## We are pricing \$400 for \$450 because customers asked us

When writing about Starbucks pricing the simplest option for me is to copy and past my past articles. After all that is exactly what Starbucks does when introducing pricing changes or super-premium products. See for example here  and here. Perfectly executed price increase and almost as effectively communicated, resulting in better profits. Make no mistake, I admire and support it and there is nothing wrong with it.

This time it is the repeat of the \$400 Steel gift card. Here is what I wrote last year,

That is correct. It costs you \$450 to get \$400 because Starbucks said it costs them a lot to make this steel card. While I called this egregious pricing, at least 5000 people did not think so. The card was sold out and worse was sold for much higher prices on eBay.

They then said, they were charging \$50 more because they spent more than \$50 just to make the card. And what do they say now,

“It actually costs us more than \$50 to produce this card,” she said. “That’s what you’re paying for — the quality of the card itself.”

See they are actually losing money, just for you so you can exchange \$450 cash that has maximum fungibility with \$400 of payment that has no fungibility. They are doing you a favor so you won’t feel guilty every time you fork over \$4, after all Prospect Theory says pain from single spend of \$400 is almost same as pain single spend of \$4 (or something like that).

Another interesting thing to observe this year are the prices in eBay. Last year a curious thing happened,

Pricing on \$0 gift card provides great insight on buyer perception. It appears keeping the full \$400 value of the card helped increase its value among buyers. That is, when sellers left \$400 on the card buyers bid additional \$600 for that \$400.

We can try to explain away why anyone would pay \$650 for an empty card. But nothing in rational economics can explain why someone will bid \$1.5 for each additional \$1.

Current highest bid is \$2499 (with the \$400 value retained). And don’t worry, shipping is free.

For all the jokes we make about left tail, they seem to have enough dispensable income than rest of the distribution. I wonder who really is the left tail here.

## We raised prices to preserve our business model

This quote comes to us from Ms. Allie Webb, the Founder and CEO of Drybar a blow dry only salon. A blow dry salon is not like any hair salon. It offers, just as name indicates, blow dry and styling. Drybar is a pioneer in this niche and does \$40 million in revenue a year. In an interview with The Wall Street Journal she was asked why  she raised her prices recently. And she offered this answer,

Ms. Webb: We always were \$40 in New York. We tried to keep prices \$35 [elsewhere] as long as we could, but you know things go up: rent, health insurance, incentives. There’s just a lot of different things that got more expensive. We had to raise the prices to keep the business model as it was.

I am willing to bet that someone as innovative and entrepreneurial like Ms. Webb, one who invented the category getting customers to pay for something they do for free, knows exactly why she raised her prices and is simply saying the best answer one could give to explain price increases. You have seen this done perfectly by Starbucks and repeatedly too.

We are increasing prices because …. ( anything but we found out customers value and charge that price).

Ms. Webb does just that, citing cost reasons, rent and salaries. I don’t have to repeat that a customer could care less about a marketer’s cost. Ms. Webb would be the first to admit that a customer getting their hair blown out does not think about offsetting Drybar’s rent. However using cost reasons to correct your past pricing sins is a perfect tool. It does allay customer concerns and push backs.

However what Ms. Webb added in the end is concerning.

We had to raise prices to keep the business model as it was

Again I believe she does not believe that statement. And no business should. You never raise prices to preserve your business model. Because your business model is nothing more than – how do you get your fair share of value you created for the customer. Pricing is the simplest way to capture the value created. If you are increasing prices without increasing value you are simply getting more than fair share of what you created. Such a business model is unstable and will be disrupted.

No one can preserve their model, let alone preserve it by raising prices. Someone else will always find a way to deliver customers more value, do it cheaper than you could and share a greater portion of that value with customers that you do. Your option is to do that before others do it to you.

## Don’t be a product person, be a merchant

Founders and product managers alike wear this proudly on their sleeves (or twitter bios)

The Ultimate Product Person – who loves products, building products and sweating the details.

Skim through any of the many valley job postings for product managers – the one mandatory requirement is love for products.

Makes sense? Why would you hire someone who does not say they are a product person to build products? Let us keep things simple and not talk all those products that are insanely great and making friction less something or other. How about coffee? Say your business is running a coffee shop, as founder and CEP, don’t you think you should be a coffee person?

Here is what someone who knows a thing or two about coffee, Howard Schultz founder and CEO of Starbucks, describes himself,

CEO Howard Schultz says he’s never been a “coffee person.” Sitting in his sprawling Seattle office overlooking Puget Sound, he says that what he’s always been is a merchant.

Schultz is right in describing himself as a merchant. The dictionary meaning does not seem to carry the intent of Schultz,

mer·chant  (mûrchnt) n.

1. One whose occupation is the wholesale purchase and retail sale of goods for profit.
2. One who runs a retail business; a shopkeeper.

Literally yes he owns the shops, buys beans on wholesale and sells grande lattes for profit. But a more apt definition for the term should be

mer·chant  (mûrchnt) n.

3. One who figures out what customers value and willing to pay a premium for and finds a way to deliver it to them at lower cost

You can obsess over the product, about its velvety finish, beveled edges, etc., but if you fail to understand how and why those features add value to customers that compels them to pay a premium price for it, being a product person is pointless.

When you are a product person you start with features, think of your product as a bundle of features, speak about features, obsess about features, throw a tantrum when engineering wants to drop a feature because of resource constraints, use words like ‘awesome’, ‘uniquely positioned, ‘award winning, and ‘remarkable’ without explaining what that means and finally price your product as a sum of its parts.

When you are a merchant you start with customers, those you want as your customers over others, find out what they value and deliver it at a price that matches the value perception and at a cost that makes you a handsome profit.

A product person keeps iterating on what is at hand, moving along the same curve and failing to jump to another curve.

A merchant is laser focused on the customer and what job they are hiring the product for. They keep adding many different  curves that are relevant to that customer.

An ultimate product person is not one who has products in their blood. The ultimate product person is really a ‘merchant‘ who understands that a product is simply a value delivery mechanism.

## Starbucks Price Increase Déjà vu

When it works why mess with it? Be it a product, price increases, or messaging?

I am talking about recent Starbucks price increase. You hardly even noticed that the prices went up – now or the past two times they did it.

Here is what they did four years ago – 8% increase in prices,  two years ago – 10% increase in prices and now –10% increase in prices.

The product mix they chose and the level of price increase, the markets they chose and how they are messaging it are all exactly same as their last time.

There are always other reasons for setting prices or raising prices and it is not about customer selection or pricing at what you can bear to pay.

Effective pricing is not just about understanding customers and demand curves but understanding how best to communicate that pricing to customers. And as an outsider, do not confuse this cost-driven price messaging with how exactly Starbucks sets prices. No company setting prices based on value will explicitly come out and admit that they their prices have no connection whatsoever to costs.

To a large extent, the price you pay for an iWhatever is disconnected from the cost of producing the gadget. Apple simply charges what the traffic will bear, and given the strength of its market position, the traffic will bear a lot.

And as Krugman agreed in his piece, it is perfectly acceptable to have this disconnect (although he had some riders attached).

Let  us look at Starbucks case  of setting prices. Here is a point by point comparison of the last two times. It is déjà vu.

Product Mix Impacted and Level of Price Increase

Then:

the price for 12-ounce “tall” brewed coffees and latte drinks went up 10 cents.

Now:

” the price of a Tall brewed coffee is changing, the biggest rise would be 10 cents, Mr. Olson said, adding that he can’t share specific price increases of specific drinks in different markets for competitive reasons”

The reason they are going after the Tall size is highly likely it is their most popular SKU with little or no demand elasticity.  Increasing price on the lowest priced item will also help make the Grande and Venti attractive due to relative pricing.

Markets where Prices are Going Up

Then:

“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.”

Now:

Starbucks Corp. SBUX -0.81% plans next week to raise prices by an average of 1% on some of its beverages in the U.S. It would mark the first price change in 18 to 24 months for some markets, the company said.”

Once again they are targeting specific markets and not increasing prices across all markets. You can’t make up such identical news items. It is the likely same markets (those that have customers with higher disposable income and fewer competition). It is the same “1% average increase” message.  The 1% average is true but average is meaningless. It is done here to make  specific price increases look smaller.

Messaging

Then:

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.

Now:

Increasing rent, labor and non-coffee commodity costs as well as competitive dynamics are the reasons behind the new pricing, Starbucks spokesman Jim Olson said.

It is same spokesperson too. I had to pause and check I was not reading old news article. The stories are that close. I wonder if Mr. Olson even talked to press this time or the PR team simply used his quote from last time.

When it works why not repeat it? Like the movie sequels I guess.

## The Simplest of all Business Models

If you want to use Wifi at Pete’s Coffee & Tea you will have to buy something first.  At the counter they give you a code to use, that allows you about an hour of surfing time.

In many local coffee stores you technically have to buy something but once you do, you can stay parked in their tables for hours without buying anything. In Pete’s bigger competitor, Starbucks coffee, it is the similar unlimited free access plus access to premium extras like The Wall Street Journal.

Coffee shops complain about those who occupy tables for hours at a stretch, buy little or nothing and mooch on their bandwidth as well as electricity. Customers who do spend money at coffee shop and need good connectivity for an hour or two complain about the poor speed and difficulty in finding tables near outlets. General customers (who hire the coffee shop for, coffee) complain about the crowd and lack of seats to simply sit and enjoy their brew or have a conversation.

Free Wifi became a popular perk for coffee shops, restaurants and hotels to attract customers and keep them in their shops. If the customers chose your business over others because of free Wifi, you win. If the customers stay because of free wifi and continue to spend during their stay, you win. You have successfully used free wifi as lead generation tactic and customer retention  tool. (Freemium?). For instance, Panera bread saw its sales increase by 15% when they introduced free wifi.

On the other hand, what is free to customers, is not so to businesses. There are costs of operation (making sure there is enough capacity) and opportunity costs (both for the money spent on their big pipe broadband and the moochers). When everyone else offers free wifi it becomes difficult for a business to either stop offering it or start charging for it. Add to this customer dissatisfaction from providing poor internet service.

Look at where we are in the discussion. We are not talking about the compelling value proposition a coffee shop (or a restaurant) offers but talking about a perk. Let us not forget the primary job these businesses wanted customers to hire them for. If customers’ choice is made based on secondary and tertiary factors, the primary value proposition has become irrelevant. If a business fears their customers will walk next door for free wifi they are admitting that their product is an easily replaceable commodity.

That is a bigger problem they ignore while fretting about wifi costs. In focusing on free wifi as lead-gen activity they ignored the core customer segment they started with and the customer jobs they hoped to serve. While some may call free wifi (and Freemium?) as business model innovation, this is essentially losing sight of customer needs and your core competence.

If the customers didn’t hire your coffee shop for coffee, should you tie your business model to selling coffee? That is an incongruence between value creation and value capture.

On the other hand your strategy – to serve the most amazing coffee – need not be fixed. You can see the customer shift and decide your strategy is to serve those customers who have a connectivity need and are not satisfied with existing alternatives. You recognize customer issues with poor speeds in free wifi places and provide reliable speeds as differentiated feature. In such a case you cease being a coffee shop and become a workspace provider. And guess what, you now can charge for that value delivered.

The business model is back in sync with value capture matched to value creation.

That is exactly what is happening in Russia’s Clock Cafe.

“You don’t have to pay for coffee or tea or cookies. You should pay for time, and time costs — I hope — [are] not that expensive.”

And their target segment? Students and business folks who hire them for connectivity and hence pay for the value they get.  Nicely done. However, I think they fixed one mistake but introduced another – making coffee free. There really is no reason for them to offer free coffee, especially the premium kind they claim they deliver,

We have cappuccino, latte, espresso, Americano, and our coffee is not the cheap one

They are committing the flip side of free wifi at coffee shop mistake. Sooner or later they will run into the free wifi problem in reverse. Why bother with coffee or why not charge for it? Especially if the customers didn’t hire you for coffee?

When it comes to business strategy, starting with customer needs and choosing the ones that you can serve better than others remains the best approach. And when it comes to business models, charging for value you deliver remains the simplest of all approaches.

## The Incredible Starbucks Steel Gift Card

To refresh your memory, just before the holidays Starbucks launched a limited edition (5000 only) steel gift card priced at \$450. The card carries a value of \$400 and comes with some sundry benefits like free refill on brewed coffee and free drink on birthday.

That is correct. It costs you \$450 to get \$400 because Starbucks said it costs them a lot to make this steel card. While I called this egregious pricing, at least 5000 people did not think so. The card was sold out and worse was sold for much higher prices on eBay.

By last check there were 510 sold listings.

• 70 odd listings were for just the empty card (\$0 value) sold from \$325 to \$650
• Most of the listings were with the full \$400 value and sold from  \$670 to \$1250
• Very few listings with \$5 and \$25 value and with no other values