Starbucks and the Dangers of Discounting

Starbucks suspended guidance as it tries a difficult thing: pulling the discounting IV out

Starbucks suspended its revenue guidance as it broke the news that same store US sales were down 6% from the prior year in the three months ending Sept 29, while the number of transactions in US stores was down 10%.

The new CEO, Brian Niccol, has announced plans for a significant decrease in discounting. During the first part of this year, Starbucks was increasingly using Buy-One-Get-One offers and 50% off discounts offered through its app in an attempt to juice sales. But the result was reported to be unpredictable surges of traffic which the stores were not staffed for and drawing in opportunistic customers who did not return to buy full priced drinks.

What Starbucks is doing is one of the most difficult transitions a company can go through: convincing your customers you are serious about stopping heavy discounting behavior without destroying your sales in the process.

There are plenty of notable examples of how this can fail. When Ron Johnson, famous for his success in running the Apple retail stores, became CEO of struggling retailer JCPenney he tried to eliminate the store’s deep discounting strategy. Customers revolted and Johnson was fired as CEO. JCPenney continued its decline and went through bankruptcy several years later.

Heavy discounting is a dangerous tactic for businesses in part because in the short term it works so well. If you have a well-known, desirable product, and you offer a significant discount, you will sell a lot more.

When I was dealing with promotions on Lawn & Garden products, we found that a deep promotion such as 5-for-$10 on bagged mulch or garden soil could achieve increases of up to 10x in unit volume compared to the sales you would normally expect for that time in the season. When I was dealing with ecommerce sales of consumer electronics like cameras, TVs, and music players, huge lifts were similarly possible with a market leading discount.

If you really need revenue (or foot traffic in your store) this is very, very attractive. But there are some big problems.

First, while such deep discounts significantly increase your revenue, they will always decrease your margin rate and sometimes decrease your overall margin dollars. Let’s do a little quick math.

Imagine you have a coffee drink which costs $1.00 to make: coffee, milk, flavor syrup, cup, and lid. Say you’re selling that coffee for $5.00. You sell 50 cups a day, but when you do a 50% off deal, you sell 200 cups.

Your sales on that item double for $250 per day to $500. Your profits increase more modestly, from $200 to $300. Still, your profits are higher. Why not keep doing it?

One key question is: while your product costs are higher, has it hurt your business in other ways? Are your workers worn out and frustrated, or did you have you bring in more workers to cover the extra work? Is the store dirtier and in need of more cleaning?

But another question is: Will the customers who got those drinks for 50% off want to pay the normal price next week?

Discounts that are frequent or deep will decrease customer perceptions of the product’s value, and thus decrease the customer’s willingness to pay full price. Increasingly, the discounted price will begin to seem like the normal price to the customer.

When the customer comes to think of the discounted price as the normal price, they wait to buy the product when it is on sale and no longer buy at full price at all. Now running a discount produces little or no increase in volume, but when you aren’t on discount, you sell less than before.

Companies sometimes try to escape from this trap by increasing the price of the product, so that the price after the discount will be higher.

However, this can result in further loss of pricing credibility. Taking your “regular” price from $5 to $6 will increase your net price when you do a 50% off promotion, but the $6 full price is even less credible than the old one.

The situation for Starbucks is even trickier because the discounts they were offering were not available to all customers, just the ones who used the app. That means that ordinary customers who walked in the door simply say the price go up to even higher levels, while it was only the app users who saw the discounted price.

This would result in the increasing loss of non-app customers (who would think of the coffee shop as being unreasonably priced) while the discount-addicted app users stayed. The result is what we call “bad customer mix”: you lose your more profitable customers and keep the less profitable ones.

Brian Niccol has discussed trying to bring Starbucks back to its roots, as the sort of place where people sit and talk or work while drinking coffee — not just a high tech place to pick up a seasonally flavored milkshake purchased via app — and some changes in appearance and products, as well as changes in the everyday prices, may be necessary in order to retain customers while detoxing from the deep discount drug.

Starbucks has already headed down a dangerous pricing path, getting into deep discounting at a time which is already fraught for a retailer: when it is probably reaching maximum location saturation and cannot continue to grow as rapidly through additional stores.

The path back is going to be difficult, but getting off the discounts now during the new CEO’s honeymoon period with Wall Street could, if followed by the right product and store changes, be the best that can be done in a difficult situation.

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