Where Starbucks Went Wrong in Its Coffee Pricing | Hacker News Reader

Where Starbucks Went Wrong in Its Coffee Pricing

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10 pointsvwoolf26 comments

This article is completely wrong. If Starbucks has hedged, they aren't "losing" money on the price of coffee going up or down; their hedge pays out inversely with the change in operating costs due to coffee price fluctuations.

Another way to illustrate this is to note that the cost part of the equation is the same regardless of what happened to coffee prices in the last year: assuming they hedged, they'd probably raise prices by the same amount had coffee been up or flat for the year, too.

Another important flaw is that costs do not determine prices in this way. See this legendary Quora thread for details: http://www.quora.com/Why-is-iced-coffee-more-expensive-than-...

Yet another problem is that even if costs did determine their pricing, Starbucks' big costs are real estate and labor. The markup on beans and hot water alone is staggeringly high.

> Another way to illustrate this is to note that the cost part of the equation is the same regardless of what happened to coffee prices in the last year: assuming they hedged, they'd probably raise prices by the same amount had coffee been up or flat for the year, too.

Depends on what their competition is (and would have been) doing.

Agreed. There's so many issues with the article, it's kind of weird.

As you point out, they were hedging (and so did not see their bean prices go up), and even if they had, bean prices aren't even a major cost driver. But imagine, for a moment, that coffee beans were a major cost driver for Starbucks: The article suggests Starbucks' management should not be expected to manage these costs. That's ridiculous to the point of outright laughter.

In other news, Southwest execs say "damn, but there's just nothing we can be expected to do about fluctuating fuel prices" and analysts admit that Facebook "can't be expected to understand how to run large data centres; after all that's unrelated to their core business". </sarcasm>

Commodity Trading agreements are for businesses who use items as the input for their production.

Starbucks is one of the few types of companies that SHOULD be buying commodities contracts to control unpredictability

But it doesn't really make sense for the Starbucks management team to be speculating on coffee prices. To run Starbucks successfully you need a lot of management skills related to operating and marketing a large chain of coffee houses.

I dunno I'd assume that an organization the size of Starbucks can probably afford to have a few folks dedicated to their supply chain economics separate from the coffee house operations and marketing folks.

I'm sure they can afford it. But do you really expect Starbuck's coffee speculators to beat the speculators at Renaissance and GS?

In some ways I would expect exactly that. Starbucks' coffee speculators would probably know more about coffee than generalist speculators. The best solution might be for Starbucks to bring in a speculation consultant to work with them - and they probably did something like that.

I have to confess I'm a little baffled at the story here, though. My understanding is that it's often more important for a large business to have knowledge of future raw materials prices than strictly the lowest possible prices. So it should be expected that buying coffee futures will do more to smooth out the ongoing price of coffee than to minimize it. Sure, it would be nice to minimize the cost of coffee beans and I'm sure Starbucks works hard to do so, but to if they (or anyone) could constantly be perfect coffee price predictors, they wouldn't need to produce coffee to make money.

Speculation at places like Goldman Sachs isn't just about having better future-predicting power, though. It's also about sitting on buckets of money such that you have a lot of risk tolerance. Then people pay you to take their risk, and you win on the average (in terms of profit) and they also win on the average (in terms of reduced risk).

Starbucks, being as big as they are, may simply have felt that they were big and well-informed enough that the risk of self-insurance made more sense for them... a decision which is easy enough to snipe at ex post facto, but may still have made more sense.

In value-at-risk terms, Starbucks' hedging requires a negative amount of capital: they need more cash on hand if they refuse to hedge. With a given capital structure and no coffee hedging, there's a possible coffee price X that would wipe them out. With hedging, they can place an offestting bet that coffee will rise; then they're indifferent to that price fluctuation. That's one less way for them to unexpectedly lose money, so their results in the aggregate would be less aggregate.

Plus, the buckets of money thing is a canard; Goldman has to earn a percentage on their capital, just like anyone else. If they have 10X as much equity as Starbucks, they need to earn 10X as much net profit to get the same return. And ceteris paribus, that means taking 10X as much risk.

> A reasonable alternative strategy would be to just run the business as if the price of coffee was destined to be flat, and then place counterveiling speculative bets. The point of those bets, however, isn't to speculate it's precisely to try to eliminate the need to speculate.

The point of speculating is to eliminate the need to speculate? What the hell? This doesn't make a bit of sense.

What Starbucks did was place a bet that coffee prices would go up. Unfortunately for them, they bet wrong. That's the risk no matter how they bet, though. If they'd bet on flat prices (no lock-in) or declining prices (the other side of the bet they actually made), the price could have gone up and they could have lost money. That's why it's called speculation. Someone speculates that the price will go one direction, and they make a bet to that effect with someone else.

> If they'd bet on flat prices (no lock-in) [...]

You can buy contracts to bet specifically on flat prices. And of course you can also bet on moving prices, without committing on up or down. No bet isn't an implicit bet on flat prices.

Sure. You can bet many ways. No matter what you do, though, it's a bet and you take the risk of losing money vs any other bet you could have made.

And no bet is an implicit bet. You're betting that you can get as good (flat) or better (declining) a price in the future as you can get right now by locking in.

I used to go to Starbucks every morning. But they got too expensive. Their product always has had a ridiculously high profit margin, with the cost of preparing a cup being under 10 cents and selling for $1.49, then $1.59, then $1.79, now it is $2.19. Starbucks price should not have been raised in this economy just because raw inputs went from 10 cents to 13 cents. Finally the customers, well myself at least, said this is absurd I am being ripped off here, and I bought a good espresso machine for home. Come to think of it though, this is all pretty irrelevant since it seems they are still packed with enthusiastic customers most of whom are renting wifi for the price of coffee. Hey, if the market can bear it, jacking up your prices continually is not the worst plan.

What about salaries, benefits, and other costs? I think the article is placing too much importance on the price of beans rather than the prices of other overhead (including fuel and labor).

Little known fact about Starbucks cup sizing: the menu goes 'tall', 'grande', 'venti', but you can still order a 'small', it's not on the menu, and costs like $1.12 or something.

I think you mean "short." If you ask for a "small," they will probably offer you a tall (for the same reason that somebody requesting a Big Mac at Burger King will be offered a Whopper instead).

Um, isn't this the definition of sunk cost? They already lost money on their bet. Trying to raise prices in the future to pay for the past is a blunder.

If they can get away with raising prices and not losing customers, it is irrelevant that they overpaid for coffee they already bought. They just earn more per cup. If they can't get away with it, then this is a foolish thing to do, as they can't make their previous payments vanish.

Didn't their executives go to business school?

Perhaps this is why this annual cost increase is still the smallest yet, and why they're also limiting the price increase in stores even more?

It is a prime example of sunk cost (and the sunk cost fallacy), but it doesn't explain why they're only raising prices now, rather than back in October when they locked in the agreement. The linked-to WSJ article explains that Starbucks will be paying 'more than their competitors' for coffee, but they're still not paying 'more for coffee' than they expected to. That's the nature of a forward purchase agreement.

Planet Money did a story that talks about fuel speculation in the airline industry: http://www.npr.org/blogs/money/2011/09/30/140954343/the-frid... (The fuel speculation part is 8 minutes in.)

> Unfortunately for them, the coffee market fell soon after that leaving Starbucks locked in to paying higher prices than what you can get on the spot market.

Just spin it as FairTrade supreme version?

Depends on the nature of the counter part. Could be Goldman Sax, could be some coffee producer, could be a fund that's run for the benefit of little old widows but with no other connection to coffee.

I find it really surprising that the article doesn't once use the words 'hedging' or 'liquidity', since an understanding of those very basic concepts would have made the second paragraph either useful or redundant.

Unfortunately I think the author is just speculating.

They should have less bitter coffee while they're at it so people aren't so bitter.

It's a well known fact that Starbucks buy cheaper coffee than say a Tim Hortons.

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