MUST THE CYCLE START AGAIN?

by Donald V. Potter

When a long period of hostility finally ends, the heads of surviving companies give a sigh of relief-and vow never to let that happen again.

Does hostility have to recur? Is an inevitable cycle at work, or can an industry learn? Can any of the players prevent or at least delay the return of bad times?

Industry Has Rationalized

“Industry leadership often changes hands.”

Hostility ends when an industry settles around three to four major suppliers who control 75 percent or more of market share. These leaders are often new in their roles. The hard fact is that 90 percent of companies that enter hostility do not reemerge, at least as independent companies. And, though the long duration of hostility makes the transition hard to track, leadership often changes hands. As examples, we see Yellow Freight in trucking, CSX in railroads, Hyster in lift trucks, Giddings and Lewis in machine tools, Marriott in lodging, Oxychem in PVC and Phelps Dodge in copper, all of whom became industry leaders during the course of hostility.

As leaders in a no longer hostile market, these companies have the ability to raise prices knowing that the industry will follow. Naturally, prices begin to rise.

Rising Prices Cause Rising Costs

“Prices are offset by costs.”

Higher prices produce higher margins — for a while. But margins do not continue to go up even if prices keep rising. The reason is a return of competition for share. When hostility ends, surviving companies appear to accept their market share-or at least to recognize that they cannot gain additional share by price discounting. But few companies are satisfied for long.

Competition returns in the form of new benefits. Product features proliferate. Product lines are extended. But more importantly, services are increased to keep each major customer satisfied and loyal. The sales force is enlarged. Customer support is enhanced. In short, each company continually builds up an infrastructure designed to service customer needs better than competitors can. Now, price increases are offset by cost increases.

It is only a matter of time until someone finds a way to offer a product/service package with fewer benefits or lower (but still acceptable) quality for a much lower price. A modest portion of industry customers, representing 10-15 percent of industry volume, finds that this lower cost product/service package just meets its needs. Share will begin to shift, and conditions are right for the return of hostility.

Branded food products are an example of an industry that goes through this cycle repeatedly. Prices on branded products rise until they are significantly above private label prices; private labels gain share; branded producers eventually drop their prices; and private label producers retreat.

Is the Cycle Inevitable?

“Take a critical look at price increases.”

Avoiding hostility forever may be impossible. At any point in the period leading up to hostility, a company would seem to be doing what is in its best interest. How can one argue against competing for market share? Against adding benefits when others are attracting customers with benefits? Against investing in the infrastructure to deliver those benefits? Furthermore, as industry leaders raise prices, why wouldn’t all other players follow? Doing anything else would start a price war or leave money on the table.

Only the one or two top players have any real influence on the march of events that lead to renewed hostility. And, because these leaders are often new in their roles, they cannot be expected to have extensive experience in what to do.

Yet the alert industry leader can delay the onset of hostility by taking a critical look at price increases. If real prices rise several years in a row, a company manager should ask whether costs are also rising. If so, the company is inviting a new entrant who will offer a stripped down product/service package at lower cost – a cost that an incumbent producer would have difficulty matching because of its high overhead.

And, once a new entrant arrives, an industry leader can make the period of hostility shorter and less severe by dropping prices immediately to stop the new entrant’s growth. Most leaders resist price cuts, thinking that the new entrant will fade, or at least will take share only from weaker players. Quick, decisive response from the leader, however, is often the best way to prevent a new entrant from gaining enough share to trigger a long-term market price war.

Closing Thought

Rising prices help a company only if they increase margins. If price rises pull costs up at the same time, the company’s strategic situation is weakened.

(Note: This Perspective was written in the context of the economy in 1994. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)

Recommended Reading

For a greater overall perspective on this subject, we recommend the following related items: Analyses: Analysis 7: Industry Growth by Customer Size Analysis 8: Average Price Paid by Size of Customer Analysis 49: Market Segments Where Share Moves on Low Price Analysis 53: Return on Capital Employed by Competitor Analysis 61: Unit Equivalent Sales Price Needed to Justify Marginal Capacity Addition Symptoms and Implications: Symptoms developing in the market that would suggest the need for this analysis. Demand has turned up bringing a tight market and more capacity Demand rose quickly for some time in the past Profits are high because the company is in a niche segment Prices are rising as the industry runs out of capacity The industry has been able to preserve margins by increasing prices ***