Because most philosophies that frown on reproduction don't survive.

Tuesday, September 15, 2009

A Brief Pricing Exercise

or: What does Darwin do all day?

I made a quick run over to the grocery store at lunch time yesterday to pick up coffee for work, and I was pleased to find that the brand of ground coffee I normally buy was marked down from 7.99 to 5.99. Not one to waste an opportunity, I bought two.

Now in a sense, this is exactly the sort of behavior that pricers try to cause, but it also underlines some of the pitfalls of my job, and the reason why pricing is a sufficiently complex science that it has a bit of the art to it as well.

A 25% price drop caused me to buy two bags of coffee instead of one. Doubling unit demand by dropping price 25% isn't bad, though clearly no everyone would have bought two. But here's the trick: The fact I bought two bags of coffee won't cause me to drink coffee any more. (Some suspect if I drank coffee much more than I do already, one of my organs would fail anyway.) So in my case, this sale was actually a net loss for the coffee makers and the grocery store. I paid less for the same amount of coffee that I would have drunk anyway, and now they've foregone sales at full price a couple weeks down the road in order to get sales at lower profit margins now.

However, constant customers like me aren't the real targets of a sale like this -- at least, not if the seller is going to be successful. The real question is: by lowering the price of this coffee, will they win business from people who would have otherwise bought Starbucks or house brand gourmet coffee, or even Maxwell House or Community Coffee. If the lower price brought customers to the brand who would normally have bought something else, and if those customers love the coffee and decide to keep buying it even when it goes back to full price, then it's clearly a win for the brand.

At the end of the day, success for the grocery store is if they have greater revenues and greater profits overall -- though achieving this in the long run may mean sacrificing one or the other in the short term. They can do this one of three ways:
1) Have more customers come to the store.
2) Have the same customers buy more things.
3) Have the same customers buy more expensive things.

My guess is that 1) is not in play here -- I can't see gourmet coffee bringing in people who don't normally shot in the store, and I don't think this offer even made the circular. However, you'd want to check your customer count stats just to see.

I fell into 2) by buying two bags of coffee instead of one, but what they really would need is for people who don't normally buy coffee to buy some, which is unlikely. Most people either drink coffee or don't, though occasionally you have shifts in these trends. Arguably, the Starbucks phenomenon has created more coffee drinkers than there were before. For this one, I'd look to see if aggregate coffee demand for the four weeks starting with the week of the discount was up -- and whether any increased demand translated into increased profitability, or if the 25% discount ate up all the profits from the increased volume.

The gold in this case is probably 3). Does this kind of discounting turn drinkers of cheap/nasty coffee into drinkers of more expensive, quality coffee? (Bias showing through here...) To determine this, I'd look at whether there was a move from cheaper coffee to more expensive coffee during the discount, and whether some of that move proved to stick in the following weeks. If so, doing such a discount every 6-8 weeks would be a good way of converting people to the higher quality product by allowing them to try it at lower cost. (You wouldn't want to run it more frequently than that, or people would start refusing to buy at full cost and waiting for the discount, turning your high price product into a medium price product and possibly turning the entire brand into a money loser.)

And now... I have to go price.

10 comments:

Cliff said...

I think they are looking to pull customers from competing store. "Oh, while I'm here may as well pick up a few other things..."

j. christian said...

Do I sense some consumer surplus calculations going on in the grocery store?

Cliff said...

My wife was surprised the other day when I pulled into Applebees on our way to the grocery store. I simply told her I just wanted us to have some hot chocolate, I was too hungry to go grocery shopping. Worked too, don't think I put in one extra thing.

R L said...

Maybe it won't result in any extra net sales at all but the person who decided to do it needed to feel like they were doing something. Maybe just like the smell of burning margin.

R L said...

Maybe they just like...

Darwin said...

I love the smell of margin burning in the morning. It smells like... market share...

RL, you seem to know just how it is around here sometimes... ;-)

Mary McMenomy said...

I find this kind of thing fascinating, and don't know as much about it as I'd like, so thanks for sharing.

I keep thinking there would be a cool game mechanic in this, if I knew more on the topic. There are lots of "tycoon" games out there, but few of them seem to touch on this kind of decision-making in any interesting way.

Darwin said...

Mary,

Well, if you ever get the itch to work out the math of it, I've know a fair amount of it having done it for the last three years. Drop me a line. :-)

I must admit, I find it really fun too. In a geek-fun kind of way.

Gina said...

There's a whole supply side to this coffee pricing thing. It's entirely possible that the grocer isn't motivated by profits. For example, the wholesaler might have sent too much product, or are discontinuing the product, or discounted the product at the wholesale level for any number of reasons. All of these scenarios would motivate a grocer to move a product off the shelves, and a consumer benefits in the short run by paying a lower price.

I've always loved Economics. Great post to get a person thinking first thing in the morning!

crankywife said...

Interesting stuff. I work in a small service business. Our service is most certainly a luxury item of use to only a small population. We have found over the last few years as we've raised our rates we get more and better (richer) clients. We've found we make more money on fewer clients with deeper pockets for big jobs than lots of little jobs for penny pinchers. There is also the cache of charging more. It must be a valuable service if it costs so much, etc.