Why Guac is Extra - The Genius of Chipotle's Pricing Model

There has been a lot of innovation in pricing from American companies in the last two decades:

- Internet giants like Google, Twitter and Facebook made the free-to-the-consumer model mainstream (they generate large revenues through ads)

- Internet retailers like Amazon perfected dynamic price optimization and on-demand services like Uber and Sprig were able to implement surge pricing.

- The latest buzz in the industry has been around the so-called "Freemium" model. Coined by Jared Lukin in 2006, freemium is a pricing strategy where the company gives away the core product for free, with the hopes on converting a small number of users to paid, 'premium' users. Most digital software, media or game companies today utilize this strategy, with Evernote, Spotify and LinkedIn being some notable examples.

- The paid ad-free version of products is a spin-off of the Freemium strategy and is used by many popular gaming apps like Candy Crush and Trivia Crack.

Chipotle's Pricing:

While all this innovation has been going on, Chipotle (NYSE: CMG), the legendary Mexican fast-casual dining chain, has proved their genius by taking a completely novel approach to pricing (atleast in the food category). Here are some elements of their strategy:

1. Charge a premium by distinguishing quality of ingredients from Big Brand Fast Food (McDonald's, Taco Bell)
2. Price slightly below direct competition (Qdoba, Baja Fresh)
3. Keep total meal price under psychological thresholds (in their case, it's $10)
4. Chipotle's Genius 'Reverse-Freemium' Strategy

I happened to think about this last element randomly one day while I was enjoying my chicken burrito. While most fast food chains like McDonald's and Taco Bell have a pretty straight forward pay-for-what-you-get pricing, Chipotle implements a tiered pricing where the basic product is paid, but the first level of 'upgrades' come totally free.

"[Chipotle] has done a great job cultivating a brand that commands pricing power" - R.J. Hottovy, Morningstar

Here's how it works:

A. Core Product >> Paid

Chipotle charges a reasonable price for its basic product - a burrito or burrito bowl.

B. 1st Level Upgrades >> Free

Once you've paid for the core product, Chipotle's offers the first tier of 'upgrades' for free. These are side things on the menu that you can add to your meal. It includes:

• Extra rice (Qdoba charges extra the last time I checked)
• Extra cup of salsa on the side
• Unlimited toppings (as opposed to pizza)
• Half-and-half options (which is always invariably more in quantity than the regular helping)
• Tortilla on the side
• Upgrade bowl to a burrito
• Fresh lemons and sugar to make your own lemonade
• Letting you get away with stealing Sprite in your water cup*

*Chipotle uses opaque paper cups for water instead of clear plastic cups like most of their competitors. I'd like to think that the choice is intentional and they're well aware of financially constrained students stealing Sprite (according to my good friend Rocky Smith, "Everyone has done it at some point").

Now you might think that these are small and inconsequential, but when you are serving hundreds of thousands of burritos everyday, these costs add up.

C. 2nd Level Upgrades >> Paid

For the next level of premium upgrades, Chipotle wants its customers to pay a little extra. These include:

- Guacamole

- Extra Meat

- Chips and Salsa

By offering patrons a first round upgrades gratis, Chipotle is able to charge for the premium upgrades that actually cost the company a lot of money (avocados and free range meat is expensive). By charging extra for these upgrades, Chipotle is able to keep the price down for customers that don't want these items.

Why It's Genius

By offering patrons a free round of upgrades, Chipotle does two things:

1. Lets customers enjoy a just-as-they-want-it, perfectly customized meal every time they come to its stores
2. Makes customers feel that they're getting extra value for their dollars*

*Graph above - Chipotle customers pay only $x but get a percevied value of $y. In Economics, this is called consumer surplus.

This extra perceived value is pretty important for Chipotle to establish a niche pricing strategy where they are placed right in between fast food chains like Taco Bell and more expensive sit-down Mexican food restaurants. Many analysts on Wall Street call this the 'golden sweet spot of restaurant pricing'.

Results:

Chipotle has done phenomenally well as a company over the last decade. It has gone from a few stores to 1,700 stores nationwide and adds a new one every two days! A lot of things are to be attributed to Chipotle's roaring success - they're passionate about the sustainability of their ingredients, take really great care of their employees and have terrific supply chain systems (which they learned from McDonald's). The role of clever pricing, however, cannot be undermined.

The proof is in the pudding, or say ... the burrito - below is Chipotle's stock performance compared to the overall stock market and some competitors.

- Stock market as a whole (GSPC) - 63%

- YUM brands (owner of Taco Bell) - 197%

- McDonald's - 172%

- Chipotle (CMG) - a whopping 1500% !

This means that if you'd bought $100 worth of Chiptole shares a decade ago, you'd have enough money to buy approximately 214 burritos today! That's almost enough food for one entire year. Let that sink in.

Can you think of other companies that use smart pricing strategies? Feel free to write in the comments below!

This post originally appeared on my blog here