Chief Pricing Officer

Meat Demand - The Big Picture

Every day billions of us make decisions on what we will buy, and how much of each item we will purchase.  Those decisions are tempered by how much money we have to spend, the relative prices of the goods and services available to us, and our individual preferences.  Our preferences are probably more determined by social norms and habit than we would like to admit, and do vary greatly by country.

Meat demand around the world is no different than any other good.  Depending on a wide variety of local conditions there are significant differences in meat diets at any point in time.  For example, in Australia, Brazil, Argentina and the U.S. we observe that beef has a much larger share of the diet than in Europe or China.  The major reason is that beef consuming countries need large areas of land suitable for grazing a beef cow herd.  China and Europe are crowded places, with limited land available for extensive grazing systems.  So, in Europe and China pork and poultry make up the vast majority of the meat diet.

When we look at total meat produced and consumed over time the spatial differences at a point in time tend not to matter.  What does matter though is total income and resulting total consumer buying power.  Funds available for consumer spending have driven almost all the growth in meat demand since at least 1961 (and probably before that if the data were available). 

The relationship between total consumer buying power and total meat production is one of the most remarkably consistent in all of agricultural economics.  The results of a simple regression between consumer spending and total meat consumption is shown below:

Goodness of fit:

Where:

Y = Total global meat production from FAO, FAOSTAT database, 1961-2007

Consumer Expenditures = Global final consumption expenditures, $2000, from the World Bank, World Development Indicators database, 1961-2007

Graphically, the relationship between the variables appears below.  The statistical fit is not quite as good in the 1960s as it was in later years, but the overall pattern is still quite consistent.

Several functional forms, including logarithms and exponential, were tried. The simple linear form had the best statistical fit and least amount of autocorrelation. 

At the data means the elasticity of production to a change in expenditures is 0.91.  That is, a 1% increase in expenditures results in a 0.91% increase in meat production (the elasticity from a natural log functional form was also about 0.90).  The coefficient for expenditures indicates that a $1 trillion increase in $2000 expenditures results in about a 9 million ton increase in total global meat production.

Not included as a separate variable, but also of critical importance, is global population.  From 1961 to 2007 population more than doubled.  All else equal, that factor alone should have doubled meat demand.  Looking forward, the rate of population increase is expected to slowly decline over the next 40 years.  Slower population growth will slow the rate of increase in global total real income and consumer spending.  Thus we should expect some slowing in the rate of increase in meat demand and production.

The equation tells us several things about 1961-2007.  There is a strong and consistent pattern of globally increasing real incomes that drove real consumption spending, and that drove meat demand, and then production.  The relationship has been consistent enough to tell us that the preference for spending for meat has been strongly ingrained for the almost 50 years of available data.  Despite some news about increasing societal preferences for avoiding meat consumption there has been no measurable change in global meat spending behavior.

Another pattern seen around the world is that as economies reach higher levels of real income and spending the demand for meat tends to respond less to increases in real income.  Market saturation may have an effect on future responses to increases in real income on a global scale, but there is no sign of any weakness in that response through 2007.  Outside of the richest countries of the world there are still well over 5 billion middle and low income people who would very likely increase meat consumption if they had more income.  Population growth in low income countries also tends to be higher than the global average.

It is implied by the equation that future gains in the volume of meat produced in the world will depend almost entirely on demand increases driven by increased incomes and spending.  However, one significant item that has not been statistically significant, meat prices, could derail this relationship, at least temporarily.

In fact, the astute reader should have already asked: “But what about meat prices, don’t they matter too?”  The answer is yes, they do.  But from 1961 to 2007 prices on a global scale did not vary enough to disturb what consumers do with their meat spending habits. 

Looking forward from 2009 we are seeing, on a global scale, real costs of meat production coming from grains and oilseeds markets that appear to have quickly moved to new price plateaus.  Those higher costs are in the process of being passed through as higher real retail meat prices.  Will those price increases be enough to cause a permanent change in consumer behavior?  History would argue that we might not see a significant effect.

We saw this same thing happen in the 1961-2007 data used in the regression.  From 1972 to 1976 there was a similar step-up in real feed costs and real meat prices.  If you look closely at the chart 1973 global meat production did actually fall below the long term trend, but then recovered in 1974-1975.  Increases in real income overcame real price increases, and the long term trend resumed.

Prices do matter in other important ways.  The relative prices of meats have had an important effect on the global market shares of the major meats.  Beef, generally the most expensive meat to produce, has seen its global share fall.  Chicken meat, the least expensive of the major meats, has seen major global share increases since 1961. 

Prices also matter enormously on the scale of short time periods and individual country and species markets.  Here in the U.S. were are currently seeing a price-cost squeeze coupled with a decline in real consumer spending that is leading a significant reduction in total meat production.  However, if history and the regression results above mean anything at all, when the global and U.S. economy begins its recovery meat demand will resume its long term growth path.

Market-driven price signals are also essential in determining decisions all the way down to the level of how producers process and market individual meat cuts.  At an a very low level of granularity price signals can determine, for example, whether chicken leg quarters are deboned, exported, or sold in the fresh market.  These decisions are critical to producer profitability and to supplying consumers with the optimal mix of the many products that can potentially be made from a live animal of any species.

Finally, freely moving, market-driven, prices are a major driving force behind the long term growth of global meat production and consumption.  Prices are the signaling mechanism that, at a very low level in time and space, efficiently tell producers what to produce and consumers what to buy.  Market prices are the mechanism though which we can approach an efficient and optimal product mix that simultaneously avoids waste, gives consumers the products they want, and allows producers to earn a profit.  Paradoxically, at a very low level, prices are almost all that matter.

pricing and margin in disassembly businesses

Back in March, the Chief Pricing Officer wrote about the concept of a pricing waterfall, which was introduced by McKinsey in “The Price Advantage”.  Price waterfall is an important method to determine the pocket price and margin for many businesses, but for disassembly businesses the challenges in calculating margin take a different form. 

For disassembly businesses, such as meat processing or lumber, the challenge (which is caused by the nature of the business) is that the organization needs to buy the supply as a whole entity (e.g. animals to process; trees to cut, etc) and then disassemble that entity into sellable parts (e.g. beef primal cut or ground meat for a beef processor; 2×4x12 or 4×4x12 for a lumber company).

Beef Production

Lumber Production

Part of what makes this even more complicated is the fact that not all the products that are produced have the same value.  For example, in the beef business, consumers will not pay the same price per pound for ground beef as they will for New York Strip steaks. Each cut has its value to the consumer and determining the right prices requires in-depth industry knowledge as well as the appropriate toolset.

The lumber industry, encounters similar challenges when pricing the different grades; the price of wood chips is not the same as a 2×4 plank.

So why is this such a critical challenge?  Well, at the end of the day, these companies need to ensure that the revenue gained from selling all the finished goods covers their expenses, of which, the raw material often comprises the largest portion.

These challenges are the reason that understanding the historical margin at the supply unit level (e.g. live cattle or trees) is crucial to a healthy business.  So what does this have to do with pricing? 

In the meat processing business, the overall revenue from a carcass is referred to as the cutout. This represents the total revenue obtained by virtually reassembling the carcass considering each cut’s yield and the price achieved in the marketplace.  Said another way, the cutout calculation takes into consideration the disassembly bill-of-material (BOM) as well as the revenue for the different cuts or pieces. When comparing this overall revenue to the corresponding costs (typically the cost of the whole supply unit – live animal; trees – is adjusted to consider the actual yield of the finished goods), you get a good idea of the gross margin achieved. Historical prices support the calculation of a historical cutout and gross margin picture, enabling disassemblers to understand how their business performed in the past.

Even more important however is being able to look forward, by applying the cutout calculation logic to projected costs and selling prices – allowing disassemblers to view forward looking margin.  This is critical to making effective business decisions.

To better illustrate the complexity, the following illustrates how carcasses are broken-down into different cuts based on the countries:

Reassemble Beef Carcasses to Calculate Revenue

The lumber industry has a similar challenge as trees are broken down into different finished goods:

Reassemble Trees to Calculate Revenue

And this is what is common between those businesses and the used part dealer – the dealer needs to make sure that when the revenue from the different parts is added up for the tires, windows, body, etc, this revenue exceeds the cost of buying the car and the labor used to disassemble it and market the parts.

Managing prices and margin in a disassembly business is different from those portrayed in the previous price waterfall discussion, however mechanisms like cutout help disassemblers better understand historical performance and take proactive, corrective actions going forward just as the margin waterfall helps manufacturers in traditional assembly businesses.

Sounds pretty lofty and never an easy undertaking – transforming an organization.  But, even in this difficult economy and especially because of it, leading manufacturers are doing just that – transforming their pricing organizations to achieve better control over margins and profitability.

A 2008 AMR Research study “Building a Bullet-Proof Business Case for Pricing Improvement Initiatives” conducted by researchers Noha Tohamy and Heather Keltz asserts, “Companies that succeed in improving their pricing practices have typically centralized many of their pricing practices and invested in training their sales organization on fact-based pricing.”  A centralized pricing organization focused on using improved forecasting and optimization for more fact-based selling characterizes the companies that, in my experience, have successfully implemented pricing initiatives, as measured by their profit gains (ranging from over $1 million up to $20 million). Moreover they have been able to reduce price volatility.

There are four key elements at play in the success or failure of every pricing transformation:

1. Re-designed and Centralized Pricing Processes

2. Enhanced, Cross Department Communication

3. Effective Training, Integrating Process with Technology

4. Active Executive Sponsorship

Centralized Pricing Processes

In his recent guest post, Dr. Michael Freimer highlights the impact of price volatility and the need for tools and processes to control volatility.  Organizations that centralize the pricing function along with implementing better processes and tools gain better insight into customer buying patterns and improve fact-based pricing decisions.   For example, a growing commodity processor created a price management function focused on finding margin opportunities through changes in operations, product mix, and timing.  The price management function reports directly to the CEO and helps the organization execute their strategy to shift from spot to more forward sales of their commodity-based products.  Price managers have the responsibility for conducting detailed analysis of improvement opportunities using sophisticated forecasting and optimization software and communicating the results of their analysis to the sales team.  This provides sales with more fact-based and dynamic information that can be used in sales transactions.  In the fast-paced, transaction-oriented world of the sale representative, the time to conduct this type of analysis was virtually impossible without the benefit of the price manager’s role.

Enhanced, Cross Department Communication

Enhanced communication with the sales team is another benefit of a centralized pricing organization.  To achieve better communication, processes must be examined in light of the desired organizational change.  Cross-departmental communication can be facilitated through the use of common tools and by clearly defining the guidelines for how prices are quoted to the customer.  For example, one successful meat packer’s pricing team is accountable for establishing the final price quote for each transaction, while giving its sales team visibility to the same forecasting and optimization technology used for price setting so that both groups are consistent in their understanding of market trends. With this visibility, sales representatives have more “pricing courage” and provide better pricing guidance to customers, resulting in improved relationships with key accounts.

Effective Process and Technology Training

Training both the sales and pricing teams on the new processes and tools is also imperative for success during the transformation.   Understanding how to navigate forecasting and optimization applications may be fairly straightforward, however, understanding the use of these more sophisticated technologies within the pricing process is less so.  Effective training integrates both the process and technology use cases.

Active Executive Sponsorship

Too often organizations assume that by simply communicating a change and providing training that immediate execution will occur.  Training is only one aspect of managing the transformation, active sponsorship at senior levels must be present.  Executives who support structural and process changes as well as the implementation of new technologies and tools ensure that true transformation occurs.   Holding managers accountable and identifying champions for change from among the pricing and sales or buying groups are just two of the roles that executives play in managing the transformation.  Additionally, executives and managers must support shifts in the organization’s compensation structure to better align them with profitability goals.

AMR’s research points out the benefits of centralizing the pricing function as well as the risks.  Process redesign, implementation of improved forecasting and optimization technology, training and strong executive support represent the strategies for mitigating risk and achieving true transformation.   The true measure of the transformation is the attainment of profitability goals – that’s the real bottom line.

Cooperation Means More Pie for Everyone

In a downturn, especially one with deflationary moves at retail, you get enormous pressure on margins throughout the supply chain - that’s generally not debated.

There are several ways supply chain companies might react to this: manufacturers - especially those with frequent price and promotion changes - may apply analytics to the price setting process, to get much sharper about what wholesale price they’re willing to accept for their products. This advantage comes not only from quantifying their customers’ price elasticities, but also from understanding the relative margins available from various products they sell which compete for the same capacity and raw materials.

Analogously, the retailer might apply sharper analytics to the purchasing process, to more accurately measure their seller’s indifference points and minimize product cost.  While both of these measures can have a significant positive impact on margins, there is a different approach with much bigger potential: cooperation.

If the manufacturer and retailer simply work together, and make an effort to help solve each others’ “problems” there is usually a bigger advantage available to both. For example, if a manufacturer’s sales team works with its retail customer to optimize exactly which product promotions will work best in specific stores, in specific time periods, he provides his customer with knowledge acquired from a much larger data set than the customer has available on his own.

However, what really turbo-charges this model is that there are win-win opportunities available at times when the manufacturer is undersold or “long” on a product in some future time window, say six weeks out, and needs to solve this problem. In this case the manufacturer calculates how much discount it’s willing to offer to get back into “balance,” and uses analytics to decide exactly which retailer customer would get the most bang for the buck from putting this product on promotion in that window, and then works with that retailer to strike a deal. So the manufacturer fixes a problem, and the retailer gets help with a promotion tailored to their own customers’ preferences, and for which they bought the product at a very special price. This is much better for both parties than haggling - no matter how good they are at it!

The bottom line is that there are clear, and significant, advantages to manufacturer-retailer cooperation, when they work together as real partners.

Thanks to the advanced price and product mix optimization technology manufacturers and retailers are starting to use today, it is possible for the entire supply chain to sharpen their game - and their margins. BOTH sides can  get a bigger slice of the proverbial pie.

Mike Neal, Founder & CEO
SignalDemand
www.signaldemand.com

Today Businessweek magazine is featuring comments from my friend and colleague Mike Neal (CEO, SignalDemand) on its homepage in reference to the article “Grocery Stores Fight Back Against Food Prices.”

According to its editorial staff, Businessweek’s new online “In Your Face” section highlights readers that offer “smart, incisive comments that move the conversation forward” - and this week the topic is Food 2.0:

The article is a worthwhile read, taking a look at the quickly forming “battleground” over food prices. Here’s an excerpt to give you an idea:

A year ago, when the cost of commodities such as wheat, oil, and corn was soaring, grocers grudgingly accepted price increases from Kellogg (K), General Mills (GIS), H.J. Heinz, (HNZ) and other food manufacturers. The strange thing is, those price tags never came back down, even when commodity prices collapsed in the fourth quarter of 2008. As a result, grocers have little cheer to offer their shoppers at a time of deepening economic gloom. “The prices don’t seem to go down as fast as they go up,” says Jeffrey Noddle, CEO of Minneapolis-based Supervalu, one of the nation’s leading grocers.

Now, the grocers are demanding action. On Jan. 7, Noddle told analysts to expect a “battleground” over the next six months as he pressures manufacturers to adjust their prices. And if they refuse? “In almost every category,” notes Noddle, “you have other vendors to look to.”

The food companies recognize that increases in the price of food outpaced commodity inflation during the fourth quarter last year, which should have resulted in higher profits. However, they argue, previous price hikes didn’t completely cover escalating production and commodity costs….

And for your convenience, Mike Neal’s comments in full:

Every major food producer has been anticipating this impasse. The problem lies in the fact that many producers don’t have the ability to accurately resassess their risk if they were to adjust prices. In order to confidently renegotiate contract prices, food producers must be able to accurately calculate the impact of price changes on volumes and margins, for each product line and customer contract.

Part of that calculation is a prediction of the success of demand shaping with strategic price changes. Without this knowledge and assurance, food producers with long term contracts could be effectively signing their own death warrants if faced with another jump in commodity prices.

Fortunately, technology has caught up with the pressures of the global marketplace and food producers are starting to adopt technologies that allow them to bring a new transparency and confidence to price strategy and contract negotiations. I envision that a new role - Chief Pricing Officer - will emerge from this awareness of the powerful strategic role pricing can play in the enterprise.

All you price professionals out there - what’s your take? Weigh in with a comment of you own on ChiefPricingOfficer.com.

Rip

The art and science of price strategy is not easily understood, let alone mastered. P.J. Jakovljevic at Technology Evaluation Centers (TEC) has undertaken this field as part of TEC’s coverage of supply chain issues.

Jakovljevic demonstrates keen insight in the not-to-be-underestimated area of pricing and offers several interesting articles via the TEC blog. He recently posted Part 2 of his analysis of SignalDemand, which I encourage you to check out, along with his overview of other pricing technology vendors. Here’s a brief excerpt to give you an idea:

Pricing Science of Matching Supply and Demand

Other price optimization solutions really only consider the demand side of the pricing equation, and these results are insufficient for manufacturers to make decisions when they need information on capacity and production constraints as well. SignalDemand’s hand-picked team of scientists and mathematicians from prestigious universities have built a pricing science based on eight pending patents.

This sophisticated science drives the recommendations provided by the software application. When making decisions on margins, the idea is to account for all major profit drivers such as to

• align strategic business objectives with pricing decisions;
• understand demand drivers to forecast future sales;
• account for fluctuating costs;
• on the supply side, account for asset utilization, available capacity, and inventory situation; and
• determine the most profitable product mix for a given demand.

Accounting for all the above factors helps with much more complete, consistent and actionable information to better anticipate future costs, forecast demand, identify poorly performing products or customers, and explore projections in the context of historical sales.

I encourage you to check it out along with his overview of other pricing technology vendors and general supply chain coverage.

SignalDemand: Dealing with Supply- and Demand-side Pricing Matters — Part 1

SignalDemand: Dealing with Supply- and Demand-side Pricing Matters — Part 2

The TEC Supply Chain Logistics Blog

One particular phrase in Obama’s inauguration speech really struck a chord with me and the folks I work with at SignalDemand. Obama declared he would…

“restore science to its rightful place”

To our ears, that sounded like a ringing endorsement for the work we do.

Science isn’t limited to the R&D labs - it should be at the heart of business. Applied science can provide the concrete evidence and predictive models required for making strategic, high-impact business decisions when thousands of variables and millions of potential outcomes are involved - way beyond the realm of standard business software or spreadhsheets. The field of wholesale pricing is a prime example and it’s a white hot area on the cusp of reaching its potential. It’s encouraging to hear that the new administration plans to refocus on science.

So, do you think he’s going to do it? Cast your vote by commenting below on whether Obama will “restore science to its rightful place.”

Recently, Dave Dewalt of Franklin Foodservice Solutions shared his perspective on the current state of foodservice price strategy with the CPO blog.

Dave Dewalt, Franklin Foodservice Solutions

Dave works with some of the largest, best-known food companies in the world to tighten up their pricing practices, tune up their redistribution programs, trim their product lines and generally improve business through improving pricing programs. Dave has a masters in marketing and finance from the Kellogg Graduate School of Management at Northwestern University and he worked with Sara Lee Bakery, Vlasic foods and Awrey Bakeries before joining AT Kearney as a management consultant. He launched Franklin Foodservice Solutions in 1996 and in 2006 helped launch the SMART Share Group of Food Service Broker Agencies, which broadened his perspective on foodservice issues.

Dave offers an excellent monthly e-newsletter, featuring an article from SignalDemand’s Chief Scientist Bob Pierce this month: “Get Smart About Foodservice Pricing.” You can subscribe to the Franklin Marketing Insights newsletter or download the current issue from the Franklin Foodservice Solutions homepage. The current volume is also posted on the SignalDemand “In the News” section of its Website, here.

Here’s what Dave had to say about the pricing challenges faced by all foodservice manufacturers today:

Most organizations believe that they are totally unique in their challenges. What shared price-related challenges do you see across all sizes and types of foodservice companies?

I see the major distributors taking an intense interest in understanding the manufacturer’s logistics costs, and working to separate them from product costs. This might ultimately lead to changes in manufacturer price structures, pickup allowance programs, and policies. Distributors want manufacturers to make transportation and warehousing costs transparent, then work with the distributors to determine the best way to share these costs.

The challenge for manufacturers is twofold:

• To quantify their costs at a level of detail which is unprecedented for many

• To share this information with trading partners, which requires a level of trust which has historically been lacking in many manufacturer-distributor relationships

In your opinion, in what way has the introduction of increased commodities volatility changed pricing for foodservice companies?

Many food manufacturers adopted “formula pricing” models for low value-added producs sold to major chains (pricing based on a published commodity cost plus a “conversion cost”). In some cases, the supporting assumptions and math were not particularly accurate, but manufacturers priced to get the business, and in times of stable commodity costs, everyone “got by.”

With significant swings in commodity costs, these programs are being called into question. In the worst cases, customers refused to accept the price increases which resulted from applying the formula to high commodity prices, sending everyone back to the table. Hopefully, manufacturers, distributors, and large operators are reconsidering these programs, and supporting them with better documentation and clearer understanding of what will happen the next time markets become volatile.

Wholesale pricing for the food industry is certainly going through a period of change, and transparency of costs is definitely emerging as a top priority. Commodities volatility is requiring that everyone evaluate their pricing programs, hopefully instigating a renewed commitment to really optimize price strategy using the technologies now available to weigh costs, supply and demand factors - rather than relying on old models that were used to eek by in the past.

Thanks, Dave!

As mentioned previously in the CPO blog, the 2008 SIGNALS event’s keynote speaker was best-selling author and Duke University professor Dan Ariely. Of course, as the economy and election aftermath take center stage, it would make sense to see the behavioral economist’s commentary all over the media:

Business Week:  “Homeowners cling to false optimism about own home”
Scientific American:  “Who has a better sense of humor – Liberals or conservatives?”
The New York Times: “Eyes Off the Price”

But whether we’re talking about the housing slump, politics or the gas pump, his observations show us that the human and emotional sides to pricing are very real. In the BusinessWeek article regarding real estate pricing, Ariely says, “To a homeowner, a low, but realistic, listing price is ‘like someone calling your kids ugly.’” And in relation to that weekly fill-up, he slyly notes, “Perhaps it would be better if gas station attendants filled the tank for us, as they used to, so we did not stand at the pump watching the rising price of our gasoline.”

As he highlights the emotions surrounding our sense of pricing and what we feel that things should cost, I am reminded of what this means on a larger scale: Manufacturers dealing in millions of widgets, barrels of oil, or bushels of wheat aren’t immune to the pitfalls of what is essentially irrational human behavior. But if they are to compete in today’s economy, they have to make the effort to stay above the fray.

Price optimization science – integrating as much historical, economic, and market-based data as possible – is essential to achieving this. The key word here is science: Every price should be as informed as possible and framed in the most current and relevant context available. And while there is always going to be an emotional component to the prices that humans negotiate with other humans, the goal should be – especially for complex and many-tiered industries – decreasing the weight that those emotional factors play.

Experts like Ariely throw very valid questions into the mix, and the marketplace of ideas is the better for their contributions. But how can we mitigate the irrationality in our own pricing behavior? Information is key in that battle. With everything available to us at the push of a button, it’s almost foolish to not use as much data as possible to make decisions – be it to guide our decision making, or to prove or justify a hunch or gut feeling. Information can help us better rationalize the choices we make, and it’s key to helping us make pricing decisions that make sense, both today and tomorrow.

Need more proof that pricing is more important than ever? Well, how about this headline from the Associated Press: “Food Prices Remain Stuck at High Levels.”

The American Farm Bureau Federation (AFBF) released its quarterly survey of retail food prices and found that even though gas prices and other costs of production may have dropped slightly, manufacturers are still feeling the pinch of rising production costs. Of the 16 items surveyed in the study, 11 went up in price, while only five went down. The overall price increase for these 16 items was 10.5 percent. Among the products that went up: pork chops, sirloin tip, ground chuck, cheese, apples and potatoes. The reason?

“We continue to see increases in several staple food items due primarily to the long-term effects of high energy prices in the food sector. Sustained high costs for processing, hauling and refrigerating food products are reverberating at the retail level,” said Jim Sartwelle, an AFBF economist.

Regarding the top gainer in this quarter’s survey, Sartwelle explained, “Acreage planted to potatoes was down nearly 8 percent this year. The combination of a smaller crop and some production losses in the field has led to higher-priced spuds in the produce aisle.”

The reality for food producers is that price spikes are here to stay - at least for the foreseeable future. So, what to do? Producers and manufacturers need to find a balance between maintaining profits without passing too many costs off to consumers. With proper insight into prices across channels, customers and product lines, producers should be able to make smart decisions about where margins can be maximized and where demand can be shaped with price in order to drive profitability without across-the-board price increases.