India Knowledge@Wharton | Getting the price hike right

India Knowledge@Wharton | Getting the price hike right
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First Published: Sun, Sep 14 2008. 10 43 PM IST

Illustration: Malay Karmakar/Mint
Illustration: Malay Karmakar/Mint
Updated: Sun, Sep 14 2008. 10 43 PM IST
With the US consumer price index up 5% for the year ended 30 June and unemployment currently at 5.7%, many retailers in that market have found themselves in a tough situation, locked between rising product costs and a limited ability to raise their prices. Even cost-savvy market leaders such as Costco Wholesale Corp. are having a difficult time. But Wharton faculty say the current inflationary period may actually be a business opportunity for some retailers, especially if they make selective changes in pricing.
Illustration: Malay Karmakar/Mint
Value-oriented retailers typically do well in hard times, says Wharton marketing professor David Reibstein. “For the Wal-Marts of the world, inflation is actually something pretty good because so many customers are trying to figure out, ‘How do I save money during these inflationary times?’”
However, this particular environment presents some peculiar difficulties. “The problem is not only that there are inflationary pressures but that aggregate demand is going down,” says Wharton marketing professor Leonard Lodish.
Retailers typically try to pass through their costs by adding their margin to the supplier’s higher price. By itself, such cost-plus pricing can be a profitable strategy in an inflationary time if consumers have accepted the idea that prices are rising in a given category, such as baked goods, Lodish says. A price hike to keep up with inflation may actually create more profit for the retailer, he adds. How? An item sold for $2 (about Rs88) at wholesale nets 20 cents for a retailer who sells at a 10% markup. But a $2.10 wholesale item nets a retailer 21 cents at the same markup. If the retailer’s overall costs—such as labour, shipping, marketing and other products—remain static, that extra penny of margin can flow to the bottom line.
But with rising product costs and consumers worried about their jobs, marking up the price of goods becomes a delicate business. “The smart way for the retailer to do it is to ...raise prices a little bit here, a little bit there over time so that the consumer doesn’t have one big sticker shock,” says Wharton marketing professor Stephen Hoch. “In order to do that, the retailer has to absorb some of the pain in the short run and eventually pass it on down. And frankly, the manufacturers are trying to absorb pain too because...they don’t want to be the one that’s raising prices when their competitors aren’t.”
How much exactly is “a little bit”? In the past, most retailers have not known how to quantify the point at which price increases start cutting into demand. Now, business scholars are trying to work out more robust models to determine how much a price should be increased; among them is Wharton marketing professor Omar Besbes.
He cites one study which found that a good way to gauge the market is to test several different prices at once, ideally in different stores, and see how consumers respond. “This is a way to hedge against future changes in the market,” Besbes says, by enabling the retailer to develop a model to test how consumers will react to future price increases.
Hoch warns that retailers should not overlook the other aspects of their business, particularly service. “Retailers need to go out of their way to provide friendly customer service because everybody’s going to be out there screaming value,” he says.
Subprime crisis: testing ground for leaders
In June 2007, the stock price of Radian Group—a Philadelphia-based credit risk management firm—was at $64 a share, close to its all-time high, and Radian was moving towards a merger with a fellow mortgage insurer that would have created an almost $12 billion company.
One year later, the merger was off, Radian share prices were in steep decline—tumbling below $1 a share in August—and Standard and Poor’s had downgraded the group’s credit rating from A- to BBB. The US subprime mortgage crisis had hit hard.
“We are in the credit risk business. As you can imagine, we have had to deal with a lot of challenges the last year,” says Radian CEO S.A. Ibrahim, who spoke at the annual Wharton Leadership Conference last month. He noted that Radian Group’s total credit and default risk exposure stands at approximately $160 billion, with $45 billion of that coming from the group’s mortgage insurance subsidiary, Radian Guaranty. Radian Group has more than 800 employees and offices in Australia, Hong Kong, London and New York, according to the company’s website.
While dealing with regular-sized challenges is difficult even in good times, Ibrahim says: “Dealing with greater challenges—while at the same time your stock price is down—is more difficult than you can imagine. But deal we must. Persevere we must.”
Today the subprime crisis “has turned into a raging housing-credit- and-capital-markets storm of global proportions,” he says. “It is a storm that has engulfed many large and small companies and a storm whose passing is likely to permanently alter the housing, credit and risk markets in ways that remain to be seen.” The two key questions industry leaders now face are when the storm will pass and what the landscape will look like in its wake.
According to Ibrahim, the role of a leader involves three things: setting the vision and direction, rallying the organization behind that direction, and then encouraging and rewarding extraordinary performance. “What separates a leader from a manager is the ability to inspire others to go beyond the limits that they and others may have set for them,” he says. And when it comes to inspiring people, says Ibrahim with a chuckle, “I’ve often found that an apt quote helps get people moving when they get stuck.”
The subprime crisis may be less emotionally stirring than, say, a terrorist attack or a natural disaster but it is no less of a testing ground for leaders. Speaking of how the Radian Group is handling the crisis, he says: “I never cease to be impressed by how our leaders constantly rise to deal with every situation we encounter. I’m also amazed at how new challenges breed new leaders. These are the leaders who will make the realization of a better tomorrow a reality for us.”
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First Published: Sun, Sep 14 2008. 10 43 PM IST