Scarcity Pricing: Why Discount When Supply Is Constrained?

I prefer soaps with no additives, scents or other assorted chemicals. Accordingly, I have purchased Tom’s of Maine natural soaps for almost 20 years after a dermatologist introduced me to this friend of sensitive of skin. The soap is a bit expensive and sometimes hard to find. So when I find a reliable source, I stick with it and buy in bulk. Unfortunately, Vitacost.com, my latest supplier, recently restricted orders to 3 bars of soap per person. I am not sure whether the company is suffering supply constraints as a result of the coronavirus pandemic, but I am mystified by the company’s approach to scarcity pricing. Despite the supply constraint, Vitacost discounts the price of this Tom’s of Maine soap.

I first emailed Vitacost for more information on the ordering policy. Customer service explained: “Unfortunately, due to the high demand of this product, we have placed a limit on how many you can order at once. This is in place so that every customer is able to enjoy the product.” The demand is relatively high because Vitacost cannot supply all the soap customers want. Still, this rationing policy surprises me. The soap is not a critical, life or death product. After my last order, I realized the company’s scarcity pricing is inconsistent with such high demand.

Vitacost warns customers about an order limit on this Tom's of Maine soap while at the same time discounting the price of the soap.
Vitacost warns customers about an order limit on this Tom’s of Maine soap while at the same time discounting the price of the soap.

I emailed Vitacost again for answers. Customer service responded with a non-answer:

“Thank you for contacting Vitacost.com. We appreciate your candid comments about the quantity limit and pricing of the Tom’s of Maine Sensitive Natural Beauty Bar Fragrance Free — 5 oz. . We are always looking for ways to improve your experience, which is why I’ve sent your comments to the appropriate department for further discussion.”

Companies should charge higher prices for high demand products. The price should increase until demand balances with supply. Vitacost should not discount the price. For example, the company could raise the price until the average order reaches around 3 bars of soap. Vitacost could even use those profits to motivate its supplier to invest in more capacity or divert supply from other retailers. (I would love to know whether the wholesaler is also under-pricing the soap!). So why does Vitacost apply a discount for its scarcity pricing?

Perhaps Vitacost uses this soap as a kind of “loss leader.” The reasonable cost keeps customers coming back to the site to shop for other products. Those other purchases should deliver more profits than Vitacost loses from the discounted scarcity pricing. However, the company risks losing single-product customers like me who are now hunting for alternative retailers. For example, I will pay retail price if I can get a lot more soap.

I prefer to buy in bulk both to make sure I have plenty of supply on hand and to reduce the per unit cost for shipping. Now, I pay $4.95 to ship just three bars of soap. This kind of ordering increases my costs. I pay more to ship each bar of soap. I also spend more of my time ordering soap. Moreover, the odds go up I will experience the frustration of running out of soap at exactly the wrong time.

Plenty of room left in this box for more Tom's of Maine Soap!
Plenty of room left in this box for more Tom’s of Maine Soap!

Can you think of any other (rational) reasons that explain Vitacost’s discounted pricing on a highly popular product? I would love to hear about it!

Grocery Pricing: When A Sale Is Not A Sale

The topic of pricing is one of my favorite on this blog. Over the years, I have developed a keen sense of pricing dynamics. So when I find (apparent) pricing anomalies, I feel compelled to talk about and explain them.

I made a quick 2019 New Year’s Eve run to Target and decided to take a quick trip through the grocery aisle for some breakfast options. My eyes soon landed on an old favorite, Corn Chex from General Mills. The cereal was one of the few sales Target offered at the time. Almost without a thought I reached for the 12-ounce box which was attractively priced at $2.50, a whole $1.49 lower. The 37% discount looked like a steal!

However, me eyes drifted to the even bigger 18-ounce family size Corn Chex, and I got distracted by a decision. At $3.79 a box, this jumbo-sized offering surprisingly cost 20 cents less than the regular price of the 12-ounce box! The 18-ounce box cost 21 cents/ounce. At the sales price, the 12-ounce box also cost 21 cents/ounce. Suddenly, Target’s sale did not seem so attractive. Since I love Corn Chex, I put the smaller box down and put the bigger box in my shopping cart. If I am paying the same effective price, I do not need the sale.

So what gives? Most likely, Target charges slightly more for the smaller box to encourage consumers to buy the bigger box of cereal. Surely the decision is easy for large families with a lot of corn Chex eaters. The only people who would pay 20 cents more for 6 ounces less of cereal are people who have no room in the pantry for the bigger box. Consumers who are solely focused on quantity over price might also pay more for less. Either way, Target makes a sizable margin on those sales. When customers purchase enough of the bigger box, Target uses the appearance of a sale to push the smaller box out the door. Target “anchored” consumers to the $3.99 price point for the 12-ounce box, so $2.50 looks like an incredible deal. With the “sale”, the only people who will buy the bigger box are people like me who truly want to eat a LOT of Corn Chex.

Retail stores use regular prices to anchor their customer’s measurement of value. Anyone who shops regularly at Target looks at the Corn Chex sale and sees a fantastic bargain. Target just sees the end of their opportunity to gain out-sized profits from people who are not paying attention.

The lesson? Pay attention to your price per unit of measure and decide accordingly! Sometimes a sale is not really a sale…sometimes a sale is just the end of a non-bargain.

Target's sale on the 12-ounce box of Corn Chex just brought the price per ounce in-line with the 18-ounce box of corn Chex.
Target’s sale on the 12-ounce box of Corn Chex just brought the price per ounce in-line with the 18-ounce box of corn Chex.

Jeff Bezos and More: In Defense of the Value of Valedictorians

Jeff Bezos is one of the most successful valedictorians in American history.
Jeff Bezos is one of the most successful valedictorians in American history.

Source: Steve Jurvetson – Flickr: Bezos’ Iconic Laugh, CC BY 2.0

Jeff Bezos is known as the founder and CEO of Amazon.com (AMZN). The stock for his company is toying with the $1000 level for the first time ever and is close to pushing Bezos past Bill Gates as the world’s richest man.

Amazon.com (AMZN) trades near an all-time high as it flirts with a historic $1000 level.
Amazon.com (AMZN) trades near an all-time high as it flirts with a historic $1000 level.

Source: FreeStockCharts.com

As of May 25, 2017, Bezos had an estimated $82.8B net worth. Bezos also graduated from Miami Palmetto High School as his class’s valedictorian. You would never believe this combination of information after reading headlines like this recent one from CNBC: “This is why class valedictorians don’t become millionaires.”

In this article, CNBC interviewed Eric Barker, author of the recently released book “Barking Up the Wrong Tree: The Surprising Science Behind Why Everything You Know About Success Is (Mostly) Wrong.” Barker made the following strong claim:

“[Valedictorians] do well…but they don’t actually become billionaires or the people who change the world.”

Given the fame, fortune, and impact of Bezos, I wondered how could Barker make such a strident claim with no qualification and how the claim could be accepted with no critical review (CNBC was far from alone). I decided to do a quick internet search. In the top results, I discovered several sites which list famous, impactful, and even very rich people who were the valedictorians of their respective high school classes. I provide the list, edited by own cross-referencing, at the end of this post. This list is far from comprehensive. Given the readily available information, I have to assume that Barker started with a theory or hypothesis and focused on confirming data. It seems he mainly relied on the work of one researcher from Boston College, Karen Arnold. Again from the CNBC article:

“[Barker’s] assessments are based on research by Karen Arnold, a professor at Boston College and the author of ‘Lives of Promise: What Becomes of High School Valedictorians: A Fourteen-year Study of Achievement and Life Choices.’ She tracked 81 high school valedictorians and salutatorians after graduation…

…’Valedictorians aren’t likely to be the future’s visionaries,’ says Arnold. ‘They typically settle into the system instead of shaking it up.'”

I put aside the technicality that Arnold included salutatorians in her study and not just valedictorians. Instead, I was left unclear about the implicit relationship Barker drew between “billionaire” and “visionary” when Arnold did not appear to do so in her research. As far as I can tell from some references to Arnold’s 1995 book which followed graduates from the class of 1981, Arnold did not create monetary quantifications of success. However, I can definitely understand why someone with a money-based view of success would make the connection. Indeed, the hurdle Barker offers up as a definition of success is extremely high. The CNBC article produced this related quote from Barker’s book:

“There was little debate that high school success predicted college success. Nearly 90 percent are now in professional careers with 40 percent in the highest tier jobs. They are reliable, consistent and well-adjusted, and by all measures the majority have good lives.

But how many of these number-one high school performers go on to change the world, run the world or impress the world?

The answer seems to be clear: zero.”

Zero impact. Nada. Not Jeff Bezos. Not Conan O’Brien. Not Sonia Sotomayor. Not W.E.B. Du Bois. And do not dare include General Douglas MacArthur. (See the end of this post for descriptions of these and other notable high school valedictorians).

Barker’s mistake was not just an over-reliance on a single, very old study. Barker also over-extrapolates and fails to consider the frame of reference for these strong claims that box valedictorians into a corner of inconsequence. (Ironically enough, Bezos seems to have graduated in 1982, one year after Arnold kicked off her study). Arnold’s sample is extremely small; the sample is too small to reliably test for the kinds of rarefied achievers that Barker highlights.

First of all, there are currently at least 22,000 high schools in the U.S. My estimate comes from the number of high schools referenced by the rankings of the U.S. News and World Report. So the U.S. presumably produces at least 22,000 valedictorians a year. For the sake of argument, I will reduce that number to 20,000 valedictorians in 1981. Arnold’s research subjects are 0.4% of the population for a given year and with each passing year, the numbers of valedictorians quickly overwhelm her longitudinal snapshot. If Arnold’s research were a survey, her results would include a whopping (minimum) margin of error of 11% for the class of 1981 assuming her sample was randomly selected (without bias). In other words, if the conclusion from this one study is that 0% of valedictorians grow up to be “world changers”, we could assume that repeating this study multiple times would generate observations of roughly as many as 11% (or 9) valedictorians of consequence in each trial.

Quantifying “world changing” is not easy, so it makes sense that Barker used the short-hand of billionaires. Yet, billionaires are like needles in a haystack. There are so few billionaires that in 2016, Forbes was easily able to list all 540 of them…and this is across DECADES of high school classes, not just one. I would love for someone to categorize this list by academic achievements and class years. Anyway, according to the Census Bureau estimate for 2016, the adult population of the U.S. was about 249,485,228. So the rate of billionaires in the adult population in general is 0.0002%. Using a sample size calculator, I find that I need 1,920,726 adults to conclude that my study group produces zero billionaires with 95% confidence.

The hurdle for millionaires matches Arnold’s sample. CNBC reported earlier this year that there are 10.8M millionaires in the U.S. That amount produces an incidence rate of 4.3% in the adult population (for the sake of simplicity, I am assuming all these millionaires are adults). The sample size calculator produces a study group size of 85. Yet, the only mentions of millionaires in the CNBC article are in the title and in a reference to a different study. I quote Barker’s use of this study from an article Barker wrote in Time’s Money to promote the book with the hyperbolic title “Wondering What Happened to Your Class Valedictorian? Not Much, Research Shows“:

“School has clear rules. Life often doesn’t. When there’s no clear path to follow, academic high achievers break down. Shawn Achor’s research at Harvard shows that college grades aren’t any more predictive of subsequent life success than rolling dice. A study of over seven hundred American millionaires showed their average college GPA was 2.9.”

Barker again produced surprisingly strong conclusions based on a single result. Yet, this single result, a GPA of 2.9, is actually pretty good: just a small fraction below a B grade. Assuming that 2.0, a C grade, is average, this study showed that millionaires are above average academic achievers in college (putting aside grade inflation!), hardly a roll of the dice. I am willing to bet that the top academicians are partially responsible for pushing that study’s results above a 2.0 average.

A quick internet search helped me turn up another study of millionaires and their academic achievement. In 2016, Bloomberg reported on the work of economists at the Federal Reserve Bank of St. Louis who used data from the Federal Reserve’s Survey of Consumer Finances for 2010 and 2013:

“According to the sample, a black person’s odds of being a millionaire increase from less than 1 percent if he or she doesn’t complete high school to 6.7 percent with a graduate degree. White Americans without a high school diploma start out with slightly better chances—1.7 percent—that rapidly improve with more school: A graduate-level education increases their probability of amassing a net worth greater than $1 million to 37 percent.”

These differences are significant. Since it typically takes above average academic performance to get admitted to graduate school, THESE results seem to suggest that academic performance in college does matter in one’s drive to millionaire status. However, academics are obviously not the ONLY path to success.

The fact that there are multiple paths to success and riches tripped up “Rich Dad Poor Dad” author Robert Kiyosaki when he leveraged Arnold’s results to come to even stronger conclusions about success than Barker did. Back in 2013, Kiyosaki really slammed valedictorians when he wrote “Why Valedictorians Fail“:

“Professor Arnold discovered that, ‘while these students had the attributes to ensure school success, these characteristics did not necessarily translate into real-world success…. To know that a person is a valedictorian is only to know that he or she is exceedingly good at achievement as measured by grades. It tells you nothing about how they react to the vicissitudes of life.’

Translation: real life is not measured by grades but by your bank statement—and they don’t teach that in school.”

Kiyosaki has an even clearer money-based definition of success than Barker; if you are not rich, you have failed in life. Kiyosaki also slams valedictorians for being too timid: “Valedictorians don’t make good entrepreneurs and investors because they’re afraid of risk. They make great employees.” Poor Bezos!

Kiyosaki’s effort to portray valedictorians as failures buries the valuable message of resilience, boldness, and adaptability.

“The message is simple: Success in the classroom does not ensure success in the real world. The world of the future belongs to those who can embrace change, see the future and anticipate its needs, and respond to new opportunities and challenges with creativity and agility and passion.”

I would respond that academic success also does not exclude you from being the kind of wealthy success that Kiyosaki elevates. The list of valedictorians at the end of this post validate my claim.

After all this belittling of academic brilliance, I found humorous irony in a piece that featured Arnold defending the distinction of valedictorian as a way to honor academic achievement (emphasis mine):

“…being valedictorian is the one academic honor that does matter to students. We understand that athletes and performers merit special honors because their achievements represent hard work, focus, and motivation. So why shy away from awarding honors to students who succeed in academics?

…In 1995, I co-authored a book on what becomes of valedictorians later in life. We studied 17 years of data and determined that valedictorians become hardworking, productive adults whose educational and career achievements remain outstanding.”

Arnold is clearly not one to devalue valedictorians in the ways that Barker and Kiyosaki do. I daresay that Arnold’s main point was to build character profiles of top academic achievers and not to establish a hard and fixed ceiling of life achievement for these people. I further claim that using research in isolation, without considering a full context of data and analysis, and/or failing to review multiple possibilities leaves us vulnerable to confirmation bias and weakens our ability to lean against counter-arguments.

So overall, I say “GO!” to all of you star academicians who wish to walk in the footsteps of Bezos and so many other extremely successful people!

A LIST OF FAMOUS HIGH SCHOOL VALEDICTORIANS – a healthy mix of successful, impactful, non-conformist, and even wealthy academic achievers

(List compiled from ranker.com and Newsday with cross-checking from Wikipedia and Biography.com. High school names and graduation years were not available for all personalities.)

  • Jeff Bezos: founder, CEO, and Chairman of Amazon.com – Miami Palmetto High School, 1982 (?).
  • Douglas MacArthur – general known for World War II battles: West Texas Military Academy.
  • W.E.B. Du Bois – sociologist, historian, civil rights activist, Pan-Africanist, author, writer and editor, first African-American to earn a Ph.D. from Harvard: “an all-White high school in Massachusetts” late 19th century.
  • Sonia Sotomayor – U.S. Supreme Court Justice: Cardinal Spellman High School in the Bronx, 1972.
  • Coretta Scott King – civil rights activist (wife of civil rights leader Martin Luther King, Jr.): Lincoln Normal School, 1945.
  • Conan O’Brien – comedian, last night talk show host: Brookline High School, 1981.
  • Weird Al Yankovic – music artist specializing in parodies: Lynwood High School.
  • Kevin Spacey – actor: Chatsworth High School in Chatsworth, California, 1977 (co-valedictorian).
  • Mare Winningham – actress: Chatsworth High School in Chatsworth, California, 1977 (co-valedictorian).
  • Cole Porter – music composer: Worcester Academy in Massachusetts, early 20th century.
  • Jodie Foster – actress: the Lycée Français de Los Angeles, a French-language prep school, 1980.
  • David Duchovny – actor (made famous by the X-Files): the Collegiate School in Manhattan.
  • Chevy Chase – comedian, actor: Stockbridge School.
  • Cindy Crawford – model: DeKalb High School, 1984.
  • Bette Midler – actress, singer: Radford High School.
  • Alicia Keys – singer: Professional Performing Arts School.
  • Johnny Bench – major league baseball player: Binger-Oney High School in Binger, Oklahoma
  • Tiffani Thiessen – actress: Valley Professional High School in Studio City, Los Angeles, 1992.
  • Emmylou Harris – singer and musician: Gar-Field Senior High School.
  • Harry Anderson – actor: Buena Park High School then North Hollywood High School, 1970.
  • William Peter Blatty – author (wrote the Exorcist): Brooklyn Preparatory, a Jesuit school, 1946.
  • Troian Bellisario – actress: Campbell Hall School in North Hollywood, California.

{Addendum: title changed and small corrections made on June 5, 2017}

I’ll Have Another Order of the Escalade, Please

My wife recently relayed to me an odd story told to her by a car rental agent. This agent told my wife about a woman who for months has rented the same Escalade over and over, renewing her rental agreement for a few weeks at a time. Escalades are considered premium/luxury rentals, so the bill has mounted quite rapidly. At this point, she could have easily taken all that money she spent and bought herself a new, albeit modest, car.

The question is why is she “wasting” so much money?

Given my past training in economics, I could not accept that this woman (let’s call her “Elaine”) is behaving irrationally – I searched the deepest corners of economic logic to explain Elaine’s behavior. One saving grace is that she has not spent so much that she could have purchased an Escalade outright. This condition allows me to create two key assumptions (every economic theory needs convenient, simplifying assumptions):

  1. Elaine’s, uh, business cannot be conducted without an Escalade. The style, the comfort, etc… is an absolute necessity to demonstrate to her customers that she is one of them, rich and powerful and ready to deal.
  2. Elaine’s business is very uncertain. She lives from deal to deal. She works hard to close every deal, but she cannot afford to count her chickens more than a few weeks out. (Maybe she sells real estate to high-end clientele?!?)

These rationalizations mean that Elaine cannot risk committing to a $60,000+ purchase or even a less expensive lease, but each deal earns her enough to generate the $500-1000/week it costs to rent the Escalade she requires for her business. When she closes another substantial deal, she happily skips to the rental car agency to ask for another extension.

So is there a point at which Elaine is better off purchasing the Escalade? Not at all. As long as she is never “sure enough” about a $60,000+ income stream, she is better off buying what she can afford and still conduct her business. (Not to mention few banks, if any, especially these days, would even consider loaning money to Elaine for buying the car or for funding the business given the looming uncertainties!) At some point, she may save enough money to buy the Escalade outright, but it is also possible she has other expenses that prevent her from saving enough Escalade-money.

In other words, Elaine may be doing what so many people do NOT do – buying what she can afford now and not burdening herself with debt she can only aspire to afford.

This parable reminds me of something Nassim Taleb – the famous author of “The Black Swan: The Impact of the Highly Improbable” – said about confidence and debt:

“…overconfidence translates 1-1 into accumulation of debt…I know I’m going to make an 8% return, and if I underestimate my error rate I will know with certainty I’m going to make an 8% return, so if I borrow at 5% I can leverage up the wazoo. (“Taleb on Black Swans, Fragility, and Mistakes“, interview with Russ Roberts on EconTalk, May 3, 2010).

Go Elaine! And happy deal-making!


A Cadillac Escalade
A Cadillac Escalade

Amazon’s e-Book Pricing Problem

I intended to write a detailed examination of Amazon’s pricing problem with e-books. However after doing just a little research, I found there are plenty of people who have already provided excellent opinions and recommendations. So, instead of providing my classic unsolicited advice, I am posting links to the two most insightful pieces I found in addition to a general news story if you just want an overview on current events.

General news
ChannelWeb: “Amazon Gives In To Publisher’s Demands For Higher E-Book Prices”
BusinessWeek: “Amazon’s E-Book Price Reversal: A Mixed Blessing” – considers the impact of pricing on demand for e-readers and e-books.

Opinion
The Big Money (Marion Maneker): “Amazon’s Self-Defeating War on Publishers”
Tobias Buckell: “Why my books are no longer for sale via Amazon”

Maneker recognizes that sales of e-books will inevitably dominate sales of physical books and recommends the following:

“There is…a compromise that might benefit all parties. Amazon has been pushing the Kindle to heavy users of frontlist books. But the agency terms offer an opportunity for backlist books that gives everybody a win. With the agency model, a backlist book becomes a goldmine for publishers, authors, Amazon and Apple. Priced at $9.99, the publisher receives pretty much the same amount of money under agency terms as it would have for the wholesale book. Still protecting their preferred terms for electronic books, the publishers could maintain their 20-25% of net receipts formula for author royalties because the author would be getting more money ($1.75 vs. $1.05 in paperback royalties on a $13.95 physical paperback). Leaving the publisher with $5.25 in margin, more than they’d get from the physical paperback. When you include the savings in paper, printing and binding, freight and warehousing, the margin jumps even more.

This detente would flood the book market with titles that have stood the test of time where demand remains strong–a good incentive for Kindle and iPad buyers–while protecting the physical book distribution business. It would also buy publishers some time to divest the distribution assets that will inevitably erode as e-book selling takes off.”

Buckell write an extremely long piece, but it is worth the read given it comes from a concerned author. He laments that Amazon is attempting to abuse its market power to fix prices and thwart publishers’ ability to implement dynamic pricing. Buckell also describes process of making books in extraordinary detail. He explains his interest in writing this piece in personal terms:

“I’m not trying to exhort anyone to do anything, but to explain the situation I’m in, and to educate. I’m seeing a lot of people state things with certainty (points I try to knock down above) who have no involvement in the trade.

A lot of readers are going to take this out on authors, and I wanted to basically show my homework to explain things that people may not be aware of. People toss out prices of what eBooks ‘should be’ who’ve never even stopped to understand how the math of something like this works. They demand things they’d never demand of a jacket salesman, just because they think economics and supply and demand and volume don’t apply to eBooks. They do.

Seriously. I’ve thought about these things a lot. Mostly because I have a novel series that has not been renewed, and I keep running the numbers to see if I could write it as an eBook, and when I run these numbers, I come up looking at making a few thousand dollars for half a year’s worth of work based on how eBook sell now. Yes, there are a few J.A. Konrath’s selling well on Amazon, but as I’ve linked, other authors aren’t automagically selling thousands of eBooks there. Most who follow these footsteps sell hundreds. Not everyone becomes JK Rowling.”

The last point reminds me of Nassim Taleb’s “The Roots of Unfairness: the Black Swan in Arts and Literature“. Taleb notes that artists and writers work in a field where a few successful people take the majority of the rewards in the industry. He attributes this situation to largely unrecognized random events (luck!) that are highly improbably but have large impact (“Black Swans”). Moreover, he observes:

“The occurrence of the Winner-Take-All effect in any form of intellectual production has been accelerating along with the speed of reproduction and communications.”

So, ironically, e-books will continue the democratization of publishing and reading (through convenience, easy access, and low costs), but the percentage of winners may narrow further even while providing those winners more wealth than ever.

Burger King Broiling: Struggling with Global Vs. Local Profit Optimization

On the same day that BusinessWeek lauded Subway for the success of its discount $5 footlong sandwiches, the National Franchise Association (NFA) sued Burger King Corporation over the legality of requiring franchisees to charge no more than $1 for the Double Cheeseburger. The Subway success story features a pricing strategy built from the bottom where the initiative and innovation of a single franchise owner led the way. The local profit optimization of the franchisees directly support the global profit optimization for Subway as a whole. The unfolding drama at Burger King features a pricing strategy commanded from the top against the expressed desires of the majority of franchisees. The global profit optimization that has convinced management to plow ahead appears to violate the local profit optimization of the majority of franchisees. The dispute has now devolved into a lawsuit filed in the U.S. District Court Southern District of Florida on November 10, 2009. The class action complaint starts with the following introduction:

“This action arises out of a dispute between NFA, on behalf of all owners of franchised Burger King restaurants in the United States (the Franchisees), and Burger King Corporation (BKC) concerning BKC’s actions in compelling the Franchisees to sell a food product known as the BK Double Cheese Burger (DCB) at no more than the maximum price of $1.00, and BKC’s claim that it has the legal right to dictate price points under the respective Franchise Agreements (the Franchise Agreements) previously entered into with the Franchisees – even if those prices are below the Franchisees’ cost and cause them to incur a loss on sale of the product.”

The core of the complaint is as follows:

“The provision of the Franchise Agreement at issue is Section 5, addressing ‘Standards of Uniformity of Operation.’ It provides that ‘BKC shall establish, and cause approved suppliers to the BKC System to reasonably comply with, product, service and equipment specifications.’

While these provisions address standards of uniformity for various operational issues, including menu items, hours, and uniforms, nothing states that BKC has the right to impose mandatory price points for product sold by the Franchisees. The dispute between the parties is triggered by the position recently taken by BKC, contrary to decades of practice, that the general language of Section 5 gives it the power to set prices for its independently owned franchises…Since at least the 1960’s (if not back to the beginning of the BKC franchise system itself), BKC never attempted to unilaterally impose or require a price point for products sold by Franchisees, and did not take the position it had the right to do so under the Franchise Agreements.

After the formation of [the NFA] and a Marketing Advisory Committee in 1989 and shortly thereafter, BKC did not attempt to set, much less enforce, mandatory price points for its franchisees without the agreement of a supermajority of the franchisees.”

Burger King has responded that “the litigation is ‘without merit,’ particularly after an earlier appeals court ruling this year showing the company had a right to require franchise owners to participate in its value menu promotions.”

The legal issues will likely get resolved by determining which contracts are legally binding and what are the conditions for enforcement. I am much more concerned with the strategic and economic issues.

The price cut on the DCB is dramatic; the drop from $2 to $1 positions the DCB below McDonald’s DCB priced at $1.19. The gross margin loss of -10% is significant; the DCB costs on average $1.10 to make. The complaint notes that no other item on the BKC value menu loses money. Based on this loss, franchisees rejected the first proposal in 2008 and rejected it twice by vote this year.

In “$1 deal may boost profits,” the Miami Herald describes an analysis generated by a franchisee that concludes that the $1 DCB is a money-loser:

“…financial models run by one Illinois franchisee and circulated among franchisees across the country suggest that [the $1 DCB] won’t drive enough sales to offset the margin pressure. The franchisee models suggest that the bottom line impact for restaurants would be a loss of between $489 and $930 depending on the percentage of total sales generated by the value menu.”

However, management has its own analysis (and assumptions) showing the $1 DCB is a winner. Again, from the Miami Herald:

“Based on numbers Burger King provided to franchisees, the company projects that the double cheeseburger will lead to a 5-percent increase in restaurant sales. That will translate into an increased bottom line profit of $365 per restaurant based on $105,000 in sales, according to the analysis.”

How could the franchisees and management come to completely different conclusions on the merits of this pricing strategy? Soda and fries make the difference. Soda and fries are higher-margin items. If the cheap DCBs generate extra sales traffic that buys soda and fries, then it is possible to make up the loss in profit from the DCB. In fact, BKC management is relying exactly on this dynamic. The McClatchy-Tribune reported on Nov 13, 2009:

“During an 18-month test, the $1 double cheeseburger had a negative impact on gross profit margin, Burger King said, but restaurants increased gross profit because consumers added high profit items like sodas and fries.”

In “Burger King’s battle cry: $1 burger,” the Chicago Tribune reports how the local optimization can invalidate the attractiveness of a mandatory $1 DCB promotion:

“John McNelis, president of the real estate division of Mirabile Investment Corp., owner of more than 40 Burger Kings in the Memphis, Tenn., area [states]: “…in some price-sensitive markets, you are just selling a bunch of double cheeseburgers…”

The cheap DCB pricing strategy works if soda and fries are “complementary products” to the DCB. However, if these products are truly complementary, then the more profitable pricing strategy is to make sure that DCB-buyers purchase soda and/or fries by bundling the products into one offering. In other words, customers can only buy the DCB for $1 if they also buy soda and/or fries for a price that generates a profit for the entire bundle. Without this bundle, BKC is using a loss-leader strategy in the hopes that the extra foot traffic will behave in a profitable way.

I suspect that BKC is not bundling the $1 DCB with soda and fries because the bundle would work counter to its efforts to attract increasingly price sensitive customers (high demand elasticity) and would obscure its price positioning versus McDonald’s. Putting the reported analyses aside, I suspect that when BKC runs its global optimization, it finds that it has enough markets with customers who will buy the bundle on its own merits. Absent profits, BKC could still justify the program based on customer retention in the hopes that customers stay loyal to the brand even after the money-losing promotion ends (a much shakier proposition in the highly competitive fast-food category). The franchisees run a series of local optimizations and find too many individual franchisees who lose money to make the program worthwhile as a mandatory offering. Apparently, there are enough of these profit-losing franchises to motivate the lawsuit (according to the class action complaint, about 75% of franchisees belong to the NFA). Indeed, the diversity of markets explains why most discount promotions amongst franchises include the caveat “at participating locations only.” The local optimization typically dominates the global optimization.

Burger King’s August 25th conference call to discuss fiscal fourth quarter 2009 earnings provides additional clues into management’s rationale for implementing a mandatory $1 price point for the DCB (quotes from the transcript provided by Seeking Alpha).

Management describes how it used controlled experiments to measure the potential success of a $1 DCB:

“…we have probably now well over 40 markets in the country that are on $1 Double Cheeseburger and we’ve actually seen a pretty steady check performance…And we’ve really been pleased with what our plans were for check dilution versus what’s really happening in those markets.

…there’s no question that the $1 Double Cheeseburger through its adoption in increasing amounts of markets in the U.S. has helped to improve traffic. So we have seen month-to-month-to-month improvements, a narrowing if you will on our traffic losses nationally and we have certainly seen the markets that have adopted the $1 Double Cheeseburger move into some very strong performance as it relates to traffic.”

Burger King management is eager to reduce losses in traffic. It is probably no surprise to anyone that discounting a burger by 50% will drive increased traffic. There is no indication here that the promotion is actually making money, only that it is losing less money than expected.

Again:

“…we modeled for some GPM [gross profit margin] dilution in the business case for $1 Double Cheeseburger but so far all the test markets have been outperforming in terms of GPM dilution. In other words it has not been as deep as we originally thought. What you really kind of see happening is the effect of this discounting is sort of offsetting the price increases that we’ve taken in the past which would kind of cause for the level check if you will that you’re seeing.”

There is no explanation here that sales of sodas and fries are specifically making up for the profit loss on DCBs. Instead, it seems that price increases on a variety menu items have given BKC the extra cushion it needs to justify using the DCB as a loss-leader. Management does not provide details on these price increases, but, in general, they seem odd given the existing competitive environment and sluggish economy. All together, it seems that traffic is the prime motivator for the promotion – with the assumption that short-term profit-losses will somehow give way to longer-term profit gains.

Finally, it seems competitive pressures are forcing Burger King to take extreme measures:

“…we have to be aggressive on value for the money. There’s no way you can turn on a television set and look at any retail brand in any space and not hear language that talks about price points and value. And we’re no different. Now our value for the money equation also includes talking about a superior tasting product with flame-fresh taste. It includes featuring our superior size versus McDonald’s on our Double Cheeseburger. And yes it’ll continue to pound on the $1 access.”

In the end, BKC’s global optimization is apparently not convincing enough for the franchisees who are presumably more concerned with their individual local optimizations. Certainly, the NFA should not have filed its class action complaint if BKC’s market tests demonstrated comprehensive profit gains from a preponderance of successful local optimizations. A global optimization that delivers average profit gains across the system is insufficient to justify a franchise-wide, mandatory pricing strategy. If this averaging is indeed the true source of the conflict, it is akin to averaging the net worth of Bill Gates and your home town and concluding that your home town would be filled with millionaires if Mr. Gates moved in.

This lawsuit will be fascinating to follow as it could provide additional insights and clarity into BKC’s pricing strategy and the actual data used to justify it.

Analytic Lessons from Subway’s $5 Footlong Promotion

Subway’s $5 footlong promotion has become a nationwide hit. In “The Accidental Hero,” BusinessWeek writer Matthew Boyle describes how the promotion grew from just a few franchises in Florida to become a top-10 fast-food brand this year. The story demonstrates how a small, local idea can become a nationwide success. The story also powerfully displays some key analytic lessons on the application and use of demand elasticity and controlled experiments to improve business performance in a sustainable way.

Demand Elasticity
Subway’s $5 footlong promotion was so popular, so fast, that it caused inventory shortages throughout the company. This surge in sales volume generated more revenue AND profits starting with the pioneering franchise: “…food costs did rise as a percentage of sales, but that was offset by the overall boost in volume and the increased productivity of …employees, who had less down time. Even after adding two new staffers, [franchisee] Frankel made money on each $5 sandwich.”

In other words, the footlong sandwich used relatively more expensive food than the typical sandwich, but sales volumes increased the proportion of time employees spent making sandwiches versus standing idle. The biggest bonus likely came from the incremental demand created by the promotion. The new demand created by the promotion directly added to revenues and profits. The lower pricing brought new customers to stores and (presumably) encouraged existing customers to buy more sandwiches. Subway discovered that these sandwiches have very high demand elasticity (for reasons described in the article), meaning that the percentage increase in demand was very high relative to the percentage change in price. The menu of higher pricing had prevented Subway from tapping into a hidden reservoir of demand. (Note that food service consultant Dean Dirks speculates that Subway’s promotion is actually a money-loser).

Controlled Experiments
Subway managed to execute this powerful pricing concept without analyzing past transaction data. Instead, Subway used the more direct approach of controlled experimentation.

Controlled experimentation allows a business to try out an idea in a well-defined place and time. This setup facilitates convenient data collection and fast analysis of the data. If the idea works in the controlled setting, then expand the trial into a slightly larger controlled setting. Repeat the process until the recipe for success (or failure) appears sufficiently confirmed and understood.

In Subway’s case, the numbers spoke loud and clear. Profits and revenues soared for Frankel soon after launching the promotion at his two franchises in Miami. It ran for a year before it was tried at another Florida location, this time in Ft. Lauderdale: “On the first day of the promotion, the store nearly ran out of bread and meat. Sales doubled.” Next, the promotion expanded throughout South Florida and met more success. Despite this winning record, Subway’s franchisee marketing board still voted down a proposal to expand the promotion nationwide. Additional successes from “Washington to Chicago” finally convinced the board to approve nationwide expansion.

Key Lessons
The article does not count how many controlled experiments Subway has run in the past that began successfully and yet ended in failure. We also do not know how many “bad” ideas the board must endure at every meeting. (Many stories about success in business suffer from “survivorship bias” where only proven winners make it to the front page and the losers of the past are long forgotten). However, a key lesson in this story is that ideas for change are strengthened when backed by evidence and data. Subway was fortunate to own an infrastructure conducive to running and maintaining controlled experiments and fortunate to stumble upon an idea whose success was so undeniable. Even if your business is not similarly fortunate, applying the lessons of pricing to demand and of generating evidence through experimentation will certainly drive measurable improvement in your business.

No data = no impact

On Monday, the Atlanta-Journal Constitution reported that the state of Georgia is considering scrapping its annual sales tax holiday due to budget issues. One legislator expressed his support for the program by claiming: “‘It’s one of those things that spurs people to spend money that they may not otherwise spend. It goes directly to citizens and helps local businesses.'” Right after this quote, we learn, unfortunately, that “…Neither the state nor the Georgia Retail Association have a way to track results of the sales tax holiday.” In other words, lacking data, we could make an claim equally valid to the politician’s that all a tax holiday does is drain the state budget since consumers will simply plan their shopping around the given event.

Without data, we can have no impact. How can anyone really know whether or not a tax holiday not only works or is even worth its cost to the state budget? Certainly, everyone enjoys tax-free shopping, but the cost may outweigh the benefits if, for example, the state is not able to fund other important projects or increases taxes somewhere else to make up for the revenue gap.

These lessons apply in business as well as government. Without data to measure performance, business plans and strategies are subject to the whims of “gut instinct” or personal biases and subjectivity. One person’s success can easily be another person’s failure and power relationships may win the day instead of what actually improves profits.

How could the state of Georgia attack this problem? The first step is the collection of the retail data. This data needs to be daily so seasonal and cyclical patterns can be accounted for. The second step is to consider controlled experiments. For example, run the state holiday on different dates in different counties, skip a year, or change the dates around from year-to-year. In other words, establish a set of data than can be used as the control for comparison of performance. If the quantity of data or the number of stores present large obstacles, establish the data points for select stores that have an established record of sales in the local community. At this level, every effort should be made to track the specific items that consumers purchase as well.

I strongly suspect that if the state of Georgia applied some simple analysis to this program, the results will surprise them!