Adaptive Price Management

When the downturn started in 2008 and retail sales started dropping, the department stores started dropping prices from fear of being left with inventories. There were big sales, with 50% to 70% drop in prices even in high end retailers like Saks. There was one exception, Abercrombie & Fitch, which steadfastly refused to drop prices.

They knew they were not a product for the mass market and there was a small segment they served. For a long time that segment was not worried about price. They were more concerned about the brand and the long term effects of sales on their brand and future pricing power. They were worried about setting low reference price in the minds of their customers and did not want to train their customers to wait for sales. There was more to lose from price decrease than to gain.

However, things got worse for Abercrombie & Fitch. Their operating margin shrank from 20% to barely 4% in less than a year. Their sales fell 30%. Whatever happened to Effective Price Management  that recommends pricing for profit and protecting  price premium to deliver higher profit.

They  correctly following and religiously implementing two of the three components of Effective price management:

  1. Pricing based on value add to segments
  2. Pricing based on incremental analysis

Unfortunately there are two problems that led to profit erosion.

First  problem is effective price management requires the marketer to manage all three components and selectively choose one or two and implement just those. When a marketer optimizes a subset they end up missing the true optimal solution.They were focused on margins from individual items and not on maximizing total margin from the customer. They ignored the third component of effective price management – Focus on customer margin not product margin.

Second problem is the model is not static – you do not decide  your segment, their value proposition, their demand curve once and forget about it. The segments, their taste, value proposition and willigness to pay all change and change drastically due to external events. The New York Times  reports on a market research that found just this shift:

Aéropostale and Wal-Mart, the discount chain, are among teenagers’ go-to stores this season, while more expensive stores — like Hollister and Abercrombie & Fitch — are not, according to a survey of students ages 12 to 17 by Majestic Research.

“Rather than get one top at a Hollister, they can get two or three at Aéropostale,” said Brian J. Tunick, a retail analyst at J. P. Morgan Securities.

When this shift happens then all the previous models on segmentation, targeting and incremental analysis on sales drop and lost profit must all be reevaluated. When the model does not evolve and remains static, it results in decisions that does not deliver under changed conditions.

Effective price management is not about picking and choosing a subset of the three components but implementing all three with right balance to maximize profits. It cannot be done in a, “set it and forget it mode”,  it is a dynamic model that requires continuous tuning to adapt to changing inputs.  Failure to do so will result in sub-optimal results regardless of how optimized the partial model is or how accurate and complete the initial model is.

Retailer Going After CPG Price Increases

While the leading CPG brands (Heinz, Nestle, Unilever, Del Monte) are reporting increase in profits from price increases, the retailers are not happy with the price increase. Safeway is asking the brands to  rollback their prices and is using their private label leverage. Safeway executive Steve Burd, told analysts,

I say wait and see, because we’re going to chew  up on corporate brands

Mr. Burd makes his case based on falling input costs and hence the brands must pass on the savings to the customers. Again to repeat for the umpteenth time, costs are not relevant to pricing. These food brands were able to retain their price increase and grow their profits despite the drop in sales volume. This is because of the change in customer mix, the price sensitive segment has already moved on to private labels. The brands are doing the most rational thing, price products at what customers are willing to pay.

The retailers have a higher gross margin on the private labels and most private label products are produced by the same corporate brands Mr. Burd was talking about. The retailer margins are so thin that they need the large volume to make up for their high fixed costs. The retail operations are measured by dollars per cubic (or square) inch.  The fall in volume of name brands due to their  price increase is starting to affect retailers despite the increase in sales of private labels.

One questions we should ask is if a retailer can “chew the corporate brands” with their private labels, why not do just that? Why threaten to do this? I believe the loss to retailers with this move will be larger than it would be from a negotiated price agreement with the brands. Retailers depend on the same brands for supplying private labels, they need to spend more on promotion and stand to lose customer traffic if brands are pulled out of their stores.

What is the likely outcome? Brands are happy with their price increase and know that those who are buying now are their brand loyal customers. If a retailer pulls the brand off the shelves most customers will seek another store. But the risk exists that the brands will lose out in the long term. The most likely scenarios to happen are

  1. Brands will allow retailers to keep more of the price increase in the form of trade promotion
  2. Brands cut a better price deal with retailers on the wholesale price of private labels manufactured in their factories.

In any case it is time for retailers to start thinking about reducing their operational costs.