by Donald V. Potter

American business has rediscovered cost cutting and the strategy of competing on price as an industry’s low-cost producer. This trend is to be applauded. But good intentions alone won’t be enough to match experienced price competitors like the Koreans and Japanese unless American managers become more realistic about what a low cost/low price strategy entails.

When companies first try to compete with low prices, they usually encounter one or more of these common pitfalls:

Price Discounts Are Too Shallow. Companies frequently underestimate what it takes to compete on price. Many are trying to win with prices only 10 to 15 percent below the market. After studying some 500 cases of recent corporate strategies, I’ve developed a rule of thumb: discounts must be in the 25-50 percent range to have any chance for success. Take a look at some examples: Clones of IBM’s personal computer are advertised at 40-50 percent below IBM’s prices; Crown Book Stores claim a 40 percent savings off retail prices for books; and at $5,000, the new Hyundai Excel automobile costs less than half the average American new car. Competitors will simply match any discount that amounts to less than this 25-50 percent discount, customers prolong their decisions and everyone gets hit with the double whammy of higher selling costs.

Market Share is Too Optimistic. A second problem is over-optimistic forecasts of the potential market. Nobody can promise discounts of 25-50 percent off industry standard without offering a product that differs markedly from standard. The low price supplier may claim it’s the same product but the customer isn’t fooled. He can see he has to pay his dues. He has to buy in bulk and fight the crowds to get a deal at the Price Club. He buys stocks, but gets no advice at Charles Schwab. He gets outmoded styling with a Yugo. He gets a simple will and divorce at Hyatt Legal Services.

The price leader’s strength is also a limitation. His strength comes in a lean cost structure, producing a bare bones product at big discounts to standard pricing. But his bare bones product also limits his appeal in the market. Discounters, as a group, do not usually capture much more than 20 percent of a market. Discount brokers have captured less than 20 percent of the retail brokerage market. MCI, Sprint, and the other discounting long-distance phone companies won a combined market share of 20 percent.

Strategy is Easy to Copy. When price leaders do capture more than 20 percent of the market, the industry standard setters simply copy their approach and limit market inroads. So, some low price strategies are doomed at conception. An example is People Express. This airline offered substantial discounts on its flights to major U.S. cities, but it was easy for its competitors to match its pricing. Adding a few more passengers to a flight is a low-cost proposition in the airline industry. The airline industry also has far more capacity than it needs to handle current traffic. This excess capacity probably represents nearly 30 percent of the total capacity available in the market. Rather than give up market share to People Express, United, American, and the other major airlines used their low marginal costs and excess capacity to meet any price People Express offered. Because of its low marginal costs and substantial excess capacity, the airline industry has an atmosphere too hostile for a price leader to survive. People Express choked to death on it. So with any other aspiring low cost successor.

High Value and Low Price is Too Ambitious. A third problem is what I call the Siamese Twin Syndrome. One head of the company says it is going to compete on price, but the other head continues to say things that indicate a high value/high cost structure strategy. No company can do both. It is fine to offer a lot of services and features, but every one of these bells and whistles increases the cost structure.

Last Fall, MCI announced a new 800 number service for business. It promised prices 10-12 percent below those of AT&T along with additional services at no additional charge. The company is unlikely to succeed unless AT&T allows them to do so. If MCI gains any notable market position, AT&T will either meet its prices or copy its services and stop its growth. AT&T does not have to do both. At equal prices, MCI sinks with its higher cost structure needed to support its additional services. At equal service levels, MCI will not be able to attract customers easily enough to have lower marketing and selling costs than AT&T. It is likely that AT&T can simply sit still today because the 10-12 percent price discounts offered by MCI will not allow MCI to capture much of an entrenched market.

Price competition is a punishing game with very little margin for error. Companies tend to underestimate the rigor and discipline needed, and allow their second head to talk them back into doing business with expensive features.

Management Systems Are Too Loose. A final problem with competing on price and low cost is that it’s primarily a people game. The game requires some carefully crafted motivational and cost control systems to keep the company profitable despite thin margins. Look at the relatively few U.S. companies that have been competing successfully over the long-term on low costs and low prices. This short list includes the likes of Wal-Mart and Toys-R-Us in retailing, Quick & Reilly in discount brokerage, McDonald’s in fast food, 47th Street Photo in mail order electronics, and Nucor and Worthington Industries in steel. These companies have well-conceived management systems to enable them to make a profit despite very thin margins. Each company has a highly motivated work force for whom cost control is an ingrained way of life. Many use innovative compensation systems, with profit sharing and generous incentives, that reward and reinforce an employee’s contributions to the company’s stand as a low-cost competitor. The rewards are shared equally; so is the pain when the cost structure, as lean as it may already be, has to be lowered again to stave off a challenger. So, three cheers for our new-found commitment to cost controls and price-based competition. But if we’re going to play this game, let’s know the rules so we can play it right.

(Note: This Perspective was written in the context of the economy in 1987. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)

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