MEETING FALLING PRICES WITH CREATIVITY

Your industry’s customers have become intensely price sensitive. All around you, customers are asking for lower prices. If you refuse these requests, the customers may leave you. If you agree to them, your margins fall. Either way, you are on the defensive. What are you to do? Many companies feel compelled to reduce prices for all customers. But some take a more measured approach. These companies isolate price reductions to carefully selected portions of the market, while leaving prices at higher levels for other segments, and achieve higher margins as a result.

Through the study of many price reductions by companies over the last 25 years, we have identified patterns companies use to isolate price reductions. The patterns call for the company to make three choices to limit its price reductions. The companies we studied did not necessarily follow a particular sequence in these choices but we will describe a sequence to these choices that seems easy to use. First, choose an approach to price reduction that sets the current price for a product or service within the context of a broader customer transaction. Second, identify the customer segments who will receive the new, lower price. And, third, choose the components of the price that will contain the spread of the lower price to the target segments.

CHOICE 1: The Approach

The company’s first response to a falling price environment chooses an approach to agree on the current price of the product as part of a broader customer transaction. The current price of the product or service is only part of a broader, often longer lasting transaction the seller has with the customer. This broader customer transaction includes all the products the customer buys over a period of time. At its most limited definition, a transaction involves a customer purchasing one product, one time, at one place. For instance, you walk into a local drug store and buy a bottle of aspirin and leave. But transactions may be, and usually are, more complex than this basic case. For example, a retailer customer may agree to purchase a minimum quantity of several products from a distributor over the course of a calendar year, at a negotiated discount from list prices. This longer term agreement could be the transaction. Further, the distributor may also agree to provide several services to the retailer as part of a broad relationship defined by a contract. In this latter example, the contract is the transaction.

The term “transaction” here is something greater than a single purchase, which is a one time event, but less than the customer relationship, which may last many years. The transaction extends over several purchases and, usually, over a period of time. This transaction need not be a formal, contractual, arrangement. Both the seller and the customer may plan on a relationship extending well beyond the single purchase, even without a formal agreement.

The company and the customer may see different transactions. The company may consider both the price per unit and the full transaction revenues in deciding how to respond to falling prices in the industry. The customer, on the other hand, often focuses on the current price of the product. The company may modify its current product price, within the transaction structure, to meet the customer’s demands for a lower current price.

Using the combination of current price and transaction revenue, you may reduce the customer’s current payment with one of three possible approaches. These three approaches are combinations of current price per unit of product and longer term transaction revenues that give the customer a lower current price for the product: reduce both unit price and transaction revenues; reduce unit price but increase transaction revenues; and raise unit price but reduce transaction revenues.

Reduce Both Unit Price and Transaction Revenues

One approach to falling prices is a simple reduction in the current unit price with a resultant reduction in the transaction revenues. This approach exerts the greatest downward force on the company’s margins. You employ this approach when you are under the greatest competitive pressure, where a customer has forced a price reduction on you, or soon will.

Examples of this approach occur in the cyclical clashes between branded and private label consumer goods, in the rebate and financing battles in the auto industry and in generic drug challenges to those branded drugs coming off patent protection. A hostile market, one in overcapacity, sees this approach as a common choice. But the company can mitigate the margin losses from declining prices by focusing on specific customer segments and by changing the components of the price, as we shall see shortly.

Reduce Unit Price and Raise Transaction Revenues

A second approach to a falling price environment reduces the current unit price of the product while increasing the transaction revenues. The company offers a lower unit price in return for more purchases by the customer. This approach is less common than is the simple reduction in the current price per unit.

Generally, the approach works best where a low current unit price is the focus of the customer while the company sees opportunity to sell additional products or services in the transaction. In a commercial market, an equipment supplier might offer low prices for each piece of equipment and then sell maintenance services to support the equipment. In retail markets, this approach takes the forms of frequent shopper cards, of buy two get one free deals, and of bundling of a product with another product or service. As an example of the last concept, a cable company sells a monthly package of services including cable TV, phone and internet services.

This approach offers a variation to reduce the customer’s payment: reduce the price on the additional products in the customer transaction rather than the price of the main product. For instance, an auto manufacturer may reduce financing costs (e.g. zero down and zero interest) while leaving the price of the car unchanged.

Raise Unit Price and Reduce Transaction Revenues

A third approach to contain falling prices is to raise the unit price while reducing the customer transaction revenues. This approach seems to fly in the face of logic but it can be done. Here’s how. The company redesigns the product by changing the basis for its sale. The basis is the unit of sale. Instead of a one year subscription, the magazine sells a 22 week subscription. The price per magazine goes up compared to the price with a yearly subscription but the customer’s actual payment is for a 22 issue subscription, not a 52 issue subscription. Here’s another example. In the early 90s, Blockbuster began charging $2.50 to rent a movie for one night rather than the traditional $3.00 for two nights. The basis of sale changed from a two night rental to a one night rental. The original price per night increased from $1.50 to $2.50 but Blockbuster received lower revenues in the transaction.

This approach creates a new, lower, price point in the market. It works only in those falling price environments where the new low price point would slow the decline of prices at the original price point. There aren’t many of those kinds of markets so this approach appears only rarely in practice.

CHOICE 2: The Segments

You reduce the impact of falling prices by restricting the new lower prices to only some of your customer segments. Companies have slowed the spread of low prices by aiming them at one of three unrelated customer segments: segments with particular needs, segments who help the company improve its margins or segments where competitors are attacking the company's customers.

Customer Need Segments

Customer segments vary in the needs that the company’s products and services meet. These needs present the possibility of restricting the lower prices to particular customer need-based segments. Customers have three major categories of needs: physical, emotional and informational. In a falling price environment, emotional needs rule. The customer wants the right product but doesn’t want to pay too much for it. The customer is anxious and the company responds to this anxiety. The company may offer selected price discounts to price-sensitive customers. In contrast, the company may hold its higher prices where the customer’s primary anxiety is not the current unit price.

Some companies ease customer anxiety by emphasizing a unique low price, rather than the product’s performance benefits. Some customers worry about being “locked in” to a relationship with a seller when prices are falling. Astute companies have responded to this customer need by unlocking the price but not the customer relationship. They have offered “meet or release” contracts, which lock the customer into purchasing a product from the seller, as long as the seller can meet any verifiable price the customer receives from a competitor. In effect, this type of arrangement always gives the seller the “last look.” In retail markets, you see companies address this need with guarantees of low price. For example, the retailer promises to meet any price the consumer finds that is lower than the price at which he purchases.

Other companies ease customer anxiety by emphasizing the attributes of the product that “protect” the customer and are worth more than the average product. For example, auto manufacturers “certify” the quality of their pre-owned cars, and get a premium for the certification. Retail stores advertise “everyday low prices” but still charge more in their convenient locations than does Wal-Mart. American Express had a charge card with a high annual fee, but it doubled the length of the warrantees on products bought with the card.

The source of customer price sensitivity may be a belief that he could get by with less in the way of benefits. Companies may then offer these customer segments a product with a lower price point and with fewer benefits. The air courier business offered a two-day, rather than a one-day, delivery for a lower price. Other examples include private label products and “value” brands in consumer package goods, and the DSL broadband product, which telephone companies sell at a discount to the faster cable broadband product offered by cable companies. The lower price points satisfy the most price-sensitive customers while leaving intact the margins on customers who prefer more benefits.

Margin Building Segments

You may also reduce prices to customer segments that will help the company improve its margins. Large customers, who are big purchasers, can improve company revenues both directly and, sometimes, indirectly. In virtually every market, the larger customers pay less than smaller customers through volume discounts. These arrangements see tiers of discounts based on the volume of purchases. The first $100 of purchase may carry no discount, the next $100 may carry a 10% discount, the third $100 may carry a 20% discount, and so forth. A more subtle example occurs in some costly purchases, such as tires. Tire manufacturers routinely offer very low prices to auto manufacturers. This is not a discount meant simply to get a large customer into the fold. The purpose of the discount is to increase the odds that the branded tire manufacturer will be the choice of the consumer once the original tires on the automobile need replacement. Replacement tires carry high margins. Here, the transaction covers both the auto manufacturer and the consumer purchasing the replacement tire. Other forms of discounts for customers who purchase more from the company offer customers direct incentives to increase their share of purchases from the company, rather than from competition. Companies may offer customers larger discounts for exclusivity in the customer’s purchases or for a greater share of the customer’s total purchases.

Customer segments may improve the company’s margin structure by reducing the company’s total costs. These customers may receive compensating discounts. The ethical drug manufacturers offer their patent protected drugs at lower prices outside the United States than they do inside the United States. These offshore customers receive a lower price because they improve the economies of scale for the drug companies with their marginal purchases. Better economies of scale reduce the effective unit costs of the drug. Other forms of price discounts that come as a result of customer actions reducing the company’s costs include lower prices when customers purchase well in advance of need, and when they purchase through distribution channels that are less costly for the company to serve.

Competitive Response Segments

The final segments to whom the company may offer lower prices are those who are the subject of intense interest from the company’s competition. Price competition in these segments is greater than average in the market. The pathway the competitor uses to attract your customers with a low price defines the customer segments for your price response. The competitor may attack you at a price point, in a geographic region or in one of your key customer relationships.

The competitor may attack at a particular price point, sometimes at the low-end and other times at the industry standard product price point. As Amazon began attacking Borders’ book business with low prices, Borders created an online presence with prices matching Amazon’s. Prices on Borders’ shelves remained unchanged. You may also need to respond to specific competitors at the standard industry product price point, or higher. In the late 90s, established wireless phone service providers, such as AT&T Wireless, dropped their prices dramatically in areas where the new wireless spectrum PCS wireless providers, such as Sprint, entered their markets with big discounts.

The competitor may attack only in a geographic region. Over the last few years, Microsoft has confronted a number of challenges from Linux in developing countries. It has beaten back many of these challenges with lower prices in those countries.

Finally, a competitor may attack one or more of your particularly valuable customers, especially large customers. The auto rental market has been cut-throat for many years. Some years ago, Avis, in an attempt to gain the top position in the market, took three of Hertz’s big accounts by way of big discounts. Hertz responded in-kind, taking several of Avis’ big accounts with substantial discounts tailored for those Avis customers.

CHOICE 3: The Components of the Unit Price

Once you have chosen an approach to lower your customer’s current payments (Choice 1) and the target segments for the approach (Choice 2), you choose the components of the price. The components focus the lower price on the target segments. You can think of the price per unit as a combination of three components. The first defines the product benefits. Another component describes the unit measure of the product you sell. The third extends the unit price into a broader customer transaction.

A consumer walks into an automobile dealership. The consumer is interested in the dealership’s particular brand of automobile. He chooses a style, size and color for his automobile. The car comes with a four year warranty. The consumer agrees on a price of $35,000 for the car. He leases the automobile from the dealership. The lease specifies initial payments, monthly payments, residual values and mileage caps. This example illustrates the three major components of a price.

Benefit Package

The first component of a price is the set of benefits, or the performance package, the consumer purchases. Normally, you might not consider the performance package as a part of the price, but it is indeed, and an important one at that. The total set of benefits, the functions, the reliability assurances and the convenience of purchase of the product, determines the costs of the product. These costs, in turn, are the major determinants of the product’s price. In our consumer auto purchase example above, the color, size, style and warranty of the automobile, and the location of the dealer, are all parts of the performance package.

A company may change its price and its performance benefits at the same time. Sometimes this results in a new, lower, price point. Cable companies have various tiers of pricing available to consumers. Each of these tiers contains a different set of cable channels, the functions, with the more expensive tiers containing more channels. High tech companies respond to unauthorized gray market products, sold by customers outside normal sales channels, by invalidating warranties, changing the reliability assurances of the product. During the 1980s, Levi’s refused to sell its branded jeans in discount mass merchant outlets. Instead, Levi’s offered the lower-end Britannia brand to the discount mass merchants. In return for a lower price, the customer lost the convenience of Levi’s locations and the reliability implied by the Levi brand name.

Basis of the Unit Price

The second major component of a price is what most of us think of as the price itself. This is the unit measure of the product when it is sold, the basis of the price. In our automobile purchase example, the basis is one automobile and the price is $35,000. This basis quantifies one unit of the product. Beer sells in cases, kegs and packs; cigarettes in cases, cartons and packs. Printer ink comes in cartridges. Software sells by the seat, by transaction counts, by CPUs of the hardware using the software and by customer revenues or employees.

A change in basis may change the product price point. In the late 90s, Philip Morris responded to discounting competitors by offering a buy three cartons get two free deal on its Marlboro cigarettes. The company changed the basis of the price from a single carton unit to a package unit containing five cartons. This change in basis changed the price point. When stock markets become volatile, you may see investors demanding a different pricing structure than typical in money management firms. The typical pricing structure charges a fee that is a fixed percentage of the dollar value of an account. In difficult times, customers may ask for fees to be based on the return on investment of the fund instead. The basis of the investor’s price shifts from a percentage of assets to a percentage of profits.

Optional Components of the Price

The third component of price is one or more optional components. While every product has a benefit package and basis, these optional components may or may not be part of a product price. If they are, though, they tend to extend the product price into a broader customer transaction. These optional components of price appear in most markets but are always present in tough marketplaces, where price competition rampages. These optional components include fees added to the normal variable basis of charge, penalties or bonuses for the buyer or the seller, price caps, extended payment terms, discounts and premiums and the period of agreement to hold the price.

These optional components stretch the life of most transactions into the future, or at least over more than one unit of purchase. The final cost to the customer, and the final revenue for the seller, become clear only with the passage of time and the achievement of specific milestones. Pre-paid cellular phone plans charge set up fees in addition to their per minute phone charges. Manufacturers offer retailers co-op advertising support, which compensates the retailer with a bonus each time the retailer advertises the company’s products. Hotels charge for optional services on guest stays. Some drug companies offer selected price caps on the patient’s total annual costs for their drugs. Major equipment vendors provide financing for their customers, extending the payment period.

A pricing analyst could write a book about the various discounts and premiums available in a falling price environment. Applying a discount to a specific purchase or to a restricted segment of customers is the most common way that companies retard the spread of price declines and margin losses when prices fall. When pressured by competition from independent auto parts producers, the major auto manufacturers offered discounts on their parts, but only on those products produced by the imitation parts manufacturers. The cost of parts without the independent competition did not receive the discount. As the telecommunications market price competition intensified in 2004, Verizon teamed with DirecTV to offer a package of phone service, DSL and pay-TV at a discounted price.

Discounts may also appear on a support product rather than on the main product itself. For example, the average selling price for a cellular telephone handset has been falling for a number of years, while the price of cellular service has remained relatively steady. The handset prices are the focus of the sellers’ price competition in the cellular industry.

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Price competition may be fierce in your industry. You may have to go along with broad industry price cuts, since lost customer revenue decreases your cash flow. But, rather than implementing a broad price reduction, you may be able to defend both margins and customer relationships with the three choices: changing your approach to the price decline to emphasize a larger transaction; isolating the price reductions to specific segments; using one or more of the various price components available to you.

(Note: This Perspective was written in the context of the economy in 2009. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)