Part 2: Company Price Environment
Competition and Their Knowledge, Capacity and Will
Capsule: Competition may have the power to block our attempts to change prices. Whether they will do so depends on their knowledge of our actions, on their ability to change their capacity in response to our price move, and on their will to risk their profits.
For helpful context on this step:
Symptoms and Implications:
Since there are multiple suppliers in many customer relationships, since customers tend to learn to use "Last Look" effectively and since pricing takes on a more complex place in creating profits as industries evolve, it follows that we must consider competitors in planning our pricing tactics. More specifically, we need to assess whether a competitor is likely to try to block our price move. We make this assessment by asking three questions about each competitor and his pricing potential:
Knowledge: Does competition have knowledge of our price change?
Capacity: Does competition have the capacity to respond to our price change?
Will: Does competition have the will to risk its profits in response to our price change?
But before we ask those three questions, we need to clarify who our competitor really is.
An industry leader is unlikely to have the lowest priced Standard Leader product in the market. That distinction usually belongs to the industry's Price Shavers. These companies are rarely true competitors for the Core customers of industry leaders. The real head-to-head competitors for the Company are its Peers.
Larger customers do not view all competitors as equivalent to one another. There are a few competitors in the market that larger customers view as Peers of one another. These larger customers believe that each of these Peer competitors has a performance package able to meet their needs. They may prefer one supplier to others in the Peer group but they would use the others. Larger customers assign these Peers to their Primary and Secondary roles, the key strategic roles in their relationships.
As a rule, Peers receive identical prices in the customer's relationship. On occasion, the Secondary supplier may have a slightly lower price, but this is the exception rather than the rule. Many Secondary role suppliers are in those roles to provide back-up supply for the customer. As prices decline in the market and as customers become more price sensitive, these Secondary role suppliers provide their customers Price information. The customer uses the price of the Secondary supplier to ensure that the Primary supplier is charging a reasonable price. The customer must be willing to use the Secondary supplier to make the implied threat credible. These two suppliers must be Peers to offer that assurance.
Tertiary and Other suppliers, where there are three or four suppliers in the larger customer relationship, often do not receive the same price as the Primary and Secondary suppliers. If the Tertiary role offers a special product, that special product might carry a higher per unit price than that of the Primary and Secondary Peer suppliers. More often, the Tertiary and Other suppliers offer the larger customer Price Leverage against the other suppliers. These roles bring lower prices and lower returns to suppliers offering them. Price Leverage may also be a reason for the Secondary role in Small and Medium customers. (For more information on Supplier Roles and their purposes, please see Diagnose/Segments/Value of a Customer Relationship.)
Competition and their Knowledge, Capacity and Will Questions
If we wish to change our price, the knowledge, or lack of knowledge, our competitors have of this change is important for its success. Knowledge is a critical issue, whether we increase or decrease our price.
All of our competition should know of our price increase over current industry levels. Industry prices rise if competition follows our price increase. If we increase our price, and our competition knows about the increase, the competition has the opportunity to follow that increase. There is some probability of an industry-wide increase. The price increase usually fails if competition does not follow and match our increase. If competition does not know about our price increase, they cannot follow us. We would have to increase our prices unilaterally and risk alienating our customer, failing in the relationship. In practice, most companies simply announce their new higher prices. This is an effective communication to create knowledge of current prices. Current law precludes telegraphing future price intentions directly. Instead, companies often resort to naming the specific cost drivers behind the current price increase and leave conclusions about future price direction up to competitors and customers.
The opposite holds when we wish to reduce our prices. In the vast majority of these situations, we want none of our competitors to know of our price reduction. The objective of our price reduction is to win more customer purchases, to create a Positive Volatility event for ourselves. These increased customer purchases must more than pay for any financial effects of a price reduction. If the competition knows of this price reduction, it has the option of matching our price and taking away our advantage. This price match by our competition would likely lead to our failure to gain additional customer purchases and, in many cases, to a wider price decline. Our profits fall rather than rise. If competition does not know of our low-price offer to the customer, they cannot match it. We stand a good chance of winning more sales to the customer and our profits increase. In all declining price environments, we want only our particular customer to know of our low-price offer, and no one else.
Controlling customer actions in a falling price environment is difficult, at best. Customers talk to one another about prices and monitor apparent price advantages of their own competition carefully. To counter this, some companies offer quick-trigger price discounts to a customer. The discounts hinge on the customer's immediate acceptance of the low price in exchange for the increased purchases from the discounter. Here, at least, the discounter gains increased sales from the low price offer. Discounting competitors usually request confidentiality for the low price offer. This attempt fails more frequently than it succeeds. Customers use "Last Look" with their current suppliers to get the low price without having to change suppliers. If the customer suspects that a competing supplier might be offering lower prices, the customer might invite that competitor to bid on some purchases in order to use them for Price Leverage. Sometimes the customer may just claim a lower price offer. But you cannot count on a customer keeping absolutely quiet about his low price.
Questions about Competitor Knowledge of our Pricing Moves
In order to challenge our price change, the competition must have the ability to respond to it. More specifically, the competition must have the ability to use its capacity, or product availability, to counteract our price change.
If we increase our price, the competition must have the ability to increase capacity, or product availability, to reverse that increase. A "sold out" competitor must, of necessity, sit on the sidelines in an industry price increase game. This sold out competitor can either follow our price increase or keep pricing stable at the original, lower level for its customers alone. Of course, the competitor has little incentive to keep its prices low in a rising price environment.
If we decrease our price, the competition can counter our move only if it is willing to withdraw some of its producing capacity, or current product availability. It must be willing to allow us to take some of its current customer sales volume in order for it to keep its prices high. This is exactly what happens when an industry leader is in a Leader's Trap.
The Leader's Trap phenomenon is a particular problem for a Standard Leader company. A company in the Leader's Trap maintains a consistent Price Umbrella. This company insists on holding prices steady when all about them prices are falling. Companies in Leader's Traps are easy marks for shrewd competitors who use the obstinacy of these companies to take their customers away. The industry leader in a Leader's Trap allows discounting competitors to gain some of its current customer sales volume. This industry leader then must find a new home for this lost sales volume. If the market is growing fast enough to absorb this lost sales volume, the industry leader suffers an opportunity loss and, likely, a loss in market share. If the market does not grow fast enough to absorb this lost sales volume, the industry leader either reduces its current capacity or operates less of that capacity than before it lost sales volume to discounting competition. Along the way, industry prices continue to fall. Over time, usually within a few years, the company in a Leader's Trap sees its profits plummet, and with them its sterling reputation. The industry leader loses market share and industry prices fall anyway. A very poor outcome.
Questions about Competitor's Capacity to Counter Our Price Move
The Leader's Trap example leads us to the third question to ask as we contemplate a change in our price. Does the competitor have the will to risk his current profits in response to our price change? This is the most difficult of the three questions to answer. An answer demands a bet on the competitor's decision. We inform that wager by considering how our decision to raise or lower our prices is likely to affect the competitor's current profits. Then, we may estimate how the individual competitor might see our pricing decision's impact on its profits by considering how the competitor has responded to price moves in the recent past.
Normally, we would expect that our decision to raise prices would meet with our competitor's approval. Price increases should raise the industry's, and its own, profits. There are exceptions to this rule. They occur when individual competitors see a price increase either threatening their current sales levels, and margins, or offering a sales opportunity. The competitor may serve customers who are more price sensitive than the average in the industry. An industry price increase might drive some of these price sensitive customers from the market and reduce the individual competitor's profits by more than the price increase would increase them. This competitor suffers while some of its brethren, who serve less price sensitive customers, prosper. In another situation, the competitor with available capacity may see a price increase by its industry as an opportunity to increase its profits by refusing to follow the general price increase and then seeking additional customer volume on the back of its now lower-than-average price.
Price Shavers are competitors who are perennial discounters. These competitors specialize in serving price sensitive customers. They offer these customers discounts, usually on the Standard Leader products, that are 10% or less below the average industry price. Most commonly, their discounts average 2-5% across their relationships. Price Shavers do well in Deteriorating or Stable markets where a low price has the power to move market share.
These Price Shavers are often relatively weak competitors in Hostile markets because their larger customers place them in Price Leverage roles. The larger customers in the market (i.e., Very Large and Large customers) place Price Shavers in Tertiary, or occasionally, Secondary roles in their relationships. These customers use the low price of the Price Shavers in price leverage roles to threaten, and reduce, the prices of their more important Primary and Secondary role suppliers. This may well be an empty threat since the Price Shavers' discounts to the industry's larger customers are the consequence of important shortcomings in their product/service offerings. Price Shavers rarely have the capability to serve these larger customers well.
Price Leverage roles offer low returns and limited future growth potential. Their returns are low due both to their low prices and to their small volumes. Price Shavers cannot migrate from price leverage roles into more strategically important Primary or Secondary roles without unusual improvements in their product/service packages. The low returns from these roles may limit even the Price Shavers' willingness to offer them, especially in very Hostile markets.
The market may respond more uniformly to a price decline. Sometimes a price reduction seems irrational, but is not. Most competitors would greet a lower price with little enthusiasm. If lower costs or new customer sales would not make up for the lower price, everyone in the industry would see profits fall. A new lower price must attract more, or save existing, sales to the company initiating or following the low price or the new low price will simply reduce profits. Yet, we often see new low prices quickly copied in markets, especially in Hostile markets where prices and returns are already low. Many, if not most, price discounts in Hostile markets start with customers rather than with competitors. Once the discounting starts, most of the industry's competitors feel forced to follow along to protect their current sales volume. This is a rational decision in what seems like an irrational market.
How will competition respond? Our major risk in a price increase is the competitor's will to counter our price increase. A competitor who is unwilling to match a rising price is betting that its lower price will save existing sales volume or bring it increased sales at the expense of other competitors. A competitor who is unwilling to match a declining price must be willing to risk losing some of the sales volume and the contribution to fixed costs and profits it currently enjoys. If the competitor will not follow our price decrease, it is in a Leader's Trap. This offers us an opportunity to gain share at the competitor's expense, assuming that the customer is attractive to us.
Competitors evaluate these risks differently in different markets. We find it helpful to estimate how a competitor might react to our price change by evaluating how the competitor has responded to price increases and decreases in the past. We estimate these competitive responses by analyzing the sales volume gains and losses due to price for each competitor. More concretely, we measure the percentage of each competitor's Positive and Negative Volatility due to price compared to the percentage for the industry as a whole. The higher the ratio of the individual competitor's Positive Volatility on price to the industry's average Positive Volatility on price, the more likely the competitor is to use price offensively, to gain share. This competitor is likely to fight our price increase initiatives and to match our price declines. If the individual competitor has a low ratio of Positive Volatility on price, we expect this competitor to follow our price increase initiatives.
We examine each competitor's Negative Volatility due to price for indications of its likely response to our price declines. We measure the ratio of each competitor's Negative Volatility on price to that of the entire industry. A competitor with a high ratio is in a Leader's Trap. This competitor is more likely than the average competitor to cede share to a discounting competitor. This competitor is less willing to match low-price offers to a customer and may give up customer volume to us if we choose to discount our price to gain that volume.
We have observed that the majority of competitors in a Hostile market are consistent and predictable using these measures. A competitor with a high ratio on price-based Positive Volatility will usually have a low ratio on price-based Negative Volatility. This is the sign of a competitor who uses the price tool aggressively. This competitor initiates lower prices and follows price increases reluctantly. A competitor with a low ratio of price-based Positive Volatility will often have a high ratio of price-based Negative Volatility. This competitor initiates price increases and follows price decreases reluctantly. These are consistent indications of competitive "will." Some competitors are inconsistent in their pricing decisions and are not predictable using these analyses.
Questions about Competitor Will to Counter our Price Move
Armed with a good understanding of likely competitive responses to our price moves, we are ready to set specific objectives for the Company's pricing policy over the next 12 to 18 months.
|Next: Pricing Objectives