SELF TEST #19C: Future Prices
Why should we bother to forecast future prices?
A company in a low marketing and sales expense industry, where gross margins are at or below 10%, is usually in a capital intensive industry. Creating new capacity in these industries takes a long time, usually several years. The forecast of future prices helps the Company prepare for changes it will need in its capacity to support its Core customers. If the Company sees capacity in excess of demand, it may want to delay investments in expanding its own capacity, or even plan for reductions in capacity. These, too, take time. On the other hand, in normal to high marketing expense industries, the forecast of future prices helps the Company plan pricing tactics. If the Company sees prices beginning to soften, it can plan to put more defensive tactics into its pricing in order to protect Core customer relationships. If the Company sees prices on the rise, it can follow the general trend of rising prices without worrying about competitor retaliation.
Define defensive and offensive pricing tactics.
Defensive pricing uses tactics which seek to arrest, or minimize, the decline in average prices in an industry. You see defensive pricing in industries where prices are falling. Offensive pricing raises margins or sales volumes using price. Offensive pricing occurs in industries where prices are generally stable or rising. These offensive tactics seek to raise the average industry price from its current levels. In some falling price environments, a company may have an offensive pricing opportunity to use a unique low price to win additional sales volume.
What forces tend to put prices and margins under pressure?
The forces that tend to put prices and margins under pressure are those that create more capacity than demand. Naturally, this may happen if demand shrinks from a previous level to a new lower level. In this situation, current capacity is greater than demand. In the more common case where demand continues to grow, there are three basic forces that cause capacity to grow faster than demand. The first of these forces is new entrants to a market. The second is rapid expansion by current competitors in the market, especially low-cost competitors. The third is high returns in the industry which tend to invite more competition in the industry than exists today. These high returns are also a special incentive for current competitors to expand rapidly in the market.
Why are high returns a potential problem?
The creation of high returns is the goal of most companies. However, when those high returns are high across most, or all, of the competitors in the industry, the industry itself is at risk because these high returns attract new competitors to the market and the rapid expansion of current competitors. If the resulting capacity expansion is greater than the demand growth, prices and margins will come under pressure.
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