AVOIDING THE PRICE WAR MENACE

Part 2 of a series: Root Causes of Price Wars

> Executive Summary

In the previous article in this series, we touched upon the harsh consequences facing organizations caught in the wake of price wars. The take away message was that price wars are a zerosum game won only by avoiding them at all costs. In Part II, we offer explanations for why managers persist in starting and waging price wars, despite the damning evidence against them. In doing so, it is our hope that managers might better understand and restrain the tendencies in themselves and their organizations, which make price wars a reality in todays business environment.

Oren Levy
Senior Consultant

Avoiding the Price War Menace : Part II : The Root Causes of Price Wars

> Why Do Price Wars Occur?

Industry pundits are quick to blame price wars on cyclical market factors such as economic downturns or structural market issues such as overly price sensitive customers. Yet, it would probably surprise these same critics to learn that price wars are also rampant during bull markets and that highly price sensitive customers, although they exist in most industries and categories, typically comprise a mere 15% of all customers on average. Undeniably, these represent risk factors that increase the odds of a price war breaking out, however the driving forces behind why price wars still occur today stem from much deeper issues. Refer to Figure 1 on the following page for a convenient summary of some common price war risk factors.

Avoiding the Price War Menace : Part II : The Root Causes of Price Wars

> Figure 1: Common Price War Risk Factors

There are a number of key risk factors that, when taken on their own or in combinations, can signicantly enhance the likelihood that a price war will break out. By being aware of these risk factors and mitigating their behaviour as a result, managers can signicantly reduce the chance of starting or perpetuating a price war in the rst place.
Risk Factors Rationale
Industry players keep a close eye on volume to reduce the average unit xed cost contribution. Reasoning based on the principles of the Law of Demand, competitors resort to price discounts in the hopes of generating volume. Industry players loathe excess capacity because it signals either competitive inferiority or an industry decline. Both lead to declines in revenue performance and the perception of rising costs per unit. Ultimately, the fastest acting and most potent tool available to managers to boost capacity utilization is pricing. Industry players compete in mature markets where the opportunities to capture productbased competitive advantage have diminished. The commodity mindset takes over and price becomes the only factor competitors feel they can compete with. Industry players place pricing at the forefront of their product or service offering often advertising it as much, or even more than the benets of their solution. When it is easy for customers to switch between competitors, they follow the lowest advertised price. At the same time companies blame excessive price sensitivity, which they in fact created, as the cause. Competition is intensied when fewer, but larger competitors vie for market share. The temptation to discount price becomes a highly attractive option to feed the need for market share.

Example

High Fixed Cost Structure

Newspapers

Excess Capacity

Airlines

Low degree of industry change

Chemicals

High price awareness with low switching costs

Long Distance Telecom

More, large competitors

PCs

Avoiding the Price War Menace : Part II : The Root Causes of Price Wars

> Emotions
Consider the following situation:
You are a senior manager for a market-leading rm and you become aware that your agship product line is losing market share. Upon closer investigation, you learn that the entire category is declining and that the next generation product line, expected to reinvigorate the business, will be delayed to market for another six months. To compound matters, top management has publicly committed to growth rates similar to those observed in prior periods and has tied your groups compensation packages to meeting these goals. Last, you have six weeks before the end of the fourth quarter. What do you do?

Although this scenario is not real, we can all agree that when faced with overwhelming adversity, seemingly beyond our control, it is simply human to feel frustration and stress and we as managers and people, instinctively act in a way to relieve those stressors as quickly as possible. Enter pricing. Pricing is one of the most powerful and yet easiest levers to manipulate to elicit a quick reaction from the market. When under pressure, managers almost reexively resort to price discounts in a Hail Mary effort to improve their organizations fortunes in short order. In doing so, many sadly fail to consider the nature and severity of their competitors reactions and it is in this way that price wars are often born. But if stress and frustration predispose managers to starting price wars, it is competitive rivalry another powerful emotion - that compels managers to escalate them. In todays hyper-competitive market, managers are quick to attribute a rivals price discount as an attempt to buy market share. They are even quicker to respond with a price discount of their own, irrespective of value, other elements of the marketing mix or cost structure, in order to prevent the competition from getting the best of them. By the time both rivals realize they are embroiled in a heated price war, pointing ngers of blame at each other, it no longer matters because the damage has already been done. The Burger Battle documented in Part I of the series offers an excellent illustration of how emotions can very quickly ignite a price war.
Avoiding the Price War Menace : Part II : The Root Causes of Price Wars 5

> Commodity Mindset

Recently, a senior-level marketing manager in the electronics industry intimated that Pricing is simply out of our control. Our competitors offer similar products and support services as we do. They seem to drop price daily and we end up spending all of our time just trying to catch up. Often, when market-leading organizations engage in competitive behaviour that results in a price war, it is because they suffer from what is known as the commodity mindset. These organizations rarely sell commodities, they only feel they do, because they have not adequately invested in either understanding what their customers truly value or in identifying creative opportunities to then differentiate themselves in the minds of their customers. Classic examples of industries overrun with the commodity mindset include: chemicals, consumer electronics, industrial products and long distance telecom, to name but a few. The commodity mindset is prevalent in organizations that continue to maintain a primarily internal view of value, selling customers features and qualications which are easily matched in this day and age - instead of appropriate solutions packaged around their customers needs and pain points. Even organizations that do invest in understanding customer value can succumb to the commodity mindset if they are unsuccessful in communicating and reinforcing their value back to the customer. In the end, when managers resign themselves to the belief that their value propositions are virtually indistinguishable from their competitions, there is little recourse available to them other than to play the pricing game and instead of generating sales, most only succeed in producing price wars.

Avoiding the Price War Menace : Part II : The Root Causes of Price Wars

> Market Share Focus

Aside from its obvious implications on nancial performance, market leadership is also a tremendous source of organizational pride. It is therefore understandable when market leaders seek to grow their share or defend it against aggressive competition. Unfortunately, for many organizations the focus on market share becomes so narrow, that managers use pricing alone to achieve their goals, without adequately considering the impact on protability, customer value perceptions and competitive response. A market share focus was in fact the spark that ignited the North American automotive rebate pricing war in the early part of the decade. Ardent rivals General Motors, Ford and Daimler Chrysler had become so share driven over the years that it became industry practice to publish market share gures sometimes even down to the product line level on a quarterly basis to demonstrate competitive superiority. In 2000, when GM began offering highly attractive nancing terms and sizeable cash-back discounts to win over customers, Ford and Daimler Chrysler immediately followed suite to defend their competitive positions. More aggressive nancing terms and even larger cash-back rebates followed over the next three years of heated battle, leading to dramatic declines in industry protability with unsustainable shifts in market share.

Avoiding the Price War Menace : Part II : The Root Causes of Price Wars

> Pricing Prowess

Many managers nd themselves engaged in price wars because they simply have not been trained to avoid them by learning to manage the pricing function more strategically. As is often the case, pricing tends to be relegated to that of an episodic concern, attended to only when margins are squeezed or revenues are threatened, and by the time adequate attention is given to the problem, there is often little room for corrective action. Part of the problem lies in the fact that many organizations are generally unaware that pricing can be managed as strategically as other functions and so they do not invest in training and educating their personnel. Furthermore, even when there is awareness and a desire to invest in pricing education, organizations look to business school programs, which still place very little stress on pricing management in their curricula in general, and rarely offer courses devoted to the subject of pricing strategy. In the end, most managers only learn to avoid dangerous pricing tactics, once they have experienced, rst hand, just how destructive they can be, and this has placed too many organizations at the mercy of price wars.

Avoiding the Price War Menace : Part II : The Root Causes of Price Wars

> Because the Cost Leader can...

Certain organizations excel at providing their products or services at the lowest price in an attempt to attract the most price sensitive customers. Organizations such as Wal-Mart, Dell Computers and Home Depot come to mind. The reason why these rms are so difcult to compete directly against is because, by virtue of their competitive cost advantages, they can charge lower prices and still remain protable through a price war much longer than any of their competitors can. Consequently, most organizations have learned not to start a price war with these low cost providers. More often than not however, it is these low-cost market leaders who deliberately start price wars as a ploy to force their rivals to play up against their greatest strength. Often, there is very little an organization can do to prevent the cost leader from attempting to start a price war by dropping prices, and most companies believe they have no option other than to enter into a battle they know they cannot win.

Avoiding the Price War Menace : Part II : The Root Causes of Price Wars

> Conclusion
There are a number of deeply embedded reasons why price wars continue to rear their ugly head in business today. Fortunately, all price wars are preventable through deliberate plans to manage pricing and customer value more intensively, strategically and scientically. In Part III, we conclude the series by outlining the key initiatives that managers should and can adopt based on examples put forth by the worlds pre-eminent pricing organizations in order to secure their revenues and prots against the ails of price wars. Oren Levy has been a pricing strategy consultant for over 6 years. Prior to that he held roles in sales, marketing and market research. Oren currently heads up Value Insights Inc. and throughout his career has helped numerous clients improve their top and bottom line performance through more effective pricing management. Oren can be contacted directly at (416)-924-0904 or olevy@value-insights.com

Avoiding the Price War Menace : Part II : The Root Causes of Price Wars

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For more information, please contact us: phone : 416 924-0904 email : info@value-insights.com