Part 1: Industry Price Outlook
Capsule: The economic effect of every price is the discouragement of a competitor from operating some or all of its capacity. In low marketing and sales expense industries, the price falls just short of the cash costs of the next increment of capacity that the industry could supply the market. In other industries, prices and margins tend to rise until they attract low-priced competition.
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Symptoms and Implications:
The precision of the Company’s forecast of future prices depends on the type of industry in which the Company operates. You want more precision in low marketing and sales expense industries because the future prices are critical in determining the Company’s approach to balancing its capacity with the demands of its Core customers. The reasons are twofold: Capacity expansion or contraction may require years of lead time; and the retention of, or withdrawal from, Near-core and Non-core customer relationships to manage capacity has effects lasting several years.
In normal to high marketing and sales expense industries, the precise forecast of prices is not really practical. There is too much potential variability in marketing and sales tactics and expenses. Instead of precise price forecasts, the Company focuses on the likely expansion of capacity in its industry compared to the demand growth. If capacity grows faster than demand, then price pressures are likely to build and the Company would begin preparations for more defensive pricing tactics. The Company can predict the likely capacity growth compared to demand growth by analyzing new entrants to the market, expansions by competitors and the industry’s rates of return.
For Low Sales and Marketing Expense Industries
Prices in a market normally rise or fall to encourage or discourage the next competitor who would add capacity. This rule works most visibly in an industry with low sales and marketing expenses as a percentage of sales, where gross margins are at or below 10%. If the future capacity is greater than demand, this rule means that prices must fall below the cash costs of some currently producing capacity in order to stop the capacity from operating. As this producing capacity closes, the industry’s capacity comes into balance with demand. Where the future demand exceeds capacity, prices must rise by enough to incite the required new capacity addition, but not by so much that too much capacity enters the market, or the rise must be sufficient to reduce demand until it matches capacity. Prices keep rising until enough capacity enters the market to balance capacity with demand. The price rise should stop once the industry reaches that balance between demand and capacity.
|A few low marketing and sales industries find balancing capacity with demand difficult in the extreme. In these industries, the individual competitors are not large enough to add capacity in increments that prevent the individual supplier from going into overcapacity and creating Hostile market conditions in the industry. An example is the newsprint industry during the 1990s. A Greenfield newsprint facility is very large. Each newsprint facility must operate near its rated capacity. This industry had a very low rate of annual demand growth. Market share in the industry was fragmented among many suppliers. Virtually no competitor was large enough to add Greenfield capacity without creating a substantial excess capacity condition for itself. Each addition of a major increment of new capacity in this slow growth market created overcapacity for the entire industry.
In such an industry, the Company must consider how competitors are likely to add capacity in order to meet the growing demands of their customers in the future. Some industries do this by forming joint ventures with customers or competitors. If that new capacity is not fully absorbed by an identifiable set of customers, the industry will be in overcapacity and is likely to see low prices and margins until that situation clears itself.
|For Normal to High Marketing and Sales Expense Industries
Normal and high marketing and sales industries have prices that are less obviously sensitive to the balance of demand and capacity. Companies in normal to high marketing and sales industries need not develop specific price forecasts. Instead, these companies should try to anticipate growing pressures on prices and margins by evaluating the growth of product capacity compared to customer demand. The expansion of capacity in the industry by new entrants and by current, low cost, competitors often pressures prices and margins. High industry returns are harbingers of rapid industry expansion. A shrinkage in demand might also pressure current margins.
New entrants to the market and fast capacity expansion by any competitors, especially low-cost competitors, are simple and sure predictors of future downward price pressure. If new entrants are coming, prices are likely to fall. The vast majority of competitors newly entering a market dangle lower prices before their potential new customers, even if their performance package is already attractive. In the U.S., airline deregulation produced a host of new airline entrants with ultra-low prices. People Express was just one of many such entrants.
Prices will also fall if low-cost competitors in the industry expand faster than demand grows. For many years after airline deregulation, Southwest Airlines expanded faster than airline passenger demand grew. Prices in the industry fell and remained low. In the American automobile market, low-cost competitors expanded faster than demand grew. The domestic auto industry’s prices fell and remained low even as domestic manufacturers shrank.
Companies can develop a reasonable sense of the future outlook for pricing in their industries by evaluating the current industry rates of return on investment and their industry’s past history of price increases compared to the rate of inflation. Very high return industries attract new competitors and expansion of current competitors. (For comparisons of rates of returns across industries, see the Benchmarks/Quartile Ranking Reports section.) These industries might expect downward pressure on prices, especially if market growth slows.
Similar price pressures may confront companies in industries where prices have risen faster than inflation for a few years. These industries are likely to be producing very attractive returns. If the industry’s returns are not in the top quarter of all industries, despite several years of price increases above inflation, its basic cost structure may have risen to a point that a low-priced competitor may emerge. These competitors are likely to be Price Leaders. The industry may be incurring high cost levels for benefits that many customers do want and will support at current prices. There may be a segment, however, waiting for the emergence of a low-end price point, a Price Leader product, without so many of those benefits.
If demand should fall from a previous level to a lower level, the Company might also anticipate some price pressures. Competition may try to keep sales at previous levels and use a low price to do so.
Before moving to explore nearer term pricing objectives and opportunities, the Company should check the sensitivity of its assumptions.