By September 9, 2009 13 Comments Read More →

Starbucks Pricing on Cost or Value??

Starbucks boosts prices on some beverages – USATODAY.com

There are no direct “lean” fingerprints on the news stories about Starbucks adjusting their prices, but let’s talk about it anyway.

One of Toyota’s contributions to the management world is the idea (actually born from basic economics) that the price charged to the customer should be set by the market.

Traditional management thinking starts with your production cost, including materials, labor, and overhead. This approach takes your cost and tacks on some desired profit margin, which is a sort of entitlement thinking. Let’s say the company feels entitled to a 50% margin. If your production cost for a good or service is $1, then you would set a price of $1.50.

If the market is willing to pay $1.50, then great. If most of the market only values the product at $1.25, they might go elsewhere and the company loses business. If this is a proprietary or monopoly product, the customer might be stuck in the short-term, but they’ll work to find alternatives, which isn’t good for the company in the long-term.

If a lot of the market is willing to actually pay $2, then the producing company is leaving money on the table, if they’re not charging as much as the market would bear.

The Toyota approach would be to take the market price, say $1.50, and then work backwards to get costs low enough to meet a profit target. This is also called “target costing.” If the market only wants to pay $1.25 and you want a 50% margin, then you had better work to get your production costs down to about 83 cents.

In the news article I linked to, Starbucks announced it is raising the prices of some “complex” drinks — a Frappucino seems pretty labor-intensive when you watch them being made. Starbucks is also lower the costs of basic drinks, like black coffee (my usual beverage).

Does it sound like Starbucks is basing its prices on the complexity (and therefore, labor cost) of its drinks? This doesn’t sound Lean to me.

I wonder if they are adjusting their prices to what they think the market will bear, but they’re really using the excuse (that most customers, ironically, accept as sounding reasonable) that they have “no choice” – as other companies sometimes say – because of the labor costs?

I recently had another example of the “rising costs” excuse. My home alarm monitoring company sent a letter that said “it is now necessary” to increase my fee by $2 because of “ongoing increases in operating costs.” Hmm. That’s not my problem that they can’t manage costs. One of those costs is the advertising budget for the TV ads proclaiming their new name and corporate identity.

A more honest letter, one that you’d never receive would say, “We are going to charge $2 more because we think the market will bear it. We expect that you will just absorb the price increase rather than cancel (endangering your family and home). We’re also guessing it’s not worth $24 a year for you to go through the effort to change service companies. And if we lose you, so be it, we are adding new customers thanks to our advertising.”

Maybe Starbucks *is* taking a market view, but they just can’t say so. Are black coffee drinkers inherently price sensitive (as part of their reason for not drinking lattes), so it makes sense to lower prices in a recession? And $4.50 Frappucino drinkers have self-identified as not being very price sensitive (or they’re not hurting personally), so increase their prices?

Maybe it’s perfectly economically rational, even if it’s being explained away as a “cost” issue?

 


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Mark Graban's passion is creating a better, safer, more cost effective healthcare system for patients and better workplaces for all. Mark is a consultant, author, and speaker in the "Lean healthcare" methodology. He is author of the Shingo Award-winning books Lean Hospitals and Healthcare Kaizen, as well as The Executive Guide to Healthcare Kaizen. His most recent project is an eBook titled Practicing Lean that benefits the Louise H. Batz Patient Safety Foundation, where Mark is a board member. Mark is also the VP of Improvement & Innovation Services for the technology company KaiNexus.

13 Comments on "Starbucks Pricing on Cost or Value??"

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  1. Rob says:

    Hmmm, dosen't sound overly lean to me. For me the process is fairly simple:

    1. Understand customer needs
    * Who is the customer?
    * Match customer needs to product features

    2. Understand customer value
    * Establish specifications to meet customers needs
    * QFD

    3. Develop taget costs
    * Value and features
    * Target costs for products

    4. Move continuously to attain customer value
    * Value vs. cost in the value stream
    * Match target costs to processes
    * Continuous improvement

    Did *$ follow this? Probably not.

  2. Jim Fernandez says:

    The concept of "target costing" brings up an interesting question. If you own one company in one location you simply discover what the market price is, and proceed accordingly.

    However, if you have many operations in many locations how would you discover the market price? Would you have a different price in every location? Would the price of a cup of coffee in Beverly Hills be different than in East Los Angeles? Does Toyota sell the same car for different prices in different cities?

  3. Mark Graban says:

    Interesting question, Jim.

    For cars, you probably have to price relatively the same everywhere or you run the risk of arbitrage entering the equation.

    I believe, pricing is often different based on the incentives offered in different states. So the "list price" is the same, but the real price might actually be different.

    Does Starbucks have consistent pricing across the country? I would guess so (except for special locations like airports). I bet the customer "outrage" from being charged a higher price for a latte in Beverly Hills and the bad P.R. would outweigh benefit of charging more in certain cities?

    While price discrimination is certainly rational from an economic standpoint, it's often misunderstand and unpopular. The word "discrimination" sounds bad of course.

    Senior discounts seem to be about the only socially acceptable "price discrimination", eh?

  4. Michael Balle says:

    Hey, lean guys – as the lean venerable ancestor said "open the window! It's a wide world out there" and… there is a world outside of lean. I suspect that what Starbuck is doing is price investigation. In many markets it's very hard to know what the "market price" is, so you experiment. The general theory is that customers have a zone of price insensitivity. If you're ready to pay $1,40, why not $1,60, why not $2 – at what point do you find it too expensive to get the starbucks experience (and, of course it all depends of your appreciation of the experience as well). What companies tend to do is price high rare and unusual products to see how far they can push it – or, in coffeeshop case, what about small, sorry tall, venti, etc. The cost of the cup won't change much, but the price will, to see where people stop buying.

    I suspect Toyota does this as any other company – since you can't ask directly the customer for what they would consider a "fair price", you've got to experiment. As a result, you systematically find that when you have a brand name you can charge more than you thought.

    the lean part of it, is that you get in a price trap, and I suspect Toyota has the problem right now. High prices to high paying custoemrs make high profits and an easier life because of all teh extra cash for invest and so on. This is all fine and well unless customers suddenly change their minds – because they've got money problems, or a cheaper alternative that is not as good but will do the trick comes along – and then the bottom seems to fall out of the market.

    Japanese manufacturers have made inroads in the west by having low process cost and essentially putting more options in cars at market price, forcing western manufacturers to do the same, but with higher process costs, and so lose, lose, lose. The deal was clenched by the noticeably higher quality. Customers did not get a cheaper car, but a car with more value in it, and less value loss fucntion. Great deal.

    However, twenty years down the road, the quality difference is narrowing and the value gap as well – everyone else has had to follow suit (and with dire outcomes in some cases – giving the ranch away because they couldn't reduce enough their operating cost to compensate for teh value restituted to customers. Competition works for customers, which is good news for us as long as we're not in the auto industry). This makes Honda and Toyota ripe for an attack from cars with equivalent quality, less value but a seriously lower price: a better deal (watch the Hyundai spot). If on top of things the price insensitivity barriers suddenly drops because of say, another bubble bursting, suddenly where you thought you were king of the world from one day to the next, you're in dire trouble – sounds familiar?

    Okay, okay, I'm not an economist, so I'm probably getting this all wrong, upside down and back to front. And yes, I do believe that lean logic wins in the end. But I think we need to be careful in casting stones as well. What do you guys think?

  5. Mark Graban says:

    Michael – thanks for your comment, you raise some excellent points.

    I'm not knocking Starbucks for raising their prices. More power to them. It just seems disingenuous to say "we have to because our costs are higher" since people often buy that line.

    Funny, I don't remember GM getting away with saying "well, our healthcare costs are high and our hours per vehicle are high, so we have to raise the price of the Malibu, sorry customers."

  6. Rick Foreman says:

    It may be simply as Michael pointed out, that Starbucks is working to determine what the market will bear. As a Mocha addict, I'm not to keen on the price increase. Therefore this customer and family have reduced the number of visits and drinks considerably. I'll give them a thumbs up for moxy in raising prices during an economic squeeze, when many food and drink establishments are lowering prices or making deals. Yet, I would be shocked if they did not have some degree of data to support this trial before implmentation. Maybe their new VP of Lean has headed them down a DMAIC marketing/sales cycle? :-) At any case, the consumers will ultimately determine the market, whether it be coffee or cars.

  7. Peter P. Patterson, MD says:

    As a long time customer, I think Starbucks has always engaged in "value pricing". They are selling the total experience which includes but is not limited to the actual cost of producing the coffee. They do seem currently to have a split pricing practice which I think may be explainable on the basis of competition at the low end (think McDonald's) so the pricing here is more driven by the competition. They would have more flexibility at the upper "complex" end. I don't think they're pricing is being driven by lean thinking particularly. As Michael says, there may be more to the world than just lean. Great discussion.
    /Dr. Pete

  8. Michael Balle says:

    As far I understand, the formula for success is deliver extra value to your customers which you pay for by process improvements, thus locking out your competitors, because if they try to match the value you offer, withiout the matching processes, they've got to put more money on the table. For instance, the cash incentives to push up the car sales numbers.

    I don't know about you, but the value part of the equation is not where I feel stronger. I think we should invest more think time in this because when we move to areas such as healthcare or service, the total experience because hugely important (not that it's not with cars, see the effort Lexus does).

    In healthcare in particular – do you have any experience with figuring that out? I've played around with patient surveys, but all they tend to rank is what they can judge: food and board. Understandbly, it's verty hard fo a patient to have an informed opinion on the quality of care. Has anyone gone further?

  9. Mark Graban says:

    Michael – "Value" is sometimes complicated in healthcare since the person getting the service is often not the one paying. So the old lean rule of "is the customer willing to pay?" gets complicated. So you make educated decisions on what the patient would/should value (and some organizations will ask patients directly, helping educate them in the process if need be).

    And for quality, you are right that most "quality" measures are service quality. Clinical quality is hard for us to gauge and the data is often very lacking.

  10. Michael Balle says:

    that tends to be generally true – the person who pays the check is not always the person who uses the service.

    the way we dealt with this in hopitals is by considering that hospitals where the "after sales service" of society. the aim was to get patients back to their normal life as quickly as possible and with the least discomfort as possible, at the lowest price. Interestingly enough, this definition led us several times to focus on readmissions – and start by measuring them . Scary topic!

    have you had similar discussions? Is any oen working on this tack?

  11. Mark Graban says:

    Michael – readmission rates are on the radar of Washington D.C. Hospitals measure and work to reduce this, but it's probably not on the average patient's radar.

  12. Scott Greenhalgh says:

    I almost lost my lunch when you said said a 50% margin on an item with a $1 cost would be $1.50.
    Margin / Markup.
    Many a muttered comment can be heard throughout workplaces after this is discussed after it has been discussed numerous times before.
    50% margin on a $1 cost is $2. Margin and Markup in currency terms are the same thing. However as a percentage, markup is always expressed in terms of the cost, margin is ALWAYS expressed in terms of revenue or sell price.

  13. Mark Graban says:

    Fine, Scott, I stand corrected. If you are going lose your lunch over that, it seems you have a weak stomach.

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