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Value Signal: This article is worth $99 to most readers like yourself. Starbucks decided to raise its drink prices by as much as 8% (5 cents to 30 cents), They are doing this just when customers are cutting back on their Starbucks trips and switching to cheaper alternatives from McDonalds and Dunkin Donuts. The conventional “wisdom” on pricing is, when recession pushes customers to cut back on expenses and switch from your products to cheaper alternatives, you cut your prices to keep the customers. While this is a usually accepted and followed practice, it is neither wisdom nor based on analysis. To be successful, businesses cannot make decisions based on hunch, gut feel, latest management fad, or so called conventional wisdom. Decisions need to be based on data and analysis which is easier said than done. In the case of Starbucks, how did they arrive at price increase, going against the flow? The simplest calculation here is, when price conscious customers moved out all they are left with are price insensitive customers who prefer their products. Hence it makes sense to charge more for them as long as the loss in profit from further drop in customers is less than the increase in profit from higher price. (Here is an attempt at formal proof on why increasing prices yields better profits). Starbucks has a gross margin of 22%. This is however the average. On their high priced premium drinks we can assume that their margins are at least twice as much. So let us say it is 44% gross margin. Their premium drinks retail for $3.75 or higher, so the new price is $4.05 and at 44% margin, their profit per cup is$1.78 . (Please note that gross margin numbers from GAAP income statements are not based on just marginal costs and include fixed cost allocations.) Let us say they sell „N‟ premium drinks in a year at the current price. The increase in profit from 30 cent price increase (if the number of drinks sold remains „N‟) is 0.3N. You will see the value of N is not important to the analysis.
For the price increase to be unprofitable. most marketers accept conventional wisdom without a challenge because they lack inclination and wherewithal to seek the right data and do the relevant analysis. (Note: We assumed a 44% margin.78ΔN > 0.78ΔN Their price increase will result in net loss only if 1. One in six people has to stop buying the premium drink. Hence a 17% drop in sales is highly unlikely. premium drinks moved to inelastic part of the demand curve. So their price sensitivity is most likely to be lower than it would have been before the recession. price elasticity of demand must be just over 2 (every % increase in price should result in drop in volume of 2%). the price increase is a profitable and a smart move for Starbucks. In terms of elasticity. because no one wants to go against the flow or stand-up to authority. there is bound to be fall in sales. Worse.3N. You can see how Starbucks would have made this counter-intuitive decision – because it is based on evidence and analysis. Our pricing decisions are based on … Starbucks Raising Prices 9 Comments . The New York Times asks. “Will the hard-core customers pay more”? How likely is a 17% sales drop? Not very given that most price sensitive customers have moved out and what they are left with are those who prefer Starbucks over other brands. Unfortunately this does not come naturally to most marketers. As long as the sales drop stays below the 17% mark. But how far should the sales fall to negate the benefits of price increase? Let us say the sales falls from by ΔN cups.However. then lost profit from this lost sales is 1. that is sales has to fall by 17% from its current levels. if it is lower that that then the sales have to drop much more than 17% to make the price increase option unattractive) Another way to look at this is from price elasticity of demand – % change in volume for one % change in price.
Most likely some prices went up much higher then 1%. Atlanta. You know why from here (elasticity) and here (demand curve shifts). Boston. Starbucks Corp (SBUX. author of Priceless wrote in a guest post for this blog. customers are more likely to find the price increase acceptable if associated . They are giving reason for the price increase. They want us to focus on the small number.Image via Wikipedia Two years back we saw the story of Starbucks price increase. Dallas. Average price increase is meaningless. simply to bring down the average. making coffee-drinkers spend more in New York.N) to McDonald‟s Corp (MCD. Albuquerque and other cities.N).O) raised prices by an average of about 1 percent in the U. Starbucks expects high costs for things like coffee. Like other restaurant operators ranging from Chipotle Mexican Grill (CMG. As William Poundstone. even those that did not see price increase. Here is the link to Reuters story if you want to read it without my interpretations. You won‟t find that until you read the story. Most likely they also calculated the average over all their products.S. Washington. Northeast and Sunbelt on Tuesday. Despite widespread criticism in the news media we saw no real ill effect on its sales or brand. Now they are rolling out price increases to the rest of the country. I want to point out some key points noted in the price increase story that serve to tell us how well they are executing this change. it is raising prices to help offset some of that cost pressure. milk and fuel to cut into profits this year.
not all prices are going up. Prices on about half a dozen other beverages also were set to increase This further attests to first point. including fuel and ingredients for food and beverages. Lastly this one is the most measured statement of all (I bold texted the key phrases) The Seattle-based chain said its pricing decisions are based on multiple factors. the price for 12-ounce “tall” brewed coffees and latte drinks went up 10 cents. They are increasing prices on their tall while leaving the grande untouched. store operations and commodities. “We cater to a somewhat higher-income customer and we price our products based on customer willingness to pay. You should give them credit for both points and extra credit for giving future cost increase as the reason. Starbucks‟ Olson said the price for a 16-ounce “grande” brewed coffee. This is classic case of second degree price discrimination. Since the marginal cost of additional coffee in grande is almost negligible this is still an upside for Starbucks. After the price increase on tall. For the last point see my past post on how lower contribution margin means okay to lose sales from price increases. Starbucks has three sizes. Because they have done their versioning right. Besides we don‟t expect any push back from these high income segment”. As you read this multiple times you will find all kinds of reasons except. remained the same across the United States and has not changed since January 2011. grande and venti. They are able to capture higher consumer surplus without alienating their customers.with a fair reason. . Starbucks is going a step further in using examples. those whose demand is relatively inelastic or those with lower contribution margin such that they are okay with lost sales from price increases. not just the price of coffee. he added. tall. the company‟s most popular beverage. The price for grande lattes was unchanged in most markets. Olson said. Most likely they are increasing prices of their most popular drinks. To state the obvious. some customers may find they get more value with grande (higher consumer surplus) than they get from higher priced tall and will instead choose grande. which has eased lately. “hey others already did it and we are following them”. Those considerations include “competitive dynamics” in individual markets as well as costs related to distribution.
As more and more price sensitive customers switched to private labels and other low cost options. There are always other reasons and you never say pricing at customer willingness to pay. Here is another attempt. A key part of practicing effective pricing is effective pricing communication and managing customer perception. the second curve‟s is higher than that of the first (again proof exists in textbooks). Let us assume there are only two types of Starbucks customers one is price sensitive and the other is relatively less price sensitive. I recently made the same claim on price sensitivity of Starbucks customers. Let us take the Starbucks as example. The claim is just that if it is not formally proved. great pricing strategy. Overall. Each with linear demand curve: q1 = a – b * p (demand curve for price sensitive customers) q2 = c – d * p (demand curve for brand conscious customers) Mathematically it is easy to show that the latter curve is steeper than the previous.A key attribute of those practicing value based pricing is never explicitly saying that they are practicing value based pricing. With the recent changes in bottled water prices I made an attempt at proof. premium brands responded by raising prices. execution and communication by Starbucks. . But it was one example based on one data point and is not really a proof. Failing that you will face backlash as some brands recently did. Price Increase When Demand Shifts – Semi Rigorous Proof 4 Comments Previously I have written about pricing for recessionary times and how CPGs and other businesses are realizing increase in profits despite drop in revenues. Let us call the p* for demand curves 1 and 2 as p1 and p2. The claim is this price increase delivers higher profit than a price cut to gain back customers because once the price sensitive customers moved out those that continue to prefer the brand are less price sensitive. Any price higher or lower than p* will yield lower profit (hence the name profit maximizing price). Each demand curve yields a different profit maximizing price p*.
. p1<p3<p2 With the down economy the price sensitive customers simply stopped coming to Starbucks. its profit will be ower than what would it have been if it were to price at p2 (the profit maximizing price for the demand curve). For this demand curve any price different from p3 will yield lower profit than p3. In other words. Let us call this p3. In other words.If Starbucks can find out who is who and can separate them then they can charge different prices. This proof can be extended to account for many different demand curves and non-linear demand curves. But when a customer walks into one of their stores Starbucks has no way of finding whether she is of type 1 or 2. They are also attracted by the higher volume by combining the customer segments so to them the combined demand curve will be q = q1 + q2 = (a+c) -(b+d)p This has its own profit maximizing price which is between the profit maximizing prices of the two demand curves. This is called Third degree price discrimination. the demand curve became q = c – d*p If Starbucks continued to price at the previous profit maximizing price of p3 (which is lower than p2). Hence it makes sense for Starbucks to increase its price when the demand curve shifts. thereby revealing who the brand conscious customers are.
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