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Prices in Flux

September 2008 Pricing 1 Comment

These are exciting times.  Prices are in flux.  Many companies are raising prices, some easily, others not so much, and still others find price increases unattainable.  How to make sense of all this?  Or, more precisely, what should a pricer do?

As with every pricing decision, it is a strategic issue as much, if not more, than a cost issue.  Strategic decisions are dependent upon economics of the environment as well as competitive opportunities.  Many of the price changes in 2008 have been directly driven by changes in the global economic environment.

Economic Changes

The economy of 2008 is unlike any we have seen in the past 40 years, globally and locally.

In the US, the richest 1% reported 22% of the national total adjusted gross income in 2006, the highest percentage since 1929.  This implies that the rich are increasingly able to buy high-end and luxury goods while the rest of consumers are facing more challenging economic situations.  Middle and low income Americans are suffering from volatile and decreasing home prices.  In May, home prices fell 17% compared to the same month a year prior, increasing the total decline to 23% from peak housing prices in July 2006.  All Americans are adjusting to higher fuel prices at the pump, though again this affects the middle and lower income more than the higher income market segments.  For most Americans, stagnant wages, losses in the major savings vehicle (the home), and a higher core cost of living (transportation and food) encourages a psychological environment of high uncertainty and frugality.  From this perspective, it can be expected that most Americans will restrain their spending on all but the most necessary or individually valuable items.  Most, but not all.

Globally, developing nations are swelling with pockets of newly rich able to purchase previously unattainable goals.  At the same time, most are dealing with higher cereal prices eating into their already meager incomes.  (Cereal price increases are largely driven by the increased costs of oil coupled with increases in demand as China and much of Africa urbanizes and the new middle class begins to eat cereals rather than greens and root vegetables.)  Again, this too will drive a restraint in spending by most global consumers, but not all.

We see these effects directly in the fortunes of companies serving the higher end of the economic spectrum.  Luxury goods makers are reporting strong earnings and gaining high stock valuations.

  • Hermes International SA, maker of men’s fashion, reported 10% increase in sales between April and June in the Americas.
  • Compagnie Financier Richemont SA, maker of Cartier and Montblanc, reported 6% sales increase in the Americas for the same period.
  • Burberry Group PLC’s sales in the Americas climbed 27%.
  • Patek Phillepe SA, maker of luxury watches, is on track to sell out its entire inventory.

Similar corporate buoyancy is reported in Europe and in fast-growing emerging markets where the ranks of the newly rich are growing.

Even manufacturers of somewhat tangible goods for the masses are making moves to capture the upper end of the market.  For instance, Nokia unveiled two high-end mobile phones, the N79 and N85, although this may also be mostly fueled by the desire to directly compete with Apple’s iPhone.

All of these price actions by luxury goods makers are directly related to the new or sustained riches of the rich.  But for firms serving the common consumer, where most of the economic adjustments come in the form of pain, price changes are far more challenging.

Driving Price Increases to Match Cost Increases

Consumer goods manufacturers focusing on the masses have had to face the prospect of pushing through price increases that match cost increases related to commodity prices and energy costs.  Here we see that companies with strong brands and serving middle income consumers have been able to weather the fluctuations in the economic environment far better than those with weaker brands.

On the positive side, we find:

  • Hersey Co. increased prices on chocolate bars 13% in January and second quarter revenue increased to $1.11 billion aided by the price increase as well as growth.  Concurrent to the price increase, Hershey increased promotional spending.
  • Kraft executed a 7% increase in prices with only a 1% volume decrease, posting a 3.5% net income increase for the second quarter, partly due to the price increase and expansion.
  • Wrigley’s second quarter net increased by 14%, attributed to higher North American prices despite 5% lower volumes, and also favorable foreign exchange rates on international sales.

Not all price increases were direct.  Some came from reducing the product size or otherwise cutting corners in terms of the value of the product.

  • General Mills Inc.’s Cheerios price increased to $2.98 from $2.86 while the product size decreasing from 10 oz to 8.9 oz.
  • Hershey Co. is substituting vegetable oil for a portion of the cocoa butter in some of its chocolates.
  • McCormick & Co. is supplying food companies with cheaper spices and new flavor bends.
  • General Mills is reducing the number of spice and ingredient pouches in boxes of Hamburger Helper.

Other firms, specifically companies with weaker brands or those dealing in meat where costs have increased from the increasing costs of grains and feed, have not been so fortunate.

  • Sara Lee has weathered the recent commodity costs increases poorer than its rivals with a profit margin of only 7.7% in the recent quarter, after executing 4 price increases.  Compared to 17.5% for General Mills Inc. and 15.5% for Heinz, this is partly due to holding a weaker brand position.
  • Tyson hasn’t yet been able to pass on the high chicken feed costs to consumers, resulting in a plunging net income of only $9 million.   CEO Dick Bond anticipates price increases on the horizon.
  • CEO Clint Rivers of Pilgrim’s Pride encourages Americans to “brace themselves for sticker shock in the meat case over the next 12 months” as he prepares for price increases on chicken.  (Read:  concurrent price signaling.)

Outside of the food industry, many firms have seen stagnant prices with declining volumes.   For instance, Barnes & Noble Inc. reported sliding sales of 1.6% over the year prior. This outcome and others like it can largely be attributed to declining disposable incomes as consumers focus on getting to work and buying food rather than improving their homes and taking care of creature comforts.

Business Marketers Are Also Affected

The price changes expand beyond the consumer market area.  Manufacturers of equipment and supplies that serve the farms that make the food are also seeing a healthy market.  Farmers, reaping windfall profits from a global increase in cereal consumption and a misguided corn to ethanol policy, have recently found their pockets lined and are prepared to make new investments.  Companies serving these farmers are capturing this demand and enjoying the profits.

  • Genetically modified seed maker Monsanto Co., fertilizer maker Mosaic Co., and farm equipment maker Deere & Co., are all seeing rising sales and climbing stock values.
  • Deere & Co. in particular anticipates further price rises for 2009 of 7% on tractors, 9% to 10.5% on combines, and 4% to 9% on construction and forestry equipment, while its customers, farmers, enjoy a two-year grain-price rally.

Strategic Marketing Issue

What are all of these price changes telling us?  Much.

First, the moves by luxury goods makers and companies supplying farmers highlight the fact that pricing power is strongly affected by the economic situation of the target market.  Unfortunately, the economic situation of a target market fluctuates constantly and somewhat unpredictably.  Thus, pricing power and volume are strongly influenced by chance.  Being in the right place at the right time enables some companies to “outperform” while others linger on.  (As one mentor told me, being in the game is half of winning.)  Making the most of these opportunities is the key management challenge for these fortunate firms.

Second, the moves by consumer food makers demonstrate that pricing power is correlated in an economically significant manner with differentiation and branding.  Firms with stronger brand and more differentiated products have fared the current economic turbulence far better than those in weaker positions.  Unfortunately, true differentiation requires investment in uncovering non-obvious customer needs and developing new products that meet those needs.  Furthermore, branding isn’t a one-shot effort.  It takes time.  Sara Lee investors hopefully understand this and CEO Brenda Barnes needs to take further action on this front.

And third, companies in industries that fail to respond to costs increases with price increases suffer.  Both Pilgrims Pride and Tyson need to further communicate the need to raise prices and then back it up with execution.  Time is not on their side, action will be.

For the pricer, these facts indicate that current price moves must be done with respect to the entire marketing mix.  Not just external factors such as industry health, economic changes, and competitive moves, but also strategic issues under the companies control such as promotion, distribution, and product quality.

Prices are in flux.  Many will fail to make the transition and show their ability to only execute against managerial dictates and no-longer-relevant historic patterns.  But the best of us will create new solutions based upon sound strategic thinking and will continue improving with the new opportunities that change brings.

References

  • Jargon, Julie, “Hershey Posts Higher Profit as Costs Rise”, Wall Street Journal, July 24, 2008, p. B10.
  • Drucker, Jesse, “Richest Americans See Their Income Share Grow”, Wall Street Journal, July 23, 2008, p. A3.
  • Jargon, Julie, “High Costs Put Sara Lee CEO in a Bind”, Wall Street Journal, July 23, 2008, p. B1.
  • Jargon, Julie, Lauren Etter, “Passing Along Rising Costs Lifts Kraft, Wrigley, Meat Glut Chops Tyson’s Earnings”, Wall Street Journal, July 29, 2008, p. B1.
  • Passariello, Christina, Rachel Dodes, “Luxury Goods Weathering Economic Woes in U.S.”, Wall Street Journal, July 26, 2008, p. A1.
  • Kilman, Scott, “Food Giants Race to Pass Rising Costs to Shoppers”, Wall Street Journal, August 8, 2008, p. A1.
  • Brat, Ilan, Doug Cameron, “Deere Net Gets Boost From Grain Rally”, Wall Street Journal, August 14, 2008, p. B4.
  • Kardos, Donna, Jeffrey A. Trachtenberg, “Barnes & Noble Profit Declines 15%”, Wall Street Journal, August 22, 2008, p. B5.
  • “Nokia Introduces High-End Cellphones”, Wall Street Journal, August 27, 2008, p. B11.
  • Jargon, Julie, “Food Makers Scrimp on Ingredients In an Effort to Fatten Their Profits”, Wall Street Journal, August 23, 2008, p. A1.


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About the author

Tim J. Smith, PhD is the Managing Principal of Wiglaf Pricing, and an Adjunct Professor at DePaul University of Marketing and Economics. His most recent book is Pricing Strategy: Setting Price Levels, Managing Price Discounts, & Establishing Price Structures.

Tim J. Smith, PhD
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