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Operations and Pricing - What we can learn from the recent P&G price increase
Procter & Gamble announced it would raise prices across its portfolio. P&G, which owns over 20 different billion-dollar brands, including Head & Shoulders, Crest, Pampers, and Tide, is making a bet that the power of its brands is greater than consumers’ shrinking wallets. In doing so, the Cincinnati-based consumer goods giant joins the ever-growing list of companies who plan to pass inflation onto consumers. This shouldn’t surprise many people. The announced P&G price increase is in line with what you’d expect given the company’s operations and pricing strategy.
The relationship between pricing and operations
The relationship between pricing and operations is straightforward. If a company’s product is a commodity, it won’t be able to demand higher prices. That means it will struggle to gain any cost advantages through branding and must achieve it through operational efficiencies. Outside of the decline of anti-trust enforcement, this was the core reason Walmart succeeded so rapidly. It flawlessly aligned an every-day-low-price approach with streamlined operations.
TreeHouse Foods, which specializes in private label packaged foods, earns its’ profit this way. Now, faced with rising commodity and transportation costs, the company faces sparse operating margins–around 3%. Meanwhile, P&G, which faces the same headwinds but owns powerful brands, has operating margins of about 22%.
If TreeHouse reduced operating costs by 1%, it would have a massive impact on its profitability. To achieve that same impact via increased sales revenue, it would need to increase revenue by (.01/.026) 39%. That’s not remotely realistic. Meanwhile, P&G, with its high operating margins, would need to increase revenue by (= .01/.22) about 4.5 percentage points.
The table below shows the corresponding revenue increase needed to match a one percent decrease in operational costs across a few private label and branded CPG firms. One interesting thing to point out is that Kimberly-Clark is P&G’s biggest competitor in the disposable diaper market. It also has a significant private label presence.
Operating Margins and Price Increases
Company Operating Margin Revenue Increase per 1% decrease in Operating Costs Clorox 22.7% 4.4% P&G 22.4% 4.5% Church and Dwight 21.4% 4.6% Kimberly-Clark 13.8% 7.2% Spectrum Brands 3.2% 31.3% TreeHouse Foods 2.6% 38%
What does this mean?
Typically, branded companies could drive increased sales through more trade promotions or marketing spend. Trade and marketing drive more volume. This of course comes with added cost.
However, with inflation on everyone’s mind, branded firms seem to be piggybacking on inflation. For the strongest brands, they can add potentially add sales growth entirely through higher prices.
During the investor call, P&G CEO Andre Schulten played down any operational improvement work.
Number one, when you think about cost savings projects, they require line time, that line time is competing with the need to ship cases in a very constrained supply chain. When we think about innovation, we frequently talk about our desire to close price increases with innovation. Innovation also needs line time. So cost savings projects on the line also compete with innovation, and they compete with our desire and need to ship the business. Therefore, in a constrained environment, as you point out, our businesses make the decision to focus on innovation, focus on shipping the business, which is better for retailers better for consumers, better for us in terms of value creation, but it has an impact on cost savings. The good news is these cost savings are available to us in the future; they don’t go anywhere. But you see a little bit slower ramp-up in that context.
The P&G price increase summed up
Essentially, P&G is betting that the higher prices it will charge through innovation will make up for the lack of any increase in operational efficiencies.
Now is the time to point out that P&G is estimating that organic sales revenue for FY22 will increase 4-5%, which is right in line with the simple calculation above.