Question

HOW STARBUCKS USES PRICING

STRATEGY FOR PROFIT

MAXIMIZATION

In January 2020, Starbucks raised their beverage prices by an average of 1% across the U.S, a move that represented the company’s first significant price increase in 18 months. I failed to notice because the price change didn’t affect grande or venti (medium and large) brewed coffees and I don’t mess with smaller sizes, but anyone who purchases tall size (small) brews saw as much as a 10 cent increase. The company’s third quarter revenue rose 25% to $417.8 million from $333.1 million a year earlier, and green coffee prices have plummeted, so what gives?

Starbucks claims the price increase is due to rising labor and non-coffee commodity costs, but with the significantly lower coffee costs already improving their profit margins, it seems unlikely this justification is the true reason for the hike in prices. In addition, the price hike was applied to less than a third of their beverages and only targets certain regions. Implementing such a specific and minor price increase when the bottom line is already in great shape might seem like a greedy tactic, but the Starbucks approach to pricing is one we can all use to improve our margins. As we’ve said before, it only takes a 1% increase in prices to raise revenues by an average of 11%.

Value Based Pricing Can Boost Margins

For the most part, Starbucks is a master of employing value based pricing to maximize profits, and they use research and customer analysis to formulate targeted price increases that capture the greatest amount consumers are willing to pay without driving them off. Profit maximization is the process by which a company determines the price and product output level that generates the most profit. While that may seem obvious to anyone involved in running a business, it’s rare to see companies using a value based pricing approach to effectively uncover the maximum amount a customer base is willing to spend on their products. As such, let’s take a look at how Starbucks introduces price hikes and see how you can use their approach to generate higher profits.

An Overview of the Starbucks Pricing

Strategy:

The Right Customers and the Right Market

While cutting prices is widely accepted as the best way to keep customers during tough times, the practice is rarely based on a deeper analysis or testing of an actual customer base. In Starbucks’ case, price increases throughout the company’s history have already deterred the most price sensitive customers, leaving a loyal, higher-income consumer base that perceives these coffee beverages as an affordable luxury. In order to compensate for the customers lost to cheaper alternatives like Dunkin Donuts, Starbucks raises prices to maximize profits from these price insensitive customers who now depend on their strong gourmet coffee.

Rather than trying to compete with cheaper chains like Dunkin, Starbucks uses price hikes to separate itself from the pack and reinforce the premium image of their brand and products. Since their loyal following isn’t especially price sensitive, Starbucks coffee maintains a fairly inelastic demand curve, and a small price increase can have a huge positive impact on their margins without decreasing demand for beverages. In addition, only certain regions are targeted for each price increase, and prices vary across the U.S. depending on the current markets in those areas (the most recent hike affects the Northeast and Sunbelt regions, but Florida and California prices remain the same).

Product Versioning & Price Communication

They also apply price increases to specific drinks and sizes rather than the whole lot. By raising the price of the tall size brewed coffee exclusively, Starbucks is able to capture consumer surplus from the customers who find more value in upgrading to Grande after witnessing the price of a small drip with tax climb over the $2 mark. By versioning the product in this way, the company can enjoy a slightly higher margin from these customers who were persuaded by the price hike to purchase larger sizes.

Starbucks also expertly communicates their price increases to manipulate consumer perception. The price hike might be based on an analysis of the customer’s willingness to pay, but they associate the increase with what appears to be a fair reason. Using increased commodity costs to justify the price as well as statements that aim to make the hike look insignificant (less than a third of beverages will be affected, for example) help foster an attitude of acceptance.

on Wednesday April 8, Starbucks announced that it expects its fiscal second-quarter earnings to be cut nearly in half as the coronavirus pandemic causes sales to plunge in its two largest markets.

After reading, answer the following questions:

5- Did Starbucks make a good economic decision in raising the prices? Why?

6- What are the Starbucks’ maximum profit conditions?

7- What are the main three items groups that contribute to Starbucks variable costs?

8-What would happen to Starbucks’ profit if the prices of all three go down, holding other things fixed?

9- On Wednesday April 8, Starbucks announced that it expects its fiscal second-quarter earnings to be cut nearly in half as the coronavirus pandemic causes sales to plunge in its two largest markets. What would be the right pricing strategy to maximize revenues for Starbucks in the current circumstances?

10- If you have your own business, what do you learn From Starbucks case study

Answer 1

5. Yes, Starbucks has made a good decision by hiking the prices. This can be justified by the following premises -

a.) First, it is following on brand value. This is a pricing startegy that does not just encash on the existing brand loyalty that some of its customers have, it also further reinforces that brand loyalty. It has been established that these customers wo stick to Starbucks do so because they are price insensitive, which means their demand for Starbucks coffee does not change too much with slight changes in the price of the product. Hence, they are loyal to the brand. In this case, it is mostly because they associate Starbucks as a luxury that they can afford. Slight increases in the price can help reinforce this belief, where customers will be lead to believe that increase in price will lead to more premium quality coffee.

b.) Second, it might not have been wise to increase the price because of the economic slowdown that the COVID-19 pandemic brought with it. But, there was no way for the economy to have forseen such a situation. Hence, in the wake of the suddenness of the situation, the price rise can be justified. Further, because of the nationwide lockdown, a lot of poeple are not indulging in their luxury coffee, and sales can be expected to surge up as soon as the lockdown period is over. Average sales after the lockdown, at least for a few months, will be more than average sales before the lockdown. It might not be enough to recover the entire loss, but will be sufficient to cover up a large part of it, in which scenario the price rise will come in handy.

6. The Starbucks maximum profit conditions in this case are supernormal profits. Starbucks is able to make high profits because of its carefully desined marketting technique of customer targetting.

7. The main three items that contribute to Starbucks variable costs are -

a.) cost of raw materials like coffee

b.) cost of labour - although the amount of labour required may be constant, in the wake of the pandemic, the wages might change and that will be a part of the variable costs for Starbucks

c.) cost of non-coffee commodities like milk, sugar, cream, and other ingredients for the various products they sell

8. Starbucks profits will soar high is the prices of all three go down holding all other aspects constant. This is because these are the basic raw materials of the products that they make and sell, and if the production costs go down, then profits will definitely go up, if everything else is held constant like prices of rival products, consumer's tastes and preferences, etc.

9. As mentioned in the answer to the first question, the customers who are loyal to starbucks will still purchase starbucks coffee after the pandemic, more so than before the pandemic. The current pricing strategy seems to favour them in that case. This is because Starbucks target customer group is not the middle class but the elite class who can afford the luxury. Reducing prices will not help Starbucks, as they has all porbability of losing their target customers, and not gaining a new market.

10. The following important pointers can be noted from this -

a.) Understand your target market. It is important to understand the target customers and price according to their needs. This can be understood from how Starbucks established their market for the high income groups who can be insensitive to price changes.

b.) Differentiate your product from your rivals. Serving the same coffee that can be availed at a lower price from the rivals, Starbucks managed to increase the prices and use that price increase to create an air of superiority among its customers. Customers were led to believe that this coffee was of superior quality than that of its rivals in the market.

c.) Increase prices separately for separate products. Starbucks serves a variety of coffee products (including different sizes), and it increased the price of only one variety. This was a very carefully played strategy because the price of the variety that generates maximum sales was not changed. In this case, the price of the "tall" coffee was increased. This created an air of positivity that the remaining prices were kept the same, and people who comsumed the medium before shifted to "grande" as psychologically they thought they could pay less for the grande now than before.