Nestlé’s Cost Reduction in the Coffee Business

Nestle is the world-wide leader in the coffee business. They offer coffees at virtually all price points. They invented instant coffee in the 1930s. After the buffets of the commodity markets over the last few years, the company has created a global push to reduce its costs and to increase the quantity and quality of the coffee it buys.




We have found four generic approaches to reducing costs.



• First, reduce the rate of cost of a cost input.

• Second, reduce the cost inputs that do not produce output.

• Third, reduce unique activities and components in processes and the product

• Fourth, spread fixed cost activities over additional product output



Nestle is using the first three of these approaches in its world-wide investment in cost management.



First, Nestle redesigned part of the process. Its scientists developed a new generation of Robusta and Arabica coffee plants for Mexico. The Robusta beans are relatively inexpensive and make up the bulk of the beans in instant coffee. The Arabica beans are more expensive, harder to grow and go to the higher end coffees. Today, Nestle has planted 100 thousand coffee trees in Mexico using its newly designed coffee trees. Once this experiment is complete, the company plans to distribute 220 million plants to coffee growers world-wide over the next ten years.



The use of these new plants will enable Nestle to reduce its rate of cost for the beans it buys. The new plant design increases yields so it eliminates some inputs that do not produce the output of coffee beans. Many long-term coffee farmers are using older trees, which yield fewer beans and lower quality beans. Many of these farmers are leaving the industry since they cannot compete. This magnifies the commodity price problem Nestle faces. Nestle’s new trees fit the region’s climate. They resist disease and allow for larger and easier harvests. These trees will make coffee beans more consistently and predictably available. Nestle will give these trees to the farmers without asking for a firm long-term contract or ownership of any part of the farm. But it should be obvious that Nestle will engender a great deal of farmer loyalty with this program.



Nestle also expects to reduce the rate of cost it pays for its beans with two other cost reduction initiatives. It will offer farming and investing advice to up to ten thousand farmers world-wide. As these farmers become more efficient, Nestle’s costs will drop. In addition, Nestle will also increase the amount of coffee it buys directly from the nearly 170 thousand growers who produce its coffees.



This kind of foresight and innovation suggests why Nestle commands its market leadership.

Another Creative Pricing Scheme

It is not often that you see companies using really unusual pricing to build future business. Here is one that I like.


Every price has three and, usually four, components: the Benefit Package, the Basis of Charge, the List price and usually some Optional Components of price. The Benefit Package includes all of the Function, Reliability and Convenience benefits associated with the main product. The Basis of Charge is the way the company quantifies the unit of sale that it prices with the List Price, which is the stated price per unit of product sold. The Optional Components of price enable the company to leave the List Price unchanged, but to alter the value the company offers the customer by changing Functions, Reliability or Convenience benefits beyond those of the main product. The most creative pricing schemes usually involve the Optional Components of price.


Recently, we described one of these Optional Components of price, a Call, offered by Continental Airlines. In this blog, we will describe a “Put” offered by Best Buy. A Put is an Optional Component of price that enables the customer to sell back a product to the seller at a stated price in the future.


Best Buy recently introduced the Buy-Back program for various electronic gadgets it sells. This program adds a fee to the original List price of the product. In return for that fee, the customer gets the right to bring the product back for up to two years for a return value of a stated percentage of the original List price of the product. These percentages run from 20% to 50%, depending on the time of the return. The value of the return itself comes in the form of a Best Buy gift card. Best Buy hopes the customer will use this gift card to purchase an upgrade on the product that the consumer returns.


This Put may be attractive to consumers concerned about the speed of technological innovation in electronic gadgets. The Put effectively reduces the future price of purchasing a new electronic gadget. It leaves the current List prices and future List prices unchanged. It also increases the odds that Best Buy will be the retailer who delivers the new technologically-advanced product.

But Can You Control Other Entrants?

The United Autoworkers (UAW) is on a new campaign. The union plans to organize workers in hither-to non-union foreign-owned automobile plants in the United States. This campaign may or may not work, but in the long run it will prove futile unless the union can compete in the international market, against all international auto workers.

There are 575,000 autoworkers in the U.S. Nearly 20% work for foreign-owned plants. All of these plants are non-union. The foreign-owned plants were intentionally placed in right-to-work areas, many in the South.

The UAW is likely to have some difficulty succeeding with this campaign. The non-union workers already earn highly competitive wages and benefits. To date, these U.S. workers in plants owned by Toyota, Volkswagen, Hyundai and Honda have shown little interest in unionization.

Why would the union be so interested in this initiative? To preserve its membership. The traditional problem with unions is less the rate of wages they demand and more about the work rules they impose. These work rules reduce the productivity of the unionized plants. That has certainly been the case in the U.S. auto industry. As a result, the UAW is losing membership as UAW auto plants in the U.S. close under the onerous costs the UAW plants carry. If the union can succeed in unionizing the domestic foreign-owned auto plants to the same extent they have unionized the domestic manufacturers’ plants, they will be able to impose the same work rules and produce roughly the same productivity. The result should, in the union’s eyes, be a reduction in the rate of jobs lost in the union.

But there is a problem here. The UAW has already seen that it was unable to stop new non-union plants in the U.S. How will it stop future non-union domestic plants? O.K., let’s say they can do that. Will they also be able to stop all foreign non-union plants from becoming established and growing? Certainly not. Unless the union membership can compete on an international basis with competitive costs and productivity, this unionization effort is wasted money. If it succeeds, the U.S. loses more plants to plants located offshore. Union membership still falls.

It seems that one of the problems for unionized employees is one of definition. Union members often call their compatriots in competing companies “brothers and sisters.” These are certainly not brothers and sisters. In a marketplace they are competitors. Union employees have to be able to beat, or at least stalemate, these competitors or lose their jobs. This is true as long as the UAW can not control the entrance of other less expensive competitors, either in the U.S. or elsewhere.

The long history of the DRAM semiconductor market illustrates this. The U.S. manufacturers of DRAM semiconductors faced intense competition from the Japanese in the 1980s. The domestic industry succeeded in slowing the Japanese by using the International Trade Commission. Then arose new and equally troublesome problems. These problems were DRAM semiconductor facilities in Taiwan and Korea. Eventually, the U.S. industry evolved to the point where it had only one domestic producer of DRAM chips. Intel was one of the early competitors to get out of that market to focus its resources in the more complex, and much more profitable, domestic micro-processor business. SX4MBURBCAJQ

A Very Rare Form of Pricing

Recently, Continental Airlines introduced a new service called “FareLock.” This new service gives travelers three days, or a week, to decide whether to buy a ticket and avoid a fare increase or the risk that the passenger’s flight will sell out. In return, Continental plans to charge a flat fee of $5 for a three day hold and $9 for a one week hold. Continental is offering its passengers a Call. For a fee, the passenger has the right to buy the ticket at today’s price for a few days into the future. This is a very rare form of pricing outside of the securities market.

Every price has at least three components. Most have four. (See “Audio Tip #113: Tools to Change Pricing” on StrategyStreet.com.) The first of these components is the benefit package that the price offers. The second is the basis of charge, that is, how the company quantifies in currency what it charges for a unit of the product. The units can be a package, an individual item, a unit of time, and so forth. The third component is the list price of the product. Virtually all products also have what we call optional components, the fourth component. These optional components may, but do not have to, be a part of the product price. Optional price components include various discounts, fees, coupons and other methods of conveying a change in effective price, either an increase or a decrease, to the customer. A Call is one of the optional components of price. It occurs only rarely.

Here are some other examples:

* Some colleges have used the Call in the form of a fixed tuition price for any student returning for the four years of the student’s education. This pricing mechanism increases the college’s retention rates. (See “Audio Tip #142: Defensive Pricing Guidelines” on StrategyStreet.com.)

* There are also contingent Calls. Waterford Development Corporation was dealing with a difficult real estate market. It offered to have homes re-appraised two years after the date the transaction closed. If, after two years, the price of the home dropped, the company promised to write the buyer a check for up to 15% of the original sales price. With this Call, the customer gained the right to live in the house and yet pay a lower effective price for the house if the market should decline in the next two years. (See “Audio Tip #151: Changing Performance and Price Together” on StrategyStreet.com.)

* A discount broker, in an effort to attract more high-volume traders, offered a Call. This broker charged the customer only a single commission for multiple trades of the same stock on the same side of the market on the same day.

Strangling the Goose

Some time ago, we wrote a blog (see HERE) on the declining value of airline miles programs. At the time, we noted that most of those miles awarded were worth less than a cent. In fact, the airlines themselves believe that these miles are worth far less than a cent. That means the miles that you gain return less than 1% of your spending to your account.

Here is an example. United Airlines offers a one year membership in its Red Carpet Club for 70,000 miles. If you are a normal flyer, without particular value to United as a Premier or Premier Executive and so forth, you can buy a one year membership for $425. United Airlines is telling us that its miles are worth 6/10th of 1 cent.

But let’s say you are a highly valued flyer with United Airlines. Let’s assume you are a 1K flyer, one of their top categories. If you are in that fortunate (or unfortunate as you will have it) position, you may purchase a one year membership in the Red Carpet Club for $325. As an alternative, you can purchase the membership with 40,000 of your frequent flyer miles. This is a much better deal. Here your miles are worth 8/10th of a cent.

These airline-sponsored deals strike me as dangerous. (See the Symptom & Implication, “Customers are more price sensitive” on StrategyStreet.com.) They telegraph clearly that airline miles are worth less than 1%. This is dangerous because there are a number of credit cards available to you which will return 1% of your spending every month, in cash. That is a considerably better deal than the United Airline miles offer you. (See the Symptom & Implication, “New competition is entering a settled market” on StrategyStreet.com.) These airline miles keep losing their allure.

A Price Leader Market and Competitor

In StrategyStreet terms, a competitor or product that offers below industry standard performance for a very low price is a Price Leader. Price Leaders contrast with the typical industry leaders who set standards for the industry, called Standard Leaders in our terms. The competitors or products at the higher end of the market are called Performance Leaders.

The Price Leader’s product has fewer benefits than Standard Leader products. Because the Price Leaders are able to save costs, their product prices average 25% to 50% below the Standard Leader’s price. Because their products do offer less than the Standard Leader product, Price Leaders, as a group, have relatively small market shares, usually less than 15% of industry sales. (See the Perspective, “Why Do Leaders Lead?” on StrategyStreet.com.)

We have analyzed several hundred Price Leaders and found that we could group them into two types, Predators and Strippers. Predators offer the user of the product Functions similar to those of the Standard Leader products but less Reliability because they sell brand names that are unknown. They offer the user equivalent benefits but the purchaser fewer benefits. Strippers offer fewer benefits to both the user and the purchaser of the product. The printer ink industry offers good examples of our Price Leader findings. The total printer ink industry has sales of nearly $22 billion a year. Something just below $3 billion of this is owned by Price Leader competitors, who refill or remanufacture ink cartridges. These Price Leaders, as a group, have 13.5% of the total market.

Most of these Price Leader competitors are Strippers. (See the Perspective, “Attention K-Mart Copiers” on StrategyStreet.com.) Customers who buy their products are often dissatisfied. In fact, only about half of the customers who try the Price Leader product are satisfied with it.

One of these Price Leader competitors, Cartridge World, is in the Predator category of Price Leader competitors. Cartridge World is a leader in the cartridge refill and remanufacturing industry. As a general rule, the company prices its laser cartridges at 25% off of the cost of a new brand named cartridge. Its ink jet cartridges come with discounts of 30% compared to a new brand named cartridge. Its Function benefits are the same as the Standard Leader products. It offers less Reliability due to its unknown brand name. But, Cartridge World puts a 100% guarantee on its products and offers relatively high levels of customer service. As a result, the company is experiencing growth rates of 20% per annum, while its competitors grow at a much slower pace.

The Holiday Season: The Most Creative Pricing Season We Have

Watch the deals that retailers offer during the Christmas season. They find ever more creative ways to get us into their stores and shopping. I want to note a couple of these creative ways.

But first a bit of context. A price has four typical components: the package of benefits the product or service offers the list price, the basis of charge for the product (i.e. the unit in the dollars per unit in the list price) and, usually, some optional components of price. The optional components of price are helpful to companies who want to change the effective pricing for a customer. The retailers in this note are making creative use of some optional components of price.

The first example is the use of price to get people into stores by offering them a particular deal. Sometimes these are simply Loss Leader products, for example, offering very inexpensive bread and milk sold at the back of a grocery store in order to get a shopper in to buy other products at the store. So, one optional component of price is a Loss Leader product. Here is a creative twist. Offer the Loss Leader product in a “flash sale” with a very limited time frame. For example:

* Penney’s ran flash sales called “7 Hour Steals” offering towels for $3.69 that normally sell for $7.99 and 70% off gold and sterling silver jewelry.

* Banana Republic stores offered 40% off full-priced sweaters from 11 a.m. to 2 p.m.

Other optional components of price encourage multiple purchases. One way to do this is to offer discounts on all sales above a given purchase price. For example, a company might offer 20% off for all purchases above $50. A more creative, and aggressive, approach is to offer discounts that increase with the money spent. For example, a company might offer 20% off on a $50 purchase, an additional 20% off all purchases from $50 to $75 and a final 20% off on all purchases over $75. According to consumer research, many consumers would assume that they get a total of 60% off on all purchases over $75 with this offer. In fact, they get about 49% off on their total purchases. Still, a compelling deal.

In our study of several thousand pricing initiatives, we have found many of these optional components of price. They enable a company to improve its market share and margins in any price environment. These are available at StrategyStreet/Improve/Pricing/Innovation Ideas.

Abercrombie - Recovering in a Falling Price Environment

Nearly two years ago, we began a series of blogs about Abercrombie & Fitch (See Blogs HERE, HERE and HERE). Abercrombie & Fitch had been in a Leader’s Trap, where the company held prices high despite the onslaught of discounting competitors, including Aeropostale and American Eagle Outfitters. (See “Audio Tip #119: A Price Umbrella” on StrategyStreet.com.) The discounting competitors gained share while Abercrombie & Fitch lost it, sometimes in handfuls. In fact, all throughout 2008 and 2009, sales at stores opened at least a year declined.

We predicted in the original blog that Abercrombie would have to come out of its Leader’s Trap and discount its prices to keep its competitors at bay. (See “Audio Tip #118: The Leader’s Trap” on StrategyStreet.com.) In the spring of 2009, the company did begin discounting its prices to stop its share loss. These discounts gradually brought business back to the stores so that stores opened at least a year began to see sales increase rather than decrease during 2010. In fact, the company has found that, while it cut its prices by 10% or more, it still generated higher sales because the growth of unit volume made up for the price cuts.

The company was judicious in the way it went about reducing its prices. It discounted its prices in the United States to narrow the price gaps it had with its competition. On the other hand, it held its premium price position in its overseas markets. Prices for the same item of clothing are 30% to 50% higher in London and Tokyo stores than they are in the U.S. Abercrombie & Fitch’s international customers can not take advantage of the low U.S. prices because they can not reach the U.S. domestic internet sites of the company. Instead, international buyers searching on the internet for the company’s online stores are automatically redirected to their local company web sites of Abercrombie & Fitch.

We liken the task of pricing in a falling price environment to a game of darts. In the game of darts, the circular dart board is broken into several pie-shaped areas. The players must aim for a particular area that changes with each turn. Within each of these areas on the dart board, the more narrowly the player can target his dart, the more points he accumulates on the turn. Of course, the dart is the vehicle to hit the target area with precision. In pricing, the target area is a segment of customers. These segments reflect particular competitive situations the company faces rather than needs of the customers themselves. The darts are the components of price that the company can use to hit the target segment with precision. These price components include the set of benefits in the product, the basis of charge for the product, the list price of the product and several optional components of the price. The combination of the segment and the component of price the company uses to hit the segment limits the scope of the price reduction to those customers who absolutely require it. This precision pricing reduces the impact of the price reduction on the company’s margins. (See Improve/Pricing on StrategyStreet.com.)

Abercrombie reduced U.S. prices to meet U.S. competition. It did so by reducing some list prices and introducing new, lower priced, products to compete in the U.S. market. Overseas, however, it held its prices high because competitive conditions allowed it to do so.

Now we will wait to see whether Abercrombie regains the market share it lost to its discounting competitors in 2008 and 2009.

I Guess it Takes Bankruptcy...

In our previous blog (see Here), we described the resuscitation of the comatose manufacturing employment due to renewed flexibility in many union shops, such as GM. I guess it takes bankruptcy to get attitudes to change. Look at American Airlines, for an example.

Over the last several years, its big airline competitors have been getting bigger. United and Continental combined, as did Delta and Northwest. U.S. Airways merged and Southwest has just purchased Air Tran. Through it all, American stood largely on the sidelines.

Most of the other competitors had a real advantage. They went through bankruptcy. Of course, Southwest did not, but the other legacy carriers did. What those airlines and their workforces learned in bankruptcy created a lower cost and more flexible set of work rules for these airlines. Now American Airlines is beginning to pay the price for its competition with lower cost airlines.

American is clearly a high-cost airline. Its 2010 cost to fly a seat mile is 12.76 cents. This is the highest among the six largest carriers. Predictably, its pretax margins for the first half of the year were negative, while its peers produced positive operating earnings.

The problem American faces is primarily due to high labor costs. This may surprise you since several of the unions agreed to give-backs in 2003. Further, the American Airlines pilots claimed to be working at 1993 hourly rates. In short, all the unions working at American seem to be up in arms in frustration over their lack of economic progress.

The problem is less the rate of pay for the workforce than it is the work rules. American is at the bottom on industry measures of productivity because of restrictive work rules. Does that sound like the American automobile industry’s problem before the recent spate of bankruptcies?

Still, the unions are up in arms. Despite long term negotiations, the company has reached little in the way of agreements. Some unions are now threatening a strike. Let’s see. Take a high cost airline that is losing market share, increase its costs and scare away its future passengers with a threat of a strike. That sounds like a prescription to insure the future of an airline and the jobs that go with it, doesn’t it?

Previews of Coming Attractions in Public Services

A generation ago, public servants earned less than equivalent employees in the private sector. This is no longer the case. Many reports today suggest that public servants earn 25% or more greater compensation than equivalent private sector employees. While a percentage of the workforce employed in private industry union shops has steadily declined for more than thirty years, unionization in the public sector has grown rapidly. This is important because of the inflexibility of many unions in changing work rules and compensation when confronted with economic realities such as tightening budgets.

What might you expect to happen in such an environment? Growth of private sector companies offering the same services, or better, for less money. These private companies operate under the price umbrellas of the public sector. That is certainly happening today, even in the most unlikely of places. A little company in Maryland has grown into the country’s fifth largest library system, measured by number of branches. This small company, Library Systems and Services, Inc., runs fourteen library service systems operating 63 branches. It has $35 million in annual revenue and 800 employees. It ranks behind Los Angeles County, New York City, Chicago and the city of Los Angeles in the size of its branch system.

The company is finding it relatively easy to succeed by cutting overhead and replacing unionized employees with non-union employees willing to do the jobs for less. In a recent $4 million contract, the company pledged to save $1 million a year using its cost reduction techniques. (See “Audio Tip 187: The Components of Productivity” on StrategyStreet.com.)

Nor does the company need to reduce hours and services in order to succeed. The company has found that the operating policies of public libraries often serve to protect job security and ensure high rates of pay. (See “Audio Tip 182: Productivity as a Measure of Physical Costs” on StrategyStreet.com.) Of course, not all people are happy with the success of this company. In particular, the company’s most recent contract came in for severe criticism from the Service Employees’ International Union. That union has 87 members in libraries recently transferred to Library Systems and Services.

As the cost of public employee pay and pensions becomes less bearable in the future, we can expect to see a good deal more of companies like Library Systems and Services. These private companies should also be good investments. Their first need is not to generate greater revenues, though I am sure they will try that. Instead, they need only reduce costs. That should be relatively easy, due to the price umbrella held up by current public sector management of citizen services.

The Fall of an Industry Leader - Part II

Blockbuster declared bankruptcy in September of 2010. According to reports, the company was done in by the online service of Netflix and the in-retail store kiosks of Red Box. That is only partly true. The company was done in, first by its failure to recognize and respond to market opportunities when others created them and, second, by its determination to extract higher prices than its performance in the market warranted. Its failure as a company was a long time coming. It started in the late 1990’s. Since 2002, the company has lost more than $4 billion. Its market value fell from $4 billion eight years ago to just $12 million at the time of the bankruptcy.

In Part 2, we will look at some of the highlights of Blockbuster’s pricing over the last few years.

This may seem surprising, but the industry’s prices began their long-term decline as early as 1982. This is not unusual. Fast-growing industries often see price declines as new competitors enter the market with plenty of capacity to serve even fast-growing demand.

* In the early 90s, Blockbuster changed its pricing scheme. It had offered a movie for two nights at $3. Blockbuster changed its price to $2.50 per night. It also charged late fees. This change in pricing hurt smaller competitors, who often got business when Blockbuster was out of product due to its two-night rental policy.

* By 1994, Blockbuster felt it could raise prices with impunity, and it did raise prices. (See the Perspective, “Can We Raise Margins With a Price Increase?” on StrategyStreet.com.)

* By 1997, prices were coming under pressure due to the fall-off in demand growth caused by other forms of competition. Blockbuster and its video tape competitors had to begin reducing prices. (See the Symptom & Implication, “The Industry is Seeing its Frist Price Wars” on StrategyStreet.com.)

* In 1997, Blockbuster introduced customer loyalty campaigns to hold on to its most important customers. By then the company was earning less than its cost of capital.

* In 1999, Blockbuster introduced a rewards card. The card cost about $10 and allowed a card-holding customer to obtain one movie free each month. It also offered one free movie for every five rented in a month, and one free “Favorites” on Mondays, Tuesdays and Wednesdays. This was an attempt to create greater sales with existing customers. Movies rented for $4 a night, but late fees could often double or even triple that cost.

* In 2002, video on-demand began to grow. One company offered 430 movies for an average of $3 per rental.

* By 2002, several consumer-oriented articles argued that the late fees charged by Blockbuster would be enough to cover the cost of a Netflix subscription. Customers grew angry over the late fee prices.

* In 2002, Blockbuster responded directly to Netflix with three pricing plans. First, a customer could rent two videos at a time for $20 a month. Second, the customer could rent three videos at a time for $25 a month. In the third program, a customer could pay about $60 a year. This would allow the customer to keep three movies during the year without late fees, but the customer would have to pay for all movies rented. In the meantime, Netflix continued charging $20 to rent three movies at a time.

What do we learn from watching Blockbuster’s pricing over the years? During the 80s and 90s, Blockbuster was leading the industry on pricing. This was a double whammy for its competitors. It offered bigger, better stocked stores at lower prices than its competitors. But somewhere in the mid-90s, Blockbuster lost its edge. It decided that it had earned the right to have higher prices simply because it was the leader. Netflix continually beat Blockbuster on pricing. Red Box did the same thing with its $1 per night rental charges. Blockbuster was in a Leader’s Trap, and stayed in that unfortunate position for far longer than most industry leaders. (See the Perspective, “The Leader’s Trap” on StrategyStreet.com.)

Blockbuster engineered its own demise by failing to keep up with the performance of the new leaders in the industry, such as Netflix and Red Box, and by charging more than its competition for performance that failed to match theirs.

The Fall of an Industry Leader - Part 1

Blockbuster declared bankruptcy in September of 2010. According to reports, the company was done in by the online service of Netflix and the in-retail store kiosks of Red Box. That is only partly true. The company was done in, first by its failure to recognize and respond to market opportunities when others created them and, second, by its determination to extract higher prices than its performance in the market warranted. Its failure as a company was a long time coming. It started in the late 1990’s. Since 2002, the company has lost more than $4 billion. Its market value fell from $4 billion eight years ago to just $12 million at the time of the bankruptcy.

In this, and the next blog, we are going to look at Blockbuster’s history. We will only touch on highlights, but the highlights explain much of the story.

We will begin by looking at Blockbuster’s product and service offering over the last twenty years. (See “Basic Strategy Guide Step 7” on StrategyStreet.com.) Here are some of the highlights:

* The video rental market grew very quickly throughout the 80s and the early part of the 90s. By 1993, Blockbuster had 600 stores. It was adding a store a day to that total. In doing so, it was squeezing out of the market many small video stores.

* The first video dispensing machines, precursors to the ubiquitous Red Box kiosks, came out in the mid-80s. They were introduced by Group One using a vending machine produced by Diebold. By 1990, there were many of these machines. 70% of them were available 24 hours a day. Each machine had about 400 tapes available. Blockbuster had none of these machines. (Note: after a very late response, Blockbuster Express now has 7000 kiosks, also made by Diebold.)

* In the mid-1990s, Direct Broadcast Satellite offerings of movies began to cut into the Blockbuster demand. To make up for the slowdown in demand, Blockbuster added music, books, software, movie shirts and mugs. All were failures.

* In 1998, Netflix launched its service. The company grew very rapidly, and was introduced to the public stock market in 2002. At the time, Netflix had less than a million customers. Blockbuster had 8,000 stores world-wide. As late as 2002, the CEO of Blockbuster dismissed the Netflix product as a niche offering.

* In 2001, Netflix, though still tiny, had a far more extensive movie selection than the average Blockbuster store. At the time, Netflix offered a choice of 10,000 separate movies, about ten times what the largest Blockbuster store could offer. In addition to offering more choices, Netflix also provided customer and professional movie reviews and a service that predicted what movies subscribers would like based upon the subscriber’s reviews of previous movies. Blockbuster offered none of these additional services.

* Later in 2002, Blockbuster began to test an online offering, but decided not to enter that market. Instead, it offered the Freedom Pass product, which required customers to go to the store to pick up and return their movies. The Freedom Pass offered unlimited movies for $25 a month. Blockbuster had 9,100 world-wide stores. 70% of the U.S. population was within a ten minute drive of one of its stores. At the same time, Netflix offered its unlimited movies, three movies at a time, service for $20 a month.

* By 2002, Netflix could offer overnight service to 50% of its customers and promised to reach 70% of them with that speedy service within a year.

* In 2003, Blockbuster updated its Freedom Pass program. It offered two movies at a time for $20, three movies at a time for $30. It introduced this program in all 5,500 of its U.S. stores. In the meantime, Netflix reached a count of 1 million subscribers by charging $20 a month for three movies at a time. The Netflix price was 33% lower than Blockbuster’s.

* By 2004, Blockbuster was stumbling badly in its earnings. It held back on inventory, so many popular movies were often out, frustrating customers. (See “Video 54: Cost Reduction by Winners vs. Losers in Hostility” on StrategyStreet.com.) During this year, Blockbuster finally enters the online market, six years after Netflix entered.

* During the period of the early 2000s, Hollywood studios began selling DVDs at relatively low prices. At the same time, the cable companies were offering online movie streaming through their cable boxes. Both of these developments reduced the demand for Blockbuster’s products.

* In 2004, Netflix reached 2 million subscribers and was growing at 80% a year.

* By 2005, Blockbuster was becoming desperate for revenue and margin. The company added video games, DVD sales and DVD resales to its product line. Blockbuster’s online business was flourishing with 1 million subscribers. But Netflix had 3 million. Wal-Mart decided to leave the online rental market and directed its customers to the Netflix program.

* In 2008, Blockbuster offered an online streaming service. To access the service, customers had to purchase a T.V. set-top box for $99 and then pay regular movie fees for each movie they watched. Blockbuster claimed that the T.V. set box was free because they offered a credit for 25 movies to anyone purchasing the box. At the same time, Netflix offered its movie streaming service free to its regular subscribers.

* By 2009, Blockbuster was closing stores at a rapid rate, becoming less convenient for many customers. Netflix and Red Box continued growing rapidly. At the time of its bankruptcy, Blockbuster was down to 3,300 U.S. stores, and falling.

What does this story tell us? In the early years, until the early 90s, Blockbuster was a very successful company. It won, streamlined the video rental market and became the unquestioned industry leader. It then became complacent. It ignored the new channels of distribution, including vending machines, online rentals and video streaming. Other people developed and refined the cost structures of those markets. Blockbuster did eventually enter these channels, but by then it was too late to play catch-up.

In the next blog we will look at Blockbuster’s pricing history to see how that contributed to its failure.

Pricing in the Dog Days of August

It seems that not many people wanted to spend the weekend in Philadelphia during August. Hotels that might be full during the week were sparsely populated on the weekends. But, Marriott was not taking this situation lying down.

The Philadelphia Marriott came up with an innovative pricing strategy. Any guest who booked a two-night stay starting any Friday during August into mid-September had to pay only the price of the highest outside temperature for the Saturday night rate. So, the guest paid regular prices on Friday night and the heavily discounted rate, based on the day’s high temperature, for Saturday night. A clever approach to discounting.

This is one of several approaches companies have used to get through periodic, or seasonal slow demand times. Companies have used the components of a price in order to bring customers to its products during slow times. For example:

* A construction company changed its list price much as did the Philadelphia Marriott. It priced its services very aggressively for the months of January and February so its customers would move work forward that would normally be done in the spring or summer.

* Other companies change the definition of their product to reach a new, lower, price point. Companies who sell fractional ownerships of private jets offer discounts up to 25% for flying on off-peak days.

* Other companies make direct payments to customers. We can see this approach with the current Orbitz program called Price Assurance. Orbitz refunds customers the differences in fare if a customer purchases an airline ticket and then sees the price of the ticket fall before he leaves on his trip.

* Some sellers throw in a free, or heavily discounted, product from a third party. For example, as the housing market became more difficult, some sellers offered to outfit a media room or pay closing costs for their buyers.

We believe that a company facing a tough pricing environment can gain a lot by studying what other companies have done when facing the same circumstances. We have many of these examples on our web site. (See Improve/Pricing on StrategyStreet.com.)

Pricing in Easy Industries

Here is an example where relatively small differences in price, in normally easy industries, have a big effect in the market.

PepsiCo owns Lifewater. Over the last year, Lifewater’s sales have risen by 85%, while overall sales of bottled water have fallen by 5%. Coca-Cola owns a Lifewater competitor named Vitaminwater. During the same period, Vitaminwater saw its market share shrink.

PepsiCo has been paying more attention to Lifewater. It redesigned its bottle and introduced a no-calorie version of the drink. It also changed its advertising emphasis.

But pricing has certainly played a role in the marketplace. As the recession began to take hold, PepsiCo shaved four cents off the price of Lifewater (see “Audio Tip #106: How do we Predict Competitor Responses to our Price Moves?”), dropping it to an average of $1.18. Vitaminwater chose the opposite approach. It raised its prices by 4%. This produced a 7% swing in price difference between Vitaminwater and Lifewater. This price change meant Lifewater appealed better to both consumers and the channel of distribution. Lifewater used the lower price to increase its retail presence, especially with Target stores. This created greater Convenience for the Lifewater consumer. Overall, Lifewater’s market share increased by 1.6 share points to 3.8%. (See “Audio Tip #45: The Components of Positive Volatility” on StrategyStreet.com.) Vitaminwater’s share dropped from 14% to 11.4%. (See “Audio Tip #46: The Components of Negative Volatility” on StrategyStreet.com.)

Pricing and price differences are never irrelevant. Customers are loath to pay higher prices for products that otherwise seem Functionally comparable.

Dis-Economies of Scale

McKinsey research has found that only 10% of cost reduction programs sustain their results after three years. The problem seems to be overhead. Companies have exploited manufacturing efficiencies to reduce the cost of goods sold as a percentage of revenues by nearly 3% over the past decade. On the other hand, sales, general and administrative costs have remained about the same. The performance of sales, general and administrative SG&A costs is an example of dis-economies of scale.

A few definitions are in order. Economies of scale is the phenomenon where unit costs decline as the number of units sold increases. (See “Audio Tip #195: Economies of Scale and Their Measurement” on StrategyStreet.com) This happens because part of the cost structure is fixed, so it grows at a fraction of the rate of growth of the unit volume the company sells. Dis-economies of scale occur where units of costs increase at a rate that is greater than the increase in the units of output. (See “Audio Tip #198: Dis-Economies of Scale” on StrategyStreet.com) In other words, there appear to be no significant fixed costs in the company’s cost structure when dis-economies of scale occur. At the other end of the cost spectrum, you see super-economies of scale. Super-economies occur with costs decline, even as the number of units sold increases. (See “Audio Tip #199: Super-Economies of Scale” on StrategyStreet.com) Usually the super-economies occur due to changes in technology, when the company replaces many employees with technology capital investments.

Now let’s return to the problem of SG&A costs. In 1998, the SG&A costs for the S&P 500 companies were roughly 22% of sales. By 2008, SG&A costs still commanded 22% of the sales dollar. During those ten years, the physical units of output the S&P 500 companies produced certainly increased. On the other hand, the SG&A costs remained the same as a percentage of sales. Are none of the SG&A costs fixed? If there were some fixed costs in SG&A, the companies should have been able to increase the units sold without a proportional increase in numbers of people in the SG&A functions, creating economies of sale. But they did not produce economies of scale as measured as a percentage of revenue. What happened then? Either the number of people employed in the SG&A functions grew with unit sales or the companies paid the average SG&A employee at a higher rate than sales grew. In either case, you have dis-economies of scale operating in SG&A.

Over the years, we have been involved in many cost reduction efforts. We have seen that it is hard to sustain the results of a cost reduction effort over a long period of time. The McKinsey study serves as ample testimony to this fact. What may be helpful is to tie physical units of costs, for example numbers of full time equivalent employees, to physical measures of output, such as customer orders. If the ratio of physical units of cost to physical units of output goes down, the company has an excellent chance of creating economies of scale.

Here We Go Again

The leader of the United Auto Workers is retiring. He is leaving a union under siege. By 2009, UAW membership was about half of the level of 1995. The union has hemorrhaged members as the big three domestic automobile producers have shrunk in market share, lost billions of dollars, and closed plants.

The departing leader of the UAW claims that the industry’s difficulties never rested with the union and its rich contracts. In his view, the crisis that led to the bankruptcies of GM and Chrysler and the near bankruptcy of Ford was strictly the result of an unexpected spike in gas prices and a recession that resulted from the mortgage crisis. He believes that the fault lay not with the union and not with the industry. Following this belief, he is encouraging his successor to begin clawing back the cost-cutting concessions that the union has granted the Detroit big three domestic automobile manufacturers now that these companies are moving toward profitable operations.

The problem is that these concessions did not do enough, at least from the results they seem to have produced. The concessions really got underway in 2003, as the union reduced its wages and benefits and transferred retiree healthcare costs from the automakers to an independent trust. Despite these concessions, union membership fell parabolically from 2003 to 2009, right along with the profits in the big three. In the meantime, German and Asian manufacturers continued to be profitable. These profits included profits in U.S. domestic manufacturing facilities as well. (See the Symptom & Implication, “Some industry leaders have lower returns than the smaller competitors” on StrategyStreet.com.)

The union is heading back to trouble and will take its unionized facilities with them. In an earlier blog (See Blog HERE), we described the hourly cost differences in wage rates between a unionized and non-unionized domestic facility. These cost differences are unsustainable in the longer term. No one can expect that an automobile plant with $73 dollar an hour labor will be profitable enough to compete with another domestic plant producing similar automobiles at $48 an hour. Despite recent troubles, the Asian manufacturers still command a premium price over their big three competitors for their products. So, Toyota and Honda get a higher price and produce with a lower costs. (See “Video #1: The Two Best Consultants in the World” on StrategyStreet.com.) Tell me how GM, Chrysler and Ford can produce an equivalent or better car with these economic conditions. The claw-backs will only make things worse.

Defending the Low Cost Position

The last couple of years have been very tough on the hotel industry. Now, some of the mainline hotel companies are starting to recover, but the high-end hotels continue their prolonged suffering. A typical example are the Four Seasons hotels. Last year the occupancy rate at the chain’s hotels was below 60% and revenue per available room, a key measure of sales, fell 26%. There are 82 Four Seasons hotels. At least 12 of them reputedly are near the breaking point.

The Four Seasons Company no longer owns any of its 82 branded hotels. It, like most of the hotel chains, sold off its hotels in the 80s to companies and investors who had more willingness and ability to carry high levels of leverage on the hotel properties. The Four Seasons, and most other hotel chains today, manage their brands but don’t own them.

The hotel brands tightly control the quality of their hotels through their management agreements. The management company receives a management fee of a percentage of the branded hotels’ revenues and also gets a percentage of the hotels’ profits. The hotel investor gets the use of the brand name and must conform to the rules as written in the management agreements. This arrangement allows for a disconnect between the interest of the hotel property owners and the hotel brand owners. The property owners may wish to find cost shortcuts that the brand owners abhor because the cost savings sully the brand name.

The founder of Four Seasons Hotels & Resorts watches carefully over the brand he created. Isadore Sharp is the founder and Chief Executive of Four Seasons Hotels & Resorts. He started with his first hotel in 1961. He built the company into the chain it is today by providing top notch service to its affluent guests. In the past, the company has weathered market downturns as relatively minor bumps in the road. This downturn has proven to be different. In this downturn, several property owners have petitioned the brand management company to reduce costs, sometimes at the guests’ expense. (See the Symptom & Implication, “The industry is reducing costs aggressively” on StrategyStreet.com.) Mr. Sharp will have little of it.

Mr. Sharp, who remains CEO of the company and 10% owner of Four Seasons Hotels & Resorts, agreed to some cost savings that have relatively little impact on the guest. Hotels may now outsource their laundry. They may simplify menus in the restaurants and even close a restaurant on slow nights on those hotels that have multiple restaurants. Some hotels may discontinue stocking fresh flowers in the lobbies as long as they replace those fresh flowers with sculptures or ornate vases. The property owners may also combine management positions and cross-train employees to work in multiple departments. Mr. Sharp believes that a guest will not see these kinds of cost savings in their visits to a Four Seasons Hotel.

But he refuses to go along with other cuts proposed by some property owners. The property owners may not combine the concierge desk with the check-in duties on the graveyard shift. Mr. Sharp insists that hotel employees continue to turn down guest bed covers each evening. He also refused a request to end room service during the middle of the night. All of these changes a guest would notice. (See “Video #46: The Place of Cost Management in Hostility” on StrategyStreet.com.)

These decisions by Mr. Sharp tell us a lot about why he has been so successful in his career. He keeps his attention focused on the quality of his guest experience, despite the short-term cost of continuing that form of Reliability. Profits may dip in the near-term, but he believes they will hold up in the long-term as customers return for the consistent quality of high level services they associate with the Four Seasons brand.

Mr. Sharp is protecting the ultimate low-cost position. We have found in our work and research in many industries that the low-cost position in a market is the ownership of a satisfied customer relationship. A company that owns a satisfied customer will not lose that customer to any other competitor unless that competitor can offer a similar product at a discount that begins at 15% and usually is more. We have not seen any market where peer competitors have cost structures that vary from one another by as much as 15%. Hence, the ownership of a satisfied customer relationship is the equivalent of having a 15% of revenue cost advantage on your peer competitors.

More Steel Capacity. Why?

China’s Anshan Iron and Steel Group has announced plans to invest in up to five new steel mills along with a U.S. domestic partner. The last time I looked, the U.S. was swimming in excess steel capacity. So why would this company enter the U.S. to add to an already over-supplied market? This is a political decision, not an economic one. Though, politics will obviously translate into dollars and cents eventually.

Anshan is partnering with Steel Development Company, a U.S. corporation, to invest $175 million in an initial “micro-mill” in Mississippi. Despite its cost, this is really a small investment. (See “Audio Tip #196: Why Economies of Scale Exist” on StrategyStreet.com.) The capacity of the mill is 300,000 metric tons. This mill will make reinforced metal bar. It adds relatively little to total capacity. The U.S. rebar market has 8 to 10 million short tons of capacity in the U.S. Nor does the new capacity add much to Anshan’s total capacity. Its total capacity in China totals 25 million metric tons.

This is a political investment. The U.S. government is under pressure from U.S. steelworkers. They charge that China competes unfairly in the steel industry. This investment is a partial response to that political problem.

We’ve seen this before. In the 1970s, I worked on a study to determine where a major Japanese electronics manufacturer should establish its first U.S. manufacturing facility. That new U.S. facility was not going to be a lower cost facility than those the company already had in Japan. But it would short-circuit arguments that the Japanese company was dumping its electronic products on the U.S. market. The Japanese automobile manufacturers, notably Honda and Toyota, did the same thing at roughly the same time. Over time, the Japanese auto plants were able to supply the domestic market economically. The domestic plants of the Japanese automakers, of course, have been operating under the cost umbrella held up by the United Autoworkers’ union wage rates and work rules. The U.S. steel industry has a lower union cost umbrella, so we are unlikely to see big foreign investments bringing a lot of new capacity to the U.S. steel industry. That is, we won’t see much more than is needed for political expediency. (See the Perspective, “Must the Cycle Start Again?” on StrategyStreet.com.)

How to Become the Industry Leader

Charles Schwab is the clear leader in the online brokerage world. While there have been hiccups in its development from a simple discount broker to a full-fledged online brokerage firm offering a range of products, the company has always maintained its leadership in the retail brokerage business. It focuses on the individual investor and, importantly, on investment advisors who manage retail customer accounts.

As the long time leader in the online brokerage industry, Schwab has emphasized the Customer Buying Hierarchy elements of Reliability and Convenience. Its advertising emphasizes Reliability, especially a personal caring relationship with its customers, for example, with its “talk to Chuck” advertising. The eponymous chairman and his company have consistently emphasized a relationship of trust between Schwab and the investor. (See the Perspective, “Reliability: The Hard Road to Sustainable Advantage” on StrategyStreet.com.)

Over the last few years, Schwab has entered many different product categories. As part of that effort, the company has recently introduced eight branded exchange-traded funds with very low cost management fees and commission-free trading. A couple of years ago, the company brought out a Visa credit card with no annual fee and a 2% cash-back feature. Its effort in entering these product categories has been to become a one-stop-shop for its customers. These are Convenience innovations. The customer has no need to leave Schwab to buy other products.

Schwab has been insightful in the way it manages its products and customer relationships. Two recent statements by Walter Bettinger, the current CEO of Charles Schwab, demonstrate the company’s commitment to Reliability and Convenience. In the first, the CEO acknowledges that the company may have to offer some products that have poor profitability in order to maintain a long term customer relationship. His observation: “We’ve never looked at product by product profitability as the answer to building a business.” A Standard Leader often has to measure profitability at the customer, rather than the product, level. (See the Perspective, “What We Do Know Can Hurt Us” on StrategyStreet.com.) The second statement is equally compelling and counter-intuitive in many companies. He observes: “Most companies are taken down, not by their competitors’ moves, but by their own.” In other words, industry leadership changes because the former leader fails, not because the new leader wins.

What's Missing in Internet Retailing

Every year I buy several things online. I don’t like to shop in stores because I usually need to buy only one thing. I hate to take the time to go to a store to buy just one item.

Online shopping, for me, beats bricks and mortar shopping on almost every dimension of the Customer Buying Hierarchy. (See “Video #17: Value and the Customer Buying Hierarchy” on StrategyStreet.com.) It has the advantage of Function. I can buy almost anything I want online. It has some advantages, though not all, over bricks and mortar in Reliability. When I shop online, I usually can find several web sites that will give me product reviews on exactly what I am trying to buy. Online shopping is more Convenient. I can sit at my desk to purchase, rather than going to a store and jostling with other equally impatient consumers. Online shopping is also more Convenient for me because I can easily check prices at a number of online outlets without having to visit them physically. So, online shopping also offers a Price advantage. I can usually get a lowest price guarantee when I shop online. That doesn’t necessarily mean that I will buy from the online site offering the lowest price, but I could if I wanted to do so.

I am sure I am not the only consumer who finds online shopping so advantageous. Web sales account for about 6.5% of total retail sales. That is a relatively small share, though it is growing. In 2009, total online sales increased by about 2%, while retail sales in bricks and mortar stores declined. So, online sales are growing market share in the retail sales industry. Why, though, doesn’t it have a higher share of total retail sales? Industry statistics lead me to think that the problem lies in a form of Reliability. (See the Perspective, “Customer Segmentation: Finding the Human Dimension” on StrategyStreet.com.)

The way people purchase today suggests that Reliability still remains a problem for online retailers. The top 500 web sites offering retail products grew 9% last year, considerably faster than total online sales at a 2% growth rate. However, the top 100 retail online sites grew 12%. Consumers clearly preferred the bigger online retail companies last year. Even more impressive, those companies that offer only online sales in the top 500 internet sales sites grew at 20% last year. Consumers are showing a strong preference for those online retailers who live and die with their online performance.

The online-only retailers tell the story of Amazon and the several thousand dwarves. Amazon has a 52% market share of the web-only online sales. The sales statistics and Amazon’s market power suggest that a form of Reliability is holding back the growth of internet retail sales. Consumers would like to know that they will receive the product that they ordered, that the product will work, that, if the product does not work, the retailer will stand behind it and that the retailer will guard the consumer’s credit card information carefully. Amazon has hurdled these barriers well and has reaped the rewards in growth and market share. All the other retailers selling online, especially those outside of the top 100, need to concentrate on creating assurances for their consumers that they can do as well as Amazon in these forms of Reliability.