How to Manage Pricing During Inflationary Times

The inflation genie isn't yet out of the bottle but it is stirring. Core consumer prices are accelerating and commodity prices are projected to continue to climb at an aggressive pace through 2008 (see charts below). The current environment bears a striking resemblance to the 1970s and early 1980s. While few serious economists and industry analysts expect stagflation to become a household word again, most are predicting that commodity costs will continue their upward trend and consumer goods companies will have to deal with pricing more assertively than many have over the past 18 months.

As consumer goods companies attempt to navigate this new, more inflationary environment, three critical business priorities are taking precedence: 1) managing to pass through costs in increased consumer prices while ensuring the price-value equation remains intact across consumers, retailers and the manufacturer; 2) implementing additional cost reduction strategies to offset inflation; and 3) gauging consumer reaction to address major changes in consumer buying behavior. Pricing is no longer a "one off" event but rather an ongoing management practice. In the current environment, it literally pays to be good at it.

Managing Pricing Activity

Pricing has become a central focus of 2008 in the effort to manage spiraling costs. At the recent CAGNY conference in February, no fewer than fifteen CPG companies reflected recent pricing actions in their presentations, substantially higher than the handful of companies with significant pricing activity in previous years. However, analysts remain skeptical in this volatile environment. Following the CAGNY conference, two leading consumer packaged goods analysts made the following statements:

"We maintain our view that these companies lack the pricing power to fully offset rising commodity costs."
Credit Suisse commenting on packaged food companies

"We continue to believe HPC players will have to manage the 'slippery slope' they are climbing (taking pricing in soft economy)..."
Wachovia Capital Markets commenting on Household Products and Cosmetics companies

Increasing prices is not a luxury CPG companies have had over the past decade and the necessary skills have become rusty. Managing price increases well requires a combination of robust analysis to get the price right, qualitative consumer insight, and just plain fortitude.

First and foremost, effective pricing requires a baseline of analysis that can get you to the right price. Critical components of an analytical pricing model include: assessment of elasticities across a product line and category, retailer and manufacturer profit incentive curves, and competitive reactions. In addition to the hard analytics, a strategic understanding of consumer trends and preferences is critical in identifying pricing thresholds, evaluating the impact of pricing on behavior, and protecting long term brand equity. A modeling exercise can tell you an optimum price is $8.12 when consumer research and common sense tells you that consumers just will not pay more than $8.00. In that case, consumer research and common sense should always win the argument.

Once the right price is established, fortitude to make prices stick is fundamental. The real world sets in very quickly as revised pricing is explained to key customers and hits the shelf. Internal analytic reviews can seem like a day at the beach when compared to the sell-in period with customers. This is when clear management directive is indispensable.

If the analytic basis is established and the consumer-retailer-manufacturer value proposition has been thoughtfully considered, near term volume adjustments and customer reaction must be managed and dealt with. All too often, new pricing can be lost to unnecessary trade promotion give backs to pump up near term volume -- basically panic. When unnecessary trade expenses draw from advertising and marketing dollars, the negative result is compounded as long term brand equity is impacted. Properly setting internal and external expectations can often be the secret to a successful price increase. As a good analytic model will tell you, it is typically overly optimistic to set expectations that a brand can support price increases with absolutely no loss in near or long term volume or increases in trade support.

Finally, effective planning and collaboration can improve the success rate for pricing actions. "When and how" are as important as "how much" in the current environment. Developing a structured approach to taking pricing across the portfolio can ease the transition and build retailer support. A good approach should include consideration of: customer plans; promotional strategies; advertising campaigns; new product introductions; and overall portfolio management (e.g., SKU rationalization, brand differentiation). Often this requires drawing on insight from across the functional boundaries of an organization. Reduction in short term volume volatility and other rewards can be substantial if prices are increased during the normal flow of business rather than as a sudden event -- easing the transition for customers and consumers alike.

Two examples of consumer packaged goods companies who have successfully managed price increases reflect this measured approach.

• Kellogg demonstrated the value of a coordinated and structured pricing strategy in 2007 by effectively layering innovation and new product introduction (including Kashi snacks and Take-Along Keebler cookie packs) in its snack segment as it took pricing and moderated promotional programs. The 7% sales growth result is even more impressive as Kellogg transitioned from warehouse to DSD for a large component of the snack business.
• Heinz timed its pricing actions to take advantage of highly publicized commodity cost increases recognizing opportunities in the marketplace. Coordinated advertising investments and new product introductions, including Smart Ones Fruit Inspirations and Classico Organic pasta sauces, solidified realized price increases of 4.5% in its North American consumer products segment during the third quarter of FY08.

Implementing Cost Reduction Strategies

Consumer goods companies have become extremely effective at cost management over the past two decades. These skills are being put to the test however in the current environment as companies work to off-set as much commodity inflation as they possibly can. The major areas for substantial cost reduction, noted in the insert at right, have been aggressively pursued by leading consumer goods companies and are slowly becoming standard practice for lagging or smaller companies as they strive to maintain earnings. Examples of successful techniques include:

• Aggressive hedging operations
  
  General Mills has built a world class hedging operation which has been successful in locking in prices for key commodities including wheat well into 2008. General Mills effectively got ahead of the inflation curve with key commodities like wheat and provided its organization both margin protection and time to adjust to the new commodity environment.
  
• Product redesign and reformulation
  
  Nestle Waters has developed a new bottle, dubbed the "Eco-shape". The bottle addresses consumer concerns about waste and petroleum-based products by using less plastic to produce. Nestle is able to reap the benefits of this consumer-friendly innovation in the form of reduced packaging costs. The new bottle design is expected to save up to 65 million pounds of plastic resin per year.
  
  Unilever has developed a healthier mayonnaise, Extra Light Hellman's Mayonnaise. While the new product responds to consumer trends toward functional food, the formulation has an added benefit for Unilever. The new product uses less oil, a commodity that has seen dramatic price increases over the last year.
  
• "Price-to-serve" modeling
  
  Companies that have mastered the cost-to-serve challenge are beginning to price these differentiated customer service models to capture the value of unique packaging and delivery offerings. Price-to-serve and other "menu based pricing" strategies are a complementary component of consumer pricing and key account strategies.

Major Trends for Transformative Cost Reduction

Low cost country sourcing and manufacturing outsourcing

While apparel and many consumable sectors have aggressively moved production off-shore or to third party contractors, many food, healthcare, household and general packaged goods companies have been surprisingly slow to do so. That attitude is changing as traditional concerns related to safety, product stability or cycle times are being creatively addressed and outsourcing or off-shore production becomes a sensible method for significant cost reduction. In many cases, the added benefit of substantial and strategic manufacturing outsourcing is creating a greater focus on those areas where a consumer goods company must excel: innovation, marketing distribution and service.

Packaging and reformulation

In addition to commodity cost inflation, sustainability programs and Wal-Mart have all put pressure on manufacturers to remove unnecessary material from packaging or product formulation. Consumers have become increasingly conscious of excess material in their consumer products and Wal-Mart and leading manufacturers are appropriately taking advantage of this and the sustainability trend to remove that waste from the consumer supply chain through improved product and packaging design.

Deeper customer cost-to-serve management

It is certainly true that not all customers are created alike and some are more expensive to do business with than others. This is not a new phenomenon but as cost pressures mount, leading consumer companies are developing advanced allocation methods to more accurately track costs by channel and key customer including retail execution costs, production and unique distribution costs, order management costs and unique channel or account services. More advanced cost-to-serve models have aided creative account arrangements designed to reward growing and profitable customers and redeploy support from stagnant or costly customers.

Gauging consumer reaction

Consumer reaction will likely be the trickiest and least predictable aspect of navigating through this new period of rising commodity costs. How will consumers react to outsourced or off-shore production? Do they mind that their favorite cookie brand doesn't actually make the cookies? Will private label become more or less attractive as overall prices rise across a category? Will consumers begin to migrate away from categories as they seem to become a luxury or appear wasteful in an age of sustainability? The answers to these questions can make or break a brand. And this is where vigilance and coordinated efforts with Marketing and Market Research are critical.

Fortunately, consumer behavior does not seem to have changed much - so far. Recent studies suggest that consumer behavior has not changed in response to price increases within the last 18 months. According to IRI data, prices have increased in 44 of 45 categories year over year (an average increase of 4.4%, 3.8% excluding dairy) with limited to moderate volume deterioration. As expected, private label has been forced to raise prices even more aggressively than branded products given their cost structure causing the gap between branded and private label products to narrow over the past twelve months.

As a protective measure, companies seem to be investing in long term brand equity. Advertising spend is up across the consumer products industry as companies attempt to balance the necessary price increases with brand-building campaigns. While consumer behavior has not changed to date, this is a very uncertain market and prices will remain volatile. Companies that are nimble in both pricing and consumer intelligence gathering may be able to have their cake and eat it too.

Dave Sievers is a principal and leader of Archstone Consulting's Consumer and Retail practice. Patti Muldowney is a director with Archstone Consulting in the Consumer and Retail practice. Archstone Consulting is a Strategy and Change, Operations and CFO Advisory management consulting firm, specializing in the consumer products, retail, life sciences and general manufacturing industries. www.archstoneconsulting.com.