Starbucks Price Increase A Case Study In Analysis

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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.

However, there is bound to be fall in sales. But how far should the sales fall to negate the benefits of price increase? Let us say the sales falls from by N cups, then lost profit from this lost sales is 1.78N Their price increase will result in net loss only if 1.78N > 0.3N, that is sales has to fall by 17% from its current levels. One in six people has to stop buying the premium drink. (Note: We assumed a 44% margin, 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. For the price increase to be unprofitable, price elasticity of demand must be just over 2 (every % increase in price should result in drop in volume of 2%). 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. So their price sensitivity is most likely to be lower than it would have been before the recession. Hence a 17% drop in sales is highly unlikely. In terms of elasticity, premium drinks moved to inelastic part of the demand curve. As long as the sales drop stays below the 17% mark, the price increase is a profitable and a smart move for Starbucks. You can see how Starbucks would have made this counter-intuitive decision because it is based on evidence and analysis. Unfortunately this does not come naturally to most marketers, because no one wants to go against the flow or stand-up to authority. Worse, most marketers accept conventional wisdom without a challenge because they lack inclination and wherewithal to seek the right data and do the relevant analysis.

Our pricing decisions are based on Starbucks Raising Prices

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Image via Wikipedia Two years back we saw the story of Starbucks price increase. Despite widespread criticism in the news media we saw no real ill effect on its sales or brand. You know why from here (elasticity) and here (demand curve shifts). 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. Here is the link to Reuters story if you want to read it without my interpretations. 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. Average price increase is meaningless. They want us to focus on the small number. Most likely some prices went up much higher then 1%. You wont find that until you read the story. Most likely they also calculated the average over all their products, even those that did not see price increase, simply to bring down the average. Starbucks expects high costs for things like coffee, milk and fuel to cut into profits this year. Like other restaurant operators ranging from Chipotle Mexican Grill (CMG.N) to McDonalds Corp (MCD.N), it is raising prices to help offset some of that cost pressure. They are giving reason for the price increase. As William Poundstone, author of Priceless wrote in a guest post for this blog, customers are more likely to find the price increase acceptable if associated

with a fair reason. Starbucks is going a step further in using examples, hey others already did it and we are following them. You should give them credit for both points and extra credit for giving future cost increase as the reason. the price for 12-ounce tall brewed coffees and latte drinks went up 10 cents. Prices on about half a dozen other beverages also were set to increase This further attests to first point, not all prices are going up. Most likely they are increasing prices of their most popular drinks, those whose demand is relatively inelastic or those with lower contribution margin such that they are okay with lost sales from price increases. For the last point see my past post on how lower contribution margin means okay to lose sales from price increases. Starbucks Olson said the price for a 16-ounce grande brewed coffee, the companys most popular beverage, remained the same across the United States and has not changed since January 2011. The price for grande lattes was unchanged in most markets, he added. To state the obvious, Starbucks has three sizes, tall, grande and venti. They are increasing prices on their tall while leaving the grande untouched. This is classic case of second degree price discrimination. After the price increase on tall, 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. Since the marginal cost of additional coffee in grande is almost negligible this is still an upside for Starbucks. They are able to capture higher consumer surplus without alienating their customers. Because they have done their versioning right. 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, 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. As you read this multiple times you will find all kinds of reasons except, We cater to a somewhat higher-income customer and we price our products based on customer willingness to pay. Besides we dont expect any push back from these high income segment.

A key attribute of those practicing value based pricing is never explicitly saying that they are practicing value based pricing. There are always other reasons and you never say pricing at customer willingness to pay. A key part of practicing effective pricing is effective pricing communication and managing customer perception. Failing that you will face backlash as some brands recently did. Overall, great pricing strategy, execution and communication by Starbucks.

Price Increase When Demand Shifts Semi Rigorous Proof

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Previously I have written about pricing for recessionary times and how CPGs and other businesses are realizing increase in profits despite drop in revenues. As more and more price sensitive customers switched to private labels and other low cost options, premium brands responded by raising prices. 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. The claim is just that if it is not formally proved. With the recent changes in bottled water prices I made an attempt at proof. But it was one example based on one data point and is not really a proof. Here is another attempt. Let us take the Starbucks as example. I recently made the same claim on price sensitivity of Starbucks customers. Let us assume there are only two types of Starbucks customers one is price sensitive and the other is relatively less price sensitive. 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. Each demand curve yields a different profit maximizing price p*, the second curves is higher than that of the first (again proof exists in textbooks). Any price higher or lower than p* will yield lower profit (hence the name profit maximizing price). Let us call the p* for demand curves 1 and 2 as p1 and p2.

If Starbucks can find out who is who and can separate them then they can charge different prices. This is called Third degree price discrimination. 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. Let us call this p3. For this demand curve any price different from p3 will yield lower profit than p3. In other words, p1<p3<p2 With the down economy the price sensitive customers simply stopped coming to Starbucks, thereby revealing who the brand conscious customers are. In other words, 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), 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). This proof can be extended to account for many different demand curves and non-linear demand curves. Hence it makes sense for Starbucks to increase its price when the demand curve shifts.