Recently, Starbucks raised prices on its coffee. The company said it raised the price of a tall (small) by 10 to 20 cents, or in the ballpark of 5% to 10% of the original price. What will happen?
Obviously, Starbucks has to trade off the additional profit per cup of coffee against the possibility of selling fewer cups of coffee. Let’s assume the average price increase was 15 cents on a $2 cup of coffee, or 7.5%. That’s all profit. However, let’s further assume that the variable cost (incremental cost) of a cup of coffee is 50 cents. Before the price increase, they were making $1.50 per cup in contribution margin. After the price increase, the contribution margin increased by 10%.
Further, if we assume Starbucks’ overall profit margin is 15%, meaning 30 cents per cup, they just increased their profit margin by 50% to 45 cents. The new overall profit margin for the company would be over 20%. Wow. Price increases can be very powerful.
Of course, this all assumes they don’t lose any sales. Here are three possible places they could lose business:
- Competition. There may be some people who walk by both a Starbucks and another coffee shop on their way to work. They stop at Starbucks because they like it a little better and both shops charge the same price. However, with the price increase, they could save $1 a week going to the other coffee shop. They switch.
- Homemade coffee. Similar to competition, only now the competition is the few minutes it takes to make the coffee yourself. Much cheaper, but more effort. Given how much people seem to like their sleep, it seems unlikely that many people will wake up earlier just to make coffee. But some will.
- Habit rethinking. Some people just go to Starbucks every day out of habit. They don’t even think about the price. They made the decision once before that this was something they wanted to do, and they don’t need to ask themselves every day if this is still something they want to do. However, when the price is increased, they may take a few moments and rethink their original decision. Maybe they don’t really like coffee that much. Maybe they read that study that said coffee was bad for you. A high percentage will at least rethink the decision, and some will decide no.
Even though these are three reasons people might stop drinking Starbucks, most won’t. My estimate is that none of these reasons are strong enough to outweigh the 10% increase in contribution margin.
But here’s an interesting question. Given the assumptions above, what percent of their unit sales can they lose and still make the same profit as before the 7.5% price increase? The answer is 9%. If you like math, getting to this answer is kind of fun. I’ll leave it to you.
However, it is very likely that Starbucks has historical data to help them predict what will happen with this price increase. We are only guessing.