But in reality, changing prices often incurs other costs. These are called “menu costs,” a reference to restaurants having to reprint all their menus when they reprice food. Menu costs can take different forms depending on the industry—for example, a grocery store has to relabel products, while gas station attendants have to use a pole to update the numbers on the outside sign. Service companies also run the risk of upsetting customers and losing business if they constantly adjust their fees, a different (but important) type of cost.
It stands to reason that lower menu costs should be good for companies, as it allows them to adjust prices to match customer demand. But do lower menu costs really increase profits? Additionally, can lower menu costs cause disruptions as they ripple through a supply chain? Moreover, when it is easier for a grocer to change the price of butter, it may do so more frequently, causing butter sales to fluctuate from week to week—which could, in turn, increase the likelihood that butter producers and dairy farmers end up with huge surpluses or shortages.
In a recent study, Rob Bray, associate professor of operations at Kellogg, and Ioannis Stamatopoulos at the University of Texas at Austin, investigated how a price change would affect not only sales of that particular product, but the entire supply chain of the product.
The team took data from dozens of Chinese supermarkets and then used a mathematical model to predict how changes in menu costs would affect store profits, as well as volatility further down the supply chain.
The model predicted that cutting menu costs would not only increase sales, but also—contrary to what they expected—stabilize the supply chain, instead of snarling it. “The data threw us a complete curveball,” says Bray.
This is important, he says, because “the main name of the game when it comes to supply chain is reducing volatility.” When a supply chain is unstable, producers are more likely to either get stuck with excess inventory or run out of high-demand items.
Bray notes that researchers have not explored the links between pricing and supply chains much, and more studies will be needed in other industries. “This paper is just a first stab at a very big problem,” he says.
Why lower menu costs can increase supply chain variability
Menu costs vary greatly from industry to industry.
Airlines, for example, have very low menu costs. They can easily re-optimize and change flight prices online using automated software, and customers are already used to the idea that airline ticket prices are volatile. At the other end of the spectrum, lawyers quote fees on long-term contracts. Their menu costs are too high because the company would have to renegotiate the contract to change the prices.
In between are retailers such as supermarkets and clothing stores. Menu costs for these companies have fallen as more sales move online and as more stores turn to electronic price tags, small screens that managers can update automatically.
However, the implications of this reduced menu cost were not entirely clear. “What about supply side effects?” Bray wondered. Specifically, the researchers wanted to know whether reducing menu costs increased or decreased volatility in a supply chain.
Supply chain management is essentially the process of matching supply with demand. When companies build products, “they have to make a risky bet,” Bray explains. the company doesn’t know exactly how much demand there will be, so they make their best guess.
However, volatility in the supply chain makes it more difficult to measure demand. And inaccurate estimates cost companies money: if they build too much, they’re stuck with inventory they can’t sell. too little and stores run out of the product. Therefore, reducing volatility is key to successful supply chain management.
A subtle source of volatility is the bullwhip effect. This means that demand tends to become more volatile as you move up the supply chain, from customer to retailer to wholesaler to manufacturer. The bullwhip effect occurs in part because order sizes get bigger the higher you go up the chain: a customer might buy two toothbrushes at a time, for example, but a grocer orders them in lots of 48 and a wholesaler buys them in packs of 480.
It seemed plausible that reducing menu costs could exacerbate volatility. “Somewhat intuitively, you might think so,” Bray says, as lower menu costs would mean more price movement, which could make sales fluctuate more — and that added volatility could get worse going forward. further up the supply chain.
How menu costs can affect profits
Bray and Stamatopoulos took data from 78 large supermarkets in China from 2011 to 2014. All stores belonged to the same chain, but each could set its own prices. Whenever an administrator for a class of goods — e.g. drinks— updated a price, another manager had to review the change, price tags had to be reprinted, and an employee had to relabel the products.
First, the team wanted to confirm that stores were in fact experiencing significant menu costs. They did this by looking at how often they repriced items.
On average, they found that stores changed the price of a product every 30 days. On the day that a commodity appreciated, the gains in that commodity tended to be relatively high. But then they steadily declined, probably because the price was no longer optimal. “It’s an outdated price,” says Bray.
The fact that stores didn’t raise prices more often suggests that menu costs were holding them back.
The average store made a profit of 2.78 yuan (about 39 cents) per item per day. However, the researchers estimated that if managers had been allowed to change prices every 10 days instead of once a month, profits would have increased to 3.41 yuan (48 cents) per item per day.
The researchers also found that the price changes helped reduce the volatility in demand that stores faced: When supermarkets repriced products, the change was more likely to increase if customers had bought a lot of that product in the past week. Conversely, the price change was more likely to be a decrease if the store still had a lot of that item in stock. This suggests that supermarkets changed prices to ‘smooth’ demand – that is, stimulate demand for less popular items by lowering prices and curb demand for popular items by raising prices.
So the researchers concluded that lower menu costs would likely boost stores’ profits and allow them to better match supply with demand, making it easier to change prices more often.
But would these more frequent price changes also cause instability in the supply chain?
Smoothing the Supply Chain
To find out, the researchers built a mathematical model of the stores’ supply chain, built to fit the data they collected on sales, orders, inventory and prices. They then reduced the menu cost on this model to see what would happen.
The model predicted that sales would become less volatile because more frequent price changes would smooth out demand. But crucially, he also predicted that missions would become less variable. Because prices were now more flexible, stores could do a better job of matching supply with demand. So stores placed more frequent, but smaller, orders to keep up with demand, which made “the shipping process appear more fluid,” the researchers wrote.
In short: reducing menu costs stabilized the supply chain, both on the demand side and on the shipping side.
As for the bullwhip effect, the net effect “is zero,” says Bray. Demand and shipments “smoothed out” in roughly equal proportions. And since the bullwhip effect is measured as the difference between upstream and downstream volatility, these changes canceled each other out.
A powerful lever
The takeaway for retailers: by repricing more frequently, they could reduce volatility throughout their supply chains, Bray says. “You use leverage to better match supply and demand.” The results suggest that it may make sense for grocers to move to electronic price tags.
What does this mean for repricing in the age of COVID-19? The answer is difficult.
The increase in the cost of hand sanitizer in the early days of the pandemic, for example, could be seen as price gouging. However, moderate price increases to smooth out demand may have helped keep volatility in check, meaning fewer stores would have run out of product – and fewer customers would have left empty-handed and disappointed. Plus, people would be less tempted to grab, say, 10 bottles at a time, leaving more on the shelf for others. “That build-up probably would have been mitigated to some extent,” says Bray.
Bray doesn’t yet know if the study’s results apply to other industries. Results depend on products being ordered in fixed lot sizes, which may not be the case in service-oriented companies such as law firms or hospitals.
What is clear is that researchers have much more work to do. “We’re a long way from fully understanding this phenomenon,” says Bray.