Pragmatic Pricing

The article “Carriers Brace for Increases in Fuel Prices” in the Wall Street Journal prompted me to wonder how the airlines handle these shocks to their costs.

Prior to doing any research, my expectation was that they use the news that oil prices are going up as an excuse to raise prices.  After all, as consumers we will accept price increases when we know there is a reason.

According to the WSJ article, they are raising prices.  United and American are adding a $20 round-trip fuel surcharge.  Now the question is “Are they making or losing money on that $20 surcharge?”

To answer that, I went to the website HowStuffWorks to learn that a 747 burns about 0.01 gallons of jet fuel per person per mile.  For a flight across the country and back of about 6,000 miles, each passenger consumes about 60 gallons of jet fuel.   According to the IATA fuel monitor web site on Feb. 25, the price of Jet Fuel is $2.838/gallon.   According to the WSJ article, the spot price of jet fuel is $3.12 today, a $0.30 price increase over a recent price.  If the surcharge is to cover the recent cost shocks the additional $0.30 times 60 gallons per person shows the airlines face an extra cost of $18 per person per round trip flight across the US.

This seems like the airlines are just covering their costs plus adding a little extra for the uncertainty of future oil prices.

The two real lessons to take away from this situation:

1.  Raising prices is best done when there is public awareness of your increases in costs.

2.  You still have to compete.  In the article both United and Delta implemented surcharges.  If the other airlines do not follow their lead you can be certain these two will pull their increase back.

The past week both Warren Buffet and Seth Godin used the term “Pricing Power”.

Seth Godin wrote a blog titled “About Pricing Power” where he claims the type of company or individual who has the power to determine prices is irreplaceable, essential and priceless.

Also this week Bloomberg published an article titled “Buffett Says Pricing Power Beats Good Management When Evaluating Companies.”  Here is a paragraph from the article.

“The single most important decision in evaluating a business is pricing power,” Buffett told the Financial Crisis Inquiry Commission in an interview released by the panel last week. “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

My first thought after reading Buffet’s quote was “if a firm can raise prices without losing business why don’t they?”  The answer to that will require more creative thought.

The second question though was what do Seth Godin and Warren Buffet really mean when they talk about pricing power?  Technically it means inelastic demand curves, but that still doesn’t really tell us anything.  What I think defines pricing power is value.  How much value does your product offer relative to your competitors?  Value is in the wallet of the customer, so it’s a combination of your differentiation and the value your customers place on that differentiation.  Pricing power means creating more value than your competitors.

My spin on their comments:  Seth Godin says create more value, then you can charge for it.  Warren Buffet says he looks for companies that create value and then capture it through value based pricing.  Mark Stiving says … I agree with both of these very smart guys.  Do you?

What is the difference between 75% gross margin and 50% gross margin?

That’s easy, 25%.  So you might be tempted to jump to the incorrect conclusion that if you currently have 50% gross margin and want to grow that number to 75%, you simply raise your price by 25%.

To go from 50% to 75% gross margin you have to double your price (assuming costs don’t change of course). Let’s go through an example.

The formula for gross margin is (Price-cost)/Price

You have a product that costs 1 dollar to make.  You sell it for 2 dollars.  Use the above formula (2-1)/2=0.5 or 50%.

If you double the price to 4 dollars, the new gross margin is (4-1)/4=0.75 or 75%.

These graphs shows what the gross margin % is at different prices for a product that costs  $1 to make.

The lesson is to not be fooled into thinking a certain percentage change in price results in a similar change in gross margin percent.  When your gross margin is very small, small changes in price make large changes in gross margin %.  When your gross margin % is very large, it takes large price moves to change the gross margin % even a little.

This is only important though if you are thinking in terms of gross margin %.  Why would you think in terms of gross margin % and not gross margin dollars?

In this posting I’m going to discuss an academic article.  I will greatly simplify it and pull out only the aspects that are interesting to us as pricing professionals.  “The Effects of Consumers’ Price Expectations on Sellers’ Dynamic Pricing Strategies” by Hong Yuan and Song Han was published in Journal of Marketing Research, Feb 2011.  This post discusses only a few interesting aspects of the article, but if you want to know more about the study you can either read the very brief description at the bottom of this article or the authors’ abstract.

One thing I like about this article is they hit us over the head with the concept that customers choose how much effort to put into searching for alternatives, and how our prices influence this decision.

Customers have a reference price, the price they expect to pay or the price they think is fair.  If they see that your price is below their reference price, they will likely just make the purchase without searching much if at all for alternatives.  However, if your price is higher than their reference price, then they will likely put more effort into shopping.

In a future post we can talk more about the many different ways reference prices are formed, but the one method used in this article is your previous price.  For customers who purchase the same item over and over, they may remember the last price they paid and they likely made that their reference price.  This means that every time you raise your price, you set your price above your customers’ reference price.  This is the same as inviting your customers to search for alternatives.  Don’t raise your prices (unless you can’t avoid it).  This also means that if you are able to lower your prices, your customers are less likely to shop around.

Of course our costs don’t always support our ability to lower prices or even hold them steady, but as pricers we must do our best to manage our customers’ expectations, their reference prices.

This becomes one explanation for why prices rise so quickly when costs go up, but fall more slowly when costs go down.  For example, when the cost of a barrel of oil goes up, gas stations tend to raise their prices the same day even though it takes time for that more expensive crude oil to get refined into gasoline and transported to the gas station.  However, when the price of a barrel of oil goes down, we don’t see the price at the pump change so quickly.

The explanation, using the logic in this article, is that when we see an increase in costs we want to raise prices only once if possible.  After all, when we raise prices we are inducing our customers to search for alternatives, which we’d rather not do.  If we have to do it, let’s do it only once.  As costs come down, we could lower our prices immediately and get the benefit of our customers not shopping around.  However, if we lower our prices slowly we get the benefit of our customers not shopping around several times.  This seems much more beneficial.  Raise prices quickly when costs go up so we only induce search once.  Lower prices slowly when costs go down to deter search multiple times.

The bottom line, when our price is below our customers’ expectations they are more likely to purchase.  When our price is above their expectations they are more likely to search for alternatives.   Raising price induces search, lowering price reduces search.  As pricers and as marketers we must manage our customer’s reference price, the price they expect to pay.

=== About the article ===

The article used game theory where the players were companies that faced changes in their cost and consumers who faced a cost to search for alternatives.  The authors proposed and supported 5 propositions, two of which were discussed above.  P2 – “The higher the buyers’ observed price in the current period, the more they search; the higher the buyers’ expected price, the less they search.”   P4 – “Sellers raise prices more quickly in response to marginal cost increases than they reduce prices in response to marginal cost decreases.”

The authors then described a couple of experiments in which students were given the role of seller or buyer.  The participants were also given actual monetary rewards based on how well they did in their role.  Their experimental results supported their propositions.