American companies are testing the limits of their pricing power

Alexander MacKay co-directs the Pricing Lab at Harvard Business School, a research center dedicated to studying how companies set prices. Since the pandemic, he has watched companies become more willing to experiment with what they charge their customers.

Large companies that had previously pushed for one standard price increase per year are now raising prices more frequently. Retailers are increasingly using digital price indicators, which can change at the touch of a button. Across the economy, executives trying to maximize profits are conducting tests to see what prices consumers will endure before they stop buying.

Huge disruptions to supply chains have driven up corporate costs during the pandemic and forced many companies to think more creatively about their pricing strategies, MacKay said. That fueled a trend toward tougher pricing and showed many companies that they could play more boldly with pricing without scaring away buyers. Experimentation continues even as costs drop.

“Prices may change more rapidly than before,” he said. That could mean increases or decreases, although companies are generally more willing to raise prices than reduce them.

Companies are trying to figure out how to protect the profits they have made since the pandemic. For large companies in the S&P 500 index, the average profit margin (the percentage of profit relative to revenue) soared in late 2020 and into 2021, as government stimulus and emergency interventions by the Federal Reserve fueled the consumer demand. At the same time, companies raised their prices so much that they more than covered the increased costs of energy, transportation, labor and other inputs, which have recently begun to decline.

Corporations as varied as Apple and Williams-Sonoma recently reported their highest margins for the third quarter, while Delta Air Lines said its international routes generated record profitability over the summer.

Margins declined a bit last year, but have recently recovered to levels that would have set records before the pandemic. Average margins in nearly all S&P 500 sectors are near or above 10-year highs, according to Goldman Sachs.

“Companies are maintaining or even widening margins because they are not passing on these cost cuts to consumers,” said Albert Edwards, a strategist at Société Générale, who called recent moves in margins “obscene.”

Now, companies are trying to figure out how to set prices to protect profits at what could prove to be a turning point. High interest rates and declining savings are making some (though not all) buyers more price sensitive.

Many companies can protect their profits simply by keeping prices stable while their own costs fall. But some are still thinking about whether they can push prices up further as demand cools and overall inflation eases.

“I don’t think companies have the monopoly power to just raise prices whether they want to or not,” said Ed Yardeni, president of research firm Yardeni Research.

Many corporations are talking on earnings calls about how they are prioritizing profit margins, even when that translates into lower growth.

Take Sysco, the food wholesaler, for example. Its business in the local market has slowed recently, Kevin Hourican, the company’s chief executive, said on an earnings call in October.

But “Sysco is not reacting by leading on price to gain share,” he said, referring to the tactic of cutting prices to gain more customers, which is commonly used during crises. “Instead, we focus on profitable growth.”

Lennox, a heating and air conditioning company, is working to refine its pricing strategy based on years of data., said Alok Maskara, the company’s CEO, at an investor event this summer.

People in the industry are “focused on dollar margin versus revenue,” he said, implying that fewer, more profitable sales are preferred to many less profitable ones.

Focusing on higher margins — even if that means selling less — is in some cases a departure from conventional wisdom in the years before and after the 2009 recession. Back then, some executives felt compelled to compete on price for buyers. cost sensitive. For hotels, that meant focusing on filling every room.

“If you remember, in the Great Recession, there was this idea of ​​lowering rates until people fell asleep,” Leeny Oberg, Marriott’s chief financial officer, said in a September meeting with investors. He added that “it wasn’t always necessarily the right strategy.”

Now “the industry has clearly learned some lessons,” he said. In recent years, the company has sought a greater balance between maximizing revenue and profits, he said.

Retailers, who have been caught off guard by changes in consumer tastes in recent years, are talking more lately about “inventory discipline,” or keeping fewer products in stock, to avoid selling things at clearance prices. The logic is that it is better to sacrifice some sales by running out of products than to be forced to cut prices in a way that affects the bottom line.

Apparel chain American Eagle Outfitters has been expanding its margins by “maintaining tight inventory and promotional discipline,” Jay Schottenstein, the company’s chief executive, said on a November earnings conference call.

While consumers are abandoning some purchases as prices rise, that is not universally true; hence the value of experimentation. Robert J. Gamgort, chief executive of Keurig Dr Pepper, recently said that consumers have shown little reaction to the higher costs of carbonated drinks.

That suggests “it was too good a value to begin with,” he said at an investor conference in September, referring to the recent inflationary period. “It was too expensive.”

The company, which raised prices at its U.S. beverage unit 7 percent last quarter, highlighted “strong gross margin expansion” at the top of its report. latest earnings report.

Some executives also find that they can charge more if they brand something as a luxury product or experience.

“Despite the current economic environment, we continue to see consumers opting for premium services,” said Melissa Thomas, chief financial officer of movie theater chain Cinemark, on a November earnings conference call.

Kellogg, the cereal company, had experienced substantial price increases without losing customers, a situation economists call low price elasticity. It’s like you break a rubber band (you increase prices) but it doesn’t react (buyers keep buying).

But recently, consumers are starting to push back in response to the label shock.

“Price elasticity has affected the market quite significantly,” Gary Pilnick, Kellogg’s chief executive, said on a call with analysts last month. “You may remember that there have been about 35 percent price increases over the last few years for us, and the elasticities were pretty benign for quite a while.”

Price sensitivity is also showing up in brands that serve low-income consumers, such as Walmart and McDonald’s, whose businesses have expanded as wealthier people look for deals.

“We continue to gain share among middle- and upper-income consumers,” Ian Borden, McDonald’s chief financial officer, said in an earnings call in October, although he noted that the company was seeing its low-income customers struggle.

Although companies are getting creative to protect their margins, the economy has also performed better than many expected. Overall growth has remained rapid, consumer spending has expanded and a long-warned recession has been kept at bay.

The question is whether companies will be able to protect their profits in an environment where that momentum slows.

“Clients are rebelling,” said Paul Donovan, chief economist at UBS Global Wealth Management. “We have reached that point of resistance.”