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What does store design have to do with price increases?

In a WSJ interview  Wal-Mart’s chief of U.S operations says this about Wal-Mart’s attempt to re-design its stores,

WSJ: Is Wal-Mart as focused as it needs to be on offering the lowest possible prices?

Mr. Simon: A lot of things have distracted us from our pricing mission. We got enamored with presentation as an example. We walked people through our [remodeled] stores and they were gorgeous.

But they cost more. And if you spend more on your building, your prices can’t be as low as you want them to be.

“Every Day Low Price” can’t come from the supplier because they have to make money too. “Every Day Low Price” has to come from every day low cost, which means we have to operate for less.

Sustainability and some of these other initiatives can be distracting if they don’t add to every day low cost.

There are two claims made here that I believe the interviewer should have pushed Mr.Simon on but did not.

  1. If you spend more on your building, your prices can’t be as low as you want them to be.
  2. Sustainability and some of these other initiatives can be distracting if they don’t add to every day low cost.

I will discuss the first point in this article and defer the second for a future article.

Better design and presentation does not mean the sourcing costs (what Wal-Mart pays to suppliers) go up.  So why should the customers offset that cost in the form of higher prices?

If the design changes are already made and if there are no recurring costs to keep-up the design, the costs are sunk. So why do they matter?

Unless of course Mr.Simon is looking at an accountant’s definition of Cost Of Goods Sold (COGS) which includes in it a share of all fixed costs. To an accountant preparing the company’s financial statements, ever bar of soap and bottle of shampoo must be assigned its share of the building cost, employee cost, utility cost etc.

It is due to the quirky accounting rule of how costs are matched with inventories and how inventories are moved into expenses as Cost of Goods Sold.

But the accountants do not run businesses, set prices or make business decisions. They report on the business’ performance with just enough clarity and obfuscation at the same time.

A business cannot spend more on a building and expect to pass on the costs to customers in the form of price increases. Before spending money to improve the aisles, they should have estimated whether the improvements will nudge their customers’ willingness to pay higher and whether they can  generate enough profit to justify the costs.

Incremental profit need not come in the form of higher prices,  it can be in the form of increase in sales from new customers. Better design could bring in new customers who otherwise would not have stepped into the store.

To say, “If you spend more on your building, your prices can’t be as low as you want them to be” is neither true nor relevant here.

As an important side point, when a store spruces up and improves its design and shopping experience will the willingness to pay of its customers go up?

The answer will take us through the path set forth by Thaler on Mental Accounting and Consumer Choice.  It starts with the  story of you relaxing in beach and thirsty for an ice cold drink.

To be covered in a later article.

Ask the Expert – Episode 2 – Using Cost Argument to Push Price Increases

Prices of commodities from sugar, wheat, cocoa to cotton are on the rise. Brands from Starbucks to Sara Lee to garment makers are starting to state their intention to pass on cost increases to customers. In a recent interview, CEO of Kroger, David Dillon said this about this cost argument made by brands,

I don’t see [rising manufacturers' prices] as a problem for us. It is a problem for them

Since costs are irrelevant to pricing,  cost increases relevant to price increases?  Is David Dillon correct or should brands use this opportunity to pass on the cost increases and gain pricing traction? As part of my “Ask the Expert” series, I posed this question to William Poundstone, author of several books, including his latest, Priceless: The Myth of Fair Value. He blogs at Priceless-Blog. When I read his book and listened to his NPR interview I felt he took consumer perspective on pricing and it is very interesting to see his detailed response that is backed by behavioral economics research.

Brands from Starbucks to Jenny-O are using cost arguments to push price increases – Should commodity cost increase be passed on to customers?

Yes. Behavioral economics has demonstrated that people do accept the need for sellers to pass on their own increased costs. 1984 was “the year that behavioral economics began,” according to psychologist and Nobel laureate Daniel Kahneman. He and two economists, Jack Knetsch and Richard Thaler, became interested in “fair” prices. The term “fair” has no meaning in standard economics. Yet it’s a word that we all use. Listen to any negotiation, from a used car sale to a corporate buyout, and you’ll hear someone earnestly insist: “I only want what’s fair.”

Kahneman’s group set out to uncover the unconscious rules of fairness. There was then a Canadian public works project that hired college gradates to conduct nationwide telephone surveys. Kahneman, Knetch, and Thaler began supplying the survey-takers with questions about prices and fairness. One of their most famous hypothetical scenarios ran like this:

“A hardware store has been selling snow shovels for $15. The morning after a large snowstorm, the store raises the price to $20.”

The Canadian public was asked simply whether they considered this “fair.” Eight-two percent said no.

There were many other questions along this line, in a which merchant raised prices to reflect low supply, high demand, or both. The public reaction was always the same: It was unfair for a merchant to profit from the most basic free market forces. As Kahneman, Knetsch, and Thaler wrote,

“Conventional economic analyses assume as a matter of course that excess demand for a good creates an opportunity for suppliers to raise prices, and that such increases will indeed occur. The profit-seeking adjustments that clear the market are in this view as natural as water seeking its level — and as ethically neutral. The lay public does not share this indifference.… the gap between the behavior that people consider fair and the behavior that they expect in the marketplace tends to be rather small.”

As a “man bites dog” story, this finding has gotten much publicity. It’s even led to a certain cynicism about behavioral economics among businesspeople. People are irrational, the message seems to be, so what can you do? Actually Kahneman’s group had a number of results that were less surprising but no less important. They found that the public did not automatically reject any price increase as unfair. In particular, the public was willing to accept price increases when the seller was passing on his own increased costs.

It’s therefore a sound psychological strategy for a company experiencing commodity cost increases to use that to justify a price increase. Of course, it’s necessary to communicate the reason through signage, ads, or other means. During the recent egg recall, prices for unaffected and organic eggs went up. This could be seen as raising the price of snow shovels after a blizzard. But my supermarket had a sign explaining that the store’s suppliers had raised their prices, and thus the market had to pass on its cost increases. This transferred any sense of unfairness to the middleman.

That’s important: No one wants to do business with someone who’s not being fair.

One further point: Don’t assume that the public understands inflation. One of the findings of Kahneman’s group was the public consistently fails to take into account changes in the buying power of the dollar. In one survey it was, for instance, “unfair” for a company to cut wages 7 percent (during a time of no inflation), but it was okay to give a raise of 5 percent during a time of 12 percent inflation. Of course, the workers’ buying power is cut by about 7 percent in both scenarios.

A company that hasn’t raised its prices in a few years may feel it’s overdue for a price increase, and no justification is necessary. But the public won’t automatically see it that way. Even a simple inflationary adjustment may need to be justified—and a psychologically savvy way to do it is to cite increased commodity costs.

—William Poundstone
See also:
Kahneman, Daniel, Jack L. Knetsch, and Richard Thaler. (1986). “Fairness as a Constraint on Profit Seeking: Entitlements in the Market.” The American Economic Review 76, 728-741.
Kahneman, Daniel, Jack L. Knetsch, and Richard Thaler. (1986). “Fairness and the assumptions of economics.” Journal of Business 59, S285-S300.

Fox Tale Soup

There is a children’s book called “Fox Tale Soup“. This is the old story of Stone Soup retold with Fox and farm animals. If you have not read the original I recommend reading this version.

The clever Fox is a great influencer. He starts out by asking for food but was denied any help by the farm animals. After being rejected for his initial request the fox starts with a trivial request,

“just some water please, after all I got the stone to make stone soup”

One of the animals yield and bring water. Of course, if only there was some seasoning, some potato, some rutabaga, …

The fox slowly builds on his seemingly trivial request for water to get to all the ingredients for the soup. The farm animals one after the other ends up bringing salt, potato, rutabaga etc. There are multiple influence principles at play here.

The fox started with an outrageous request, asking for food. Since he was a total stranger the animals so the animals were right in rejecting his request.

Then he followed up with a trivial request, water, which is available in plenty. This is  anchoring.

Once the animal agreed and brought water, there eas no turning back. They ended up giving the rest of the ingredients because of the power of commitment and the inherent need in us to act consistent to our past actions (consistency principle).

There was also consensus effect. Since other animals were helping the fox, any animal that had any misgivings about not helping the fox were nudged by the actions of others and were convinced to help.

That is the power of persuasion.

If you want the psychology behind this you should also read, Influence: The Psychology of Persuasion by Robert Cialdini.

Other book I recommend is Nudge by Sunstein and Thaler.