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.

Waging an Effective Price War

First it was the $9.99 (the $8.99, $8.98) hardcover books, now it is $9.99 DVDs. Wal-Mart’s started the price war with a very low price on pre-orders for hardcover books and DVDs. Almost immediately Amazon.com was forced to match Wal-Mart’s price and so did Target. When the three retailers wage this war, customers stand to benefit while shareholders will see value destruction.

The value lost is not uniform for all three retailers. According to WSJ that quotes a JP Morgan analyst, Wal-Mart makes less than 1% of its revenues from its online channel WalMart.com while Amazon.com it is 100%. Online revenue from books and DVDs is even smaller portion of the total revenue. I do not have numbers for Walmart.com but Amazon.com makes 58%  of its total revenue from media sales ($11 billion annual, granted that includes music CDs as well).

The all new low price is offered only on 10 new titles, so their share of total online revenue is low but even a fraction of the 58% is a larger share of total revenue than that of 1%. Wal-Mart may not gain much from this price war but stands to hurt Amazon.com a whole lot more. That is an effective price war.

It is effective not because it added to Wal-Mart’s profit but it forced Amazon.com to respond. There really was no reason for them to match the price.  Let us do back of the envelop math. Let us assume the low price was offered only for a quarter,  the new books and DVDs constitute 10% of the media sales and the margin for Amazon.com is 10%. The price cut is about 30% of their total price, all of which is lost profit. That is a total loss of $82.5 million (11*(1/4)*10%*30%)

Even if we assumed the worst so that Amazon.com’s new book and DVD sales would be completely wiped out had they not matched Wal-Mart’s  price cut, their loss would total to just $27.5 million (11*(1/4)*10%*10%). Clearly, retaliating is not a profitable option for Amazon.com and by doing so they only helped make Wal-Mart’s initial attack effective.

Meanwhile Wal-Mart is only happy to reap the benefits of free publicity from its low cost price war that hardly puts a dent on their profits while damaging their competitor’s profits.