they buy more and cost less to sell to)  happy is going to be more profitable than acquiring new customers.

In future posts  I will elaborate on many of the points I state here and provide examples.