Food Companies: Recipes for Tough Times

Faced with rising costs and pickier customers, processed foodmakers find ways to boost their products' appealand make price hikes stick

From soup to nuts, these are difficult times for food manufacturers. Spikes in energy prices have pushed up the costs of plastic packaging and transportation, while unprecedented surges in corn and wheat prices have also taken a toll on profits. On the other side are cash-strapped consumers who are reining in spending or switching to cheaper private-label foods in an effort to stretch their paychecks.

Having already teased out costs through greater automation, shrinking inventory, and tighter logistics, manufacturers are now looking for new ways to improve, or just preserve, profit margins. Although they have no choice but to pass on higher costs to customers, they are now able to do it in smarter ways—by raising prices on only the least price-sensitive items instead of whole product lines or tailoring prices to various levels of demand in local markets, for example. Foodmakers are also tweaking product presentation and packaging in an effort to boost sales volumes.

The weakened U.S. economy has actually created one benefit for the industry: a consumer shift to home-prepared meals and away from dining out. That's boosting demand for a wider range of specialty ingredients in stores as consumers try to add some restaurant-style pizzazz to home-cooked meals.

A Return to Home Cooking

Stephen Sibert, manager of the industry affairs group at the Grocery Manufacturers of America, a consortium of food manufacturers, cites a rise in consumer buying of ingredients as opposed to prepared foods. "There's a real opportunity for retailers and manufacturers to work together to bring that consumer back to the kitchen or back to the pantry, and get that consumer's confidence up again for preparing a multicourse dinner," Sibert says.

Based on feedback from its more frequent consumer research studies, Campbell Soup (CPB) is creating recipes that include 5 to 10 high-quality ingredients for easy-to-make, nutritional, and low-cost meals, says Mike Salzberg, president of its Campbell Sales subsidiary. Campbell is also doing more to educate consumers about the nutritional value of its V-8 and V-8 V-Fusion fruit-and-vegetable juices. And by working with retailers to reorganize store shelves so shoppers can easily distinguish 100% juices from those with less nutritional value, Campbell is seeing sales rise where they were flat in prior years.

"When…[consumers] understand more, they tend to purchase more, vs. getting frustrated and not buying at all," says Salzberg.

In an environment where higher prices are unavoidable, another trend has been to back up price hikes by offering a higher-quality product that stands apart from its broader food category, such as cereals or packaged cheese—a product that warrants a premium price in consumers' eyes. That's becoming easier as consumers' preference for specialty and organic foods grows.

High-Margin Organic Foods

Bill Bishop, a principal at Willard Bishop Consulting, a Chicago firm that advises food manufacturers, sees a growing trend to add value to what are basically commodity products based on higher quality that can command higher prices. "If I'm the only guy who makes what you want and you need it to satisfy the needs of your customers, we're going to have a different price conversation than the other 10 [suppliers waiting] in line," he says. Kraft Foods' (KFT) 2% Milk Natural Cheese, made without added growth hormones, and its high-fiber and protein-rich products under the South Beach Living brand are examples of this approach.

Another potential windfall from offering higher-quality, differentiated products: the chance to grab a piece of the lucrative Gen Y market, which has shown a bigger appetite for specialty, ethnic, and natural foods, according to Experian Research Services in New York.

Manufacturers see bigger profit margins in organic foods, which often command price premiums of 40% or more over nonorganic foods, says Dr. Carl Winter, a food toxicologist and director of the FoodSafe program at the University of California at Davis. That's driving increased interest by mainstream retailers who just a few years ago were inclined to see organics as a passing fad, he says.

Smoothing Price Volatility

Still, price remains the No. 1 consideration for consumers. Although prices for oil and other commodities have pulled back somewhat in the past week, food manufacturers are likely to continue to incur higher costs in the future that they'll need to pass on to consumers. As they do, pricing technology and strategies that distinguish their products from the pack will become more important to maintaining profit margins.

Large-cap, brand-name food companies for a while have been using elasticity models, which tell producers the highest price they can sell a product for without eroding demand. But now there are more complex price optimization programs that take not only demand but also supply and product mix into account—and can sharply reduce price volatility.

Meat producers have been wrangling with price volatility for years due to the inefficiency with which a massive array of cuts of beef and pork are priced in retail stores. The producers have historically overpriced their products at the start of a week only to have to offer fire-sale prices by week's end, giving rise to the industry's unofficial motto of "Sell it or smell it."

But a high-tech fix may change all that. Cargill Meat Solutions, a division of privately held Cargill, which processes 25% of all the beef and 10% of all the pork produced in North America—it makes 1.5 billion pounds of ground beef a year—has found it easier to more accurately price its products in the three years since it started using an on-demand software technology developed by SignalDemand, a San Francisco-based technology company.

Every time meat producers slaughter a cow, they get the same number of parts. And they need to know how to sell through all the parts when some are more popular than others. That usually entails cutting the price on whatever is in oversupply to bring the business back into alignment with demand, explains Mike Neal, chief executive of SignalDemand.

On-Demand Pricing Software

The SignalDemand software appears in food manufacturers' computer browsers, and can turn out pricing recommendations as often as customers want during the day. By using a manufacturer's sales history and available market data from the U.S. Agriculture Dept., for instance, SignalDemand assesses the range of fabrication options and measures demand for each product at different prices. The software then instantly calculates the profit margin and revenue for thousands of potential scenarios based on demand, cost, production capacity, and product mix, and suggests prices to manufacturers.

A steak that sells for $5 a pound might historically have a 40¢ spread on either side of that price, allowing for it to sell for as low as $4.60 and as high as $5.40, says Herb Meischen, vice-president for strategic marketing at Cargill Meat Solutions. "At $5.40, it could be high enough that it chokes off a [certain local] market. If we were to stop at $5.30…it would be better for everyone," he says.

The SignalDemand software drops the lowest and highest prices of any given product from the beginning to make the product move faster. The program not only advises Cargill where to set the price of a cut of beef on a particular day, but recommends how much of that product to make over subsequent weeks, says Neal at SignalDemand.

Shedding Light on Component Costs

Cargill has seen its price volatility drop from about 3% in the year before it began using SignalDemand to 2% in the ensuing year, says Meischen. "We were able to take a great deal of that to the bottom line," especially by raising prices on the bottom side, he says. One of Cargill's milling businesses is now adopting the program, he adds.

For National Frozen Foods, a private-label vegetable processor in Seattle, the main benefit of SignalDemand's software has been the ability to see all the components that are boosting costs, down to how well round peas vs. square-cut carrots run on its processing equipment, says Dick Grader, the company's CEO.

The software has also enabled National Frozen Foods to break down its margins item-by-item for individual customers for the first time, and allowed it to adjust those margins with minimal impact on customers, Grader says. Half of the company's $150 million to $170 million in annual revenue comes from fixed-price contracts that can't be easily amended to account for spikes in fuel or fertilizer prices.

Grader says it's unfortunate that the benefits of the software have been obscured by pricing distortions resulting from soaring commodity prices.

Collaborating with Retailers

Despite the comfort the greater insight into component costs has provided, "it's very difficult for us to assign a positive impact to the SignalDemand product when our prices are increasing at 20 times the normal rate over the history of the industry," he says. "When I raise my prices by a nickel per pound in this environment, that doesn't have anything to do with SignalDemand."

Bishop at Willard Bishop Consulting thinks the larger significance of SignalDemand's software is that processed food manufacturers are showing the data have value to them. Indeed, price optimization strategies are just the tip of the iceberg when it comes to the changing relationship between food manufacturers and their retail customers, he says. Since most manufacturers can't afford the technology that would give them access to optimal pricing methods, they have to be more creative in how they justify the price increases they're implementing, he says.

Bishop sees a range of opportunities for closer collaboration that would improve consumer sales. "You're getting a first glimpse at how suppliers may be able to work with retailers to bring value and help retailers—and help themselves," he says.

One example is Campbell's efforts to enhance the way juice drinks are positioned on its retailers' shelves. That's made it easier for shoppers to find not only Campbell's 100% juices but those of its competitors', says Salzberg. "By changing the flow, we've seen a 6% to 10% increase [in sales] in the overall juice category," he says. "We try to do what's best for the [product] category, thereby lifting all boats, which helps our retailer partner."

Before it's here, it's on the Bloomberg Terminal.