Imagine that you are a manager at a consumer-packaged-goods company. You have excess capacity, year over year flat revenues and aggressive competitors. Your goal is to retain market share. In this situation, a manager's first reaction is to implement price changes, decreasing price without a proper evaluation of the following potentially detrimental consequences:
- A 1% decrease in price reduces gross margin by 10% to 15%
- Competitors' responding by matching or further lowering their prices
In this hypothetical scenario, when you lower your price (and margin), your competitor's pricing strategy quickly matches. You respond, reduce your cost again (negatively impacting profit) only to once again, be matched by your competitor. Before you know it, you are in a full-fledged price war.
What Is a Price War?
According to Investopedia a "price war is a competitive exchange among rival companies that lower the price points on their products, in a strategic attempt to undercut one another and capture greater market share. A price war may be used to increase revenue in the short term, or it may be employed as a longer-term strategy."
What are the pros and cons of a price war? Price wars result in significant transfers of wealth from sellers to buyers. Notable examples include:
Online Retailers Entering Grocery Space – Online retailers are expanding into the grocery space using price to gain market share. Amazon, for example, has recently given its prime customers additional discounts to gain share and build loyalty.
Cloud Computing (Services / B2B) – Cloud computing and storage pricing has dropped over 14% in the last 12 months. Many B2B companies cut prices or submit low bid offers to secure long-term contracts, utilize idle capacity, and gain market share.
What Causes a Price War?
Price wars occur because of one or a combination of the following circumstances:
- Excess Capacity: The impetus to utilize excess capacity can trigger reduced pricing to increase demand.
- Comparable Products / Services – If there are similar or alternative products, companies may resort to decreasing prices to gain market share or increase sales.
- Desperation – This can occur when a large player is losing share quickly (perhaps to a new entrant). The large player will sacrifice profit (in the short-term) for share (in the long-term). Smaller companies may also be desperate to generate cash flow, thus pushing prices down to increase sales and liquidity.
- Incompetent Management – Managers using the price to hit short-term targets rather than focussing on the long-term optimal profitability target.
- Price Elasticity –Managers believing that high price elasticity within a specific segment accompanied by a decrease in price will result in a significant increase in sales.
- Low Consumer Switching Costs – This is typically seen in commoditized products with negligible differentiation, where the motivation is to reduce prices to increase market share.
- High Fixed-Cost Structure: The drive is to reduce pricing to increase volume, which, in turn, contributes to the higher total fixed cost recovery. Commonly occurring in industries with significant capital investments and long production runs.
- Lack of Industry Change / Innovation – Knowingly starting a price war to force innovation and push poorly equipped/resourced competitors to fail.
How to Avoid a Price War With Competitors
Focus on Value instead of Price – Many companies engage in price competition by using a standard markup on cost without any appreciation of the value they are conveying to the customer versus their competitor's offering. As a result, they undervalue their own product/service and miss revenue enhancement opportunities.
It is essential to understand what makes your product different from the competition. Additionally, understanding how consumers perceive your product and what they are willing to pay for it. In short, the implementation of value-based pricing.
Introduce Price Fences / Tiering – Properly segmenting your consumers and products will provide the roadmap needed to correctly create product tiers that match consumer's willingness to pay. Creating "pricing guidelines" whereby your product pricing will fit into specific ranges or conditions given your consumer versus a competitor's offerings is the key here.
This approach also provides the flexibility to match competitive offers with "lower-tiered" offerings, while protecting your premium offerings and promoting upselling—differentiating your product from the competition.
Communicate With a Purpose – In industries where there is very little transparency, what and how you communicate pricing is critical to success. Communicating your pricing strategy can be used as an intimidating tactic to avoid a price war and win a price war, forcing competitors to re-evaluate their strategy.
Business Process – There are three things you should always be evaluating to prevent a price war:
- your company's capacity and forecast,
- competitor pricing and actions and,
- your current offering and value proposition.
How to Win a Price War Against Competitors
Compete on Quality – Focus on what makes you different and why your current consumers choose you over the competition will allow you to win a price war. It could be the quality of your product, the value of your brand or any additional services you offer. Communicate this to the market. You can also formulate other attributes/features to create a gap between you and the competition.
Reveal Your Advantage/Strategic Partnerships – Show the competition why they would lose in a price war. Reveal your cost advantage, or exclusive partnerships, and try to make your competition think twice about lowering their price. Showing your competitive advantage will help win a price war.
Strategically Change Price – Try to avoid blanketing price cuts across all products. Instead, be strategic in pricing reductions. Either modify specific prices or use complex dynamic pricing strategies. When changing specific prices, it is essential to protect your high-value products/services and only cut prices on items where the wiliness to pay is low. Complex pricing actions include creating bundles, quantity discounts, limited time offers and introducing a loyalty program.
War always comes at a cost, and few, if any, actual winners. Victory comes at such a cost that it is often tantamount to defeat. If you do manage to survive, remember what Sun Tzu said in 'The Art of War' – "The greatest victory is that which requires no battle."
ABOUT THE AUTHOR Marc Carias is a Consultant at Revenue Management Labs. Revenue Management Labs helps companies develop and execute practical solutions to maximize long-term revenue and profitability. Learn more about what we do: Revenue Management Labs.