Making a Price Increase Stick

Despite Federal Reserve Chairman Ben Bernanke’s desire to quiet discussions of expected inflation, most executives working within industries dependent on agricultural and energy inputs are facing a dire need to raise prices.  Best practices in pricing indicate that the firms that raise prices first and the industries which follow those firms are likely to reap higher rewards than those who continue to attempt to stave off price increases and suffer reduced profitability.  While these facts are true, executives must still find a way to raise prices without ceding valuable market share.  Business case history provides a few key routes.

First:  Blame price increases on cost challenges, not profit demands

From the viewpoint of a pure welfare seeking customer, also known as homo economicus, the cost structure of the firm selling product to the customer is of no real concern.  Customers simply seek to increase their welfare at a minimum expenditure.  Whether the supplier’s costs increase or decrease is irrelevant to the decision to purchase as long as the consumer receives positive and preferably increasing consumer surplus.  While the description of homo economicus works well for founding the principles of economics, it often fails to fully capture real world consumer decisions.

Customers have an innate demand for transactions that are “fair”.  What is fair is often a matter of perspective, and as such, I will not attempt to describe what some authors define as fair trade.  Yet, when raising prices, it is necessary to manage customers’ perceptions.  As such, firms must communicate price increases as being a resetting of the fair market value for the product.

Business cases indicate that there are three main categories for ascribing price increases as fair and managing consumer perceptions.

One:  Input costs. Customers accept price increases that derive from input cost increases.  The price of rice has doubled in 2008 and gasoline has quadrupled since 2002.  For a food products company, this has significant direct effect on the cost of purchasing raw foods from farms, transportation and processing, and distribution to end customers.  Citing these cost increases enable customers to perceive any price increase as a necessary and fair step to ensuring a reliable supply.

Two:  Labor costs. Customers accept price increases that derive from labor cost increases.  While wages have not increased significantly across the US in the past ten years, some specific industries are facing increased pressure for raising wages.  Recently, Burger King was forced to accept a one cent per pound increase in the cost of picking tomatoes in Florida.  Other industries too are facing similar demands from labor groups for wage increases.  Citing these labor costs issues enable customers to perceive price increases as necessary to ensure a “fair” economy.

Three:  Global Welfare. Global welfare issues, such as green products, fair trade, organic growth, and other environmental concerns are important to some, but not all.  Firms which cite these factors are able to engender some level of goodwill from some customers in driving through price increases.  How large of a price increase a company can drive from these goodwill gestures is currently under debate, yet it has become clear that these global welfare issues are able to support price increases for some industries.

Second:  Signal Your Competitors of the Need to Raise Prices

Price signaling, when done properly, is perfectly legal.  Backroom discussions between executives on prices and markets are illegal in both Europe and the Americas, but open communication through proper public channels is accepted as a necessary aspect of a functioning economy as it enables both customers and financers to make rational purchasing and investment decisions.  Furthermore, the firm that raises its prices in an industry that does not will cede market share and often at the cost of profitability (unless the firm is repositioning itself in the industry or undertaking some other competitive move to seek profitability in a different manner.)  As such, a firm seeking to raise its prices must also seek to increase the price of its competitors’ products.

Usually, signaling price increases is executed in the name of improving overall industry health.  In an industry with increasing prices, the profitability of all competitors is improved concurrently.  When price increases are roughly concurrent, market shares will be left relatively unchanged.

To effectively signal a price increase to competitors, a firm should undertake the same actions as they use to communicate to consumers that the new higher price is “fair”.  This means to cite an industry wide increase in a cost factor as the driving force behind a price increase and communicate it broadly throughout the industry.

To establish the credibility of a price signal, the price increase should be communicated by the Managing Director or CEO and it should be communicated in a trade magazine of merit within the industry, preferably the Financial Times or Wall Street Journal.

Early research in price signaling led to the improper conclusion that it can only be undertaken by the market share leader within the industry.  In the past twenty years however, significant case studies have demonstrated that second and third place firms, in terms of market share, are also able to effectively lead a price increase throughout an industry.  There are caveats, details, and risk mitigation techniques, but this I leave to academic papers and consulting engagements.

Early Bird Gets the Worm

Driving a price increase throughout an industry is a difficult task, yet it is also one which many firms cannot postpone much longer.  Commodity prices are unlikely to fall significantly within the next twelve months and many economists agree that the fears of inflation are likely to become reality.  Executives who recognize the need for a price increase and are willing to undertake the endeavor first are most likely to best weather the next business cycle.  Those who wait in the hope of falling input costs or a breakthrough in productivity are betting long odds.