In the past year, the most fundamental of the 4 Ps of marketing—price—has rapidly risen to prominence.
In a way, that is an inevitable outcome of the recent media focus on macro factors that determine the economics of demand and supply—inflation, employment, and income, to name a few.
Not surprisingly, as the consumer price index flutters up and down, all eyes focus on commodity prices. So how much impact do commodity prices have on retail prices? And on product managers' pricing strategy?
The relationship between commodity prices and retail prices follows a simultaneous feedback loop. Although in the short term retail-price changes lag commodity-price changes, in the long run they can also drive commodity-price changes.
For instance, retail gas prices respond to short-term changes in crude-oil prices: Disruptions in crude oil supply cause crude-oil prices go up, resulting in a corresponding spike in pump prices. In the long run, however, as inflation and slowing economies decrease demand, the commodity prices could dip to adjust for lower demand levels.
To further complicate matters, commodity prices are heavily driven by short-term expectations and market news, and are determined by trading on financial markets; retail prices, however, are less prone to react to market news and are determined by actual demand-supply economics.
The US Department of Agriculture (USDA) has provided some insight into the relationship between input costs and food retail prices that helps us better understand how commodity prices drive retail prices. Specifically for food prices, the USDA suggests that the following factors determine that relationship:
- The share of the input costs in the total production cost
- The availability of substitutes in the food-production process (e.g., sugar vs. high-fructose corn syrup)
- The availability of consumption substitutes, which results in demand substitution and a weaker relationship between the two
- Short-term vs. long-term commodity-price changes
One would expect the first factor listed above to be the most-immediate driver, since products with a greater share of input costs in the retail-price formula would react the fastest to changes in commodity prices.
The USDA estimates that input costs are approximately 19% of retail prices and also provides the following guidelines for how corn's share of input costs affects retail prices ("Understanding the Impact of Higher Corn Prices on Consumer Food Prices" [pdf]):
- Cereal and bakery items: 4%
- Beef: 48%
- Pork: 27%
- Chicken (fryers): 50%
- Dairy products: 38%
- Fats and oils: 15%
When one looks at the above percentages, another logical aspect becomes immediately evident: The share of commodity cost depends on the complexity of the production process. So, if only 19% of the retail price consists of input-cost changes in commodity prices, should the average pass-through rate be 0.19% for every 1% change in commodity costs?
Not necessarily: 19% of retail prices is not the same as 19% of the cost of goods sold; and, depending on how much profit margin the product has and how much leverage (brand equity) the manufacturer has with the consumer, the manufacturer may be inclined to protect its margin (100% pass-through) or suffer margin compression to protect market share (less than 100% pass-through).
Correlating monthly commodity prices for various commodities such as aluminum, energy, barley, coffee beans, and high-fructose corn syrup with monthly average retail prices for more than 500 brands of beer, coffee, and soft drinks revealed some interesting insights:
- Beer brands generally showed a strong correlation to commodity-price changes. That, combined with the strong consumer preferences for beer brands, is consistent with the notion that the stronger the product's leverage or equity with the consumer, the greater the ability to pass through input-cost increases to the consumer.
- Retail prices of beer and soft-drink brand showed a stronger correlation to agricultural commodity prices as compared with aluminum's commodity price.
That possibly suggests that manufacturers may be better able to hedge the impact of price changes for stable production commodities, such as aluminum, than for agricultural commodities, which are prone to seasonal and weather shocks, or energy, which is prone to production and demand shocks. (It may also be because these categories can use plastic packaging as an alternative to aluminum.)
From the perspective of product managers, the retail price that they set is determined by the margin objectives of senior management and the promotional budget available to them. So commodity prices tend to have a less-direct impact on their day-to-day lives.
That said, it may be wise to keep a few things in mind:
- The paramount objective of corporate stakeholders is better profits, though volume growth and market-share gains may be interim objectives. So an upward pressure on input costs translates to either an increase in long-run pricing or lesser promotional discounting.
Product managers may do well to anticipate such a directive from senior management and evaluate alternatives to offset the negative impact from higher prices.
- Consumers' sensitivity to price changes is not at all uniform. Leverage pricing analytics to determine the price sensitivity (elasticity) of the product portfolio, not just in aggregate but across geographic and consumer segments.
In an inflationary environment, product managers can leverage pricing analytics to deploy a segmented pricing strategy, which consists of identifying inelastic areas within the target market where one can raise prices, while keeping prices flat in the most-vulnerable markets.
The correlation analysis suggested that brands with greater market share tend to have a stronger correlation between their retail prices and commodity prices. Such brands would be expected to have a greater equity with consumers and so would be less worried about losing market share when passing commodity-price increases to consumers.
A corollary is that an inflationary environment makes it difficult for smaller players to compete in price, as margin compression eats into their profits. A segmented pricing strategy becomes especially critical for smaller players in that environment.
One final nugget of wisdom: If a retail-price increase is inevitable as a result of a commodity-price increase, offset a drop in demand for your product with increased brand marketing. The impact of advertising on brand equity and underlying demand is gradual compared with the impact of pricing, but several studies have established that stronger brand equity results in lower price elasticity in the long run.
If you operate in a category with a significant dependency on an inflation-prone commodity, then relying on price discounts to drive market share may not be a good long-term strategy. Instead, focus on building the brand's core equity through innovation and branding.