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Low Prices = More Customers? Not Always

 
5/1/2006
Wal-Mart, Southwest Airlines, and Dell Computer are famous for their low prices. But before you follow their lead, consider the downside of cutting prices. An excerpt from the new book Manage for Profit, Not for Market Share.


By arguing against price cuts as a form of competitive reaction when you perceive a competitive threat, we hope to convince you to plan your responses more carefully and consciously by thinking through the consequences first. In some situations, your competitor may force you to make this decision, because it has cut prices itself or entered your market at a much lower price point.

But in other situations, companies decide to cut prices voluntarily, with no prompting from competitors and—as we show in this section—hardly any prompting from customers either. They decide to cut their prices out of sheer devotion to the idea that lower prices will revive their customers' wavering devotion and ultimately make the company better off. To defend the cuts, they cite changes in the competitive landscape, the convictions of upper management, a willingness to share cost savings and productivity improvements with customers, and the passage in their Economics 101 textbook that said lower prices result in higher volumes. Because price cuts seem to offer the easiest way to lavish special treatment on customers, companies find the temptation hard to resist.

But resist they should. Proactive price cuts don't make you different, nor do they make you better off. They make you poorer, unless you have the evidence, the data, and the math to prove otherwise.

You run a company, not a charity.

This holds true regardless of how you cut prices. You can cut them through outright price reductions, by offering coupons or cash-back incentives, and by heaping services upon your customers in order to clinch a deal or cling to an existing customer relationship. The people making these decisions defend them with platitudes like "The customer is always right" or "We always go the extra mile." Or they rattle off magazine covers that sing the praises of Wal-Mart, Southwest Airlines, and Dell Computer. The argument seems straightforward: If you read that Sam Walton and Michael Dell became billionaires by selling products at bargain-basement prices, why can't you do the same thing in your business?

The reason you can neither quickly nor easily replicate the success of Wal-Mart, Southwest Airlines, and Dell Computer is that they have achieved a cost advantage so large that no company could easily rival them. They also baked this advantage into their business model from Day One. There can only be one cost leader in the industry. To have Southwest's or Wal-Mart's ability to offer low prices, you would need a significant and sustainable cost advantage. We doubt that you have that advantage now, nor will you achieve it in the short term, if ever. If you operate in a mature industry in which competitors offer similar products based on similar technology and inputs, it may even be impossible for any company to achieve more than a slight cost advantage.

And even if you had that ability, why would you use it? Cutting prices almost always amounts to a huge transfer of wealth from corporate stakeholders to customers. You run a company, not a charity. But you show your charitable side when your decision to cut prices reflects entrenched political or philosophical motives, not objective ones. The following case shows how some straightforward math could have prevented a company from making a highly publicized price cut that backfired.

Case study
Issue: Whether to cut prices
Company: Universal Music Group
Product: Compact discs
Source: Analysis of publicly available information

Universal Music Group (UMG), which controlled roughly one-third of the North American market for recorded music, announced in September 2003 that it had cut the suggested retail prices and wholesale prices of compact discs by 25 to 30 percent.12 It cited consumer research that showed a strong preference at a price point well below its current price levels. It had also concluded that the threat of online piracy not only had persisted, but had fundamentally changed the way certain customers segments buy music.

None of its competitors responded with similar price cuts (a very prescient reaction!), so UMG was free to observe just how strongly a price cut will drive consumer demand. UMG cut the wholesale prices for most of its artists' compact discs to $9.09 from $12.02 to bring people back into the music stores. The goal of this initiative, called JumpStart by the company, seems to have been to provide customers with a clear incentive to return to the traditional way of buying music.

One commentary said that UMG's decision "seems less a savvy attempt to fight back and more a last-­ditch effort to avoid losing any further ground."13 Following the price cut, UMG would have needed to ship 33 percent more CD units just to maintain the same amount of revenue. Achieving the same amount of profit presented an even greater challenge. Depending on what assumptions you make about variable costs, UMG would have needed to sell between 45 and 55 percent more CDs to break even. Where was all the customer demand before the price cuts? Can a lower price point really make that many artists that hot? You might argue that UMG would have seen lower profits anyway, if it had done nothing. But even when you take the "do nothing" scenario with a volume decline into account, UMG would have been much better off without the price cuts.

UMG also fell victim to the law of unexpected consequences. In our experience, managers often neglect to ask the question of whether their price changes will contaminate their future dealings with distributors and customers. Nor do they ask how someone could use their price cut as a weapon against them. The New York Times reported that the cut in suggested retail prices, combined with a less steep cut in wholesale prices, could cause retailers to shift shelf space away from CDs to other products.14 At the time of the price cuts, Wal-­Mart had already planned to reduce the space it devoted to music by 15 percent because of slow sales and low profits, the story said. UMG also shifted its marketing dollars away from in-­store promotions and toward advertising directly to consumers. This move could accelerate the demise of smaller and specialty chains. These developments are rather ironic when you consider that Doug Morris, Universal Music's CEO and chairman, said upon announcing the price cuts that "we are making a bold move to bring people back to music stores."15

Finally, exactly whom was Morris trying to lure back into the music stores? You might think it is the old Napster-­Kazaa crowd, which came of age by downloading music for free and could be defined as the fifteen to twenty-­four age group.

But according to the Recording Industry Association of America (RIAA), that demographic group accounted for only 25 percent of all music purchases, down from 32 percent in the early 1990s. The age group thirty-­five and older accounts for nearly half of all purchases (45.2 percent), up from roughly a third (33.7 percent) a decade earlier.16

If nearly half of all music buyers in the United States haven't seen a high school classroom in almost twenty years, these are probably not people who have abandoned retail stores. Instead, these are the same people who pay hundreds of dollars for Bruce Springsteen or Rolling Stones tickets. . . . They have a proven willingness to pay for music.

A few months after the price cuts, UMG executives "conceded that the price-­cut program has not yet been successful."17 Instead of boosting unit sales and bringing customers back into music stores, the price cut appeared to have no effect at all. Universal's market share in both new releases and overall had actually fallen slightly.

After waiting almost a year for its original plan to work, UMG "partially retreated from many of the price cuts."18 The company originally expected JumpStart to boost volume by 21 percent. It achieved that only for "carryover" CDs, or those on the market for more than eight weeks but less than two years. That segment grew by 27 percent in volume. New releases, though, grew by only 5.8 percent, and sales of older CDs by just 3 percent. UMG officials said that the plan did not work because retailers did not cooperate as expected by passing on the price cuts.

What other alternatives did UMG's Morris have? He had several viable ones. He could have raised prices indirectly. Sony Music, one of Universal's main rivals, has kept CD prices steady, but has reduced the number of tracks on some discs. On a per-­song basis, this amounts to a price increase. Howard Stringer, at that time the chairman and CEO of Sony Corporation of America, said that consumers actually prefer fewer tracks on each CD, and added that putting fewer tracks on a CD could speed up the next release by the artist.19 Although this reflects a price increase—customers get less for their money and spend more often—it does not hurt them as long as the artist remains popular. This move reflects a return to the way record companies released albums decades ago. In the 1960s, rock-­and-­roll bands released smaller albums more frequently than they do today.

UMG could have raised prices directly. Had Morris mimicked AOL's approach and raised prices directly, we would argue strongly that he not only would have generated continued strong revenues from older music buyers, but also would have made his business more attractive to retailers.

The burden of proof must rest with the advocates of the price cut or loyalty incentive.

Finally, UMG could have used a preference-­based segmentation instead of taking a shotgun approach with the price reduction. As the results suggested, price cuts did make sense to some degree for carryover CDs. A strategy of "Price cuts for everybody!" does permanent damage to your price integrity as well as your profitability. Porsche's CEO Wendelin Wiedeking defined price integrity and summarized its importance in Automotive News. "Once you have sold a car with high rebates to a customer, he comes back and wants the same deal again. You'll never be able to make this customer happy, because he will say your pricing is wrong."20 But sometimes even Porsche carefully uses incentives to reduce inventories. The trick is this: Most people don't know about them. For several months, Porsche offered $2,000 to $3,500 cash rebates on 911 and Boxster models. But it offered these incentives only to current Porsche owners and never advertised them.21

When momentum in favor of a price cut or loyalty incentive grows within your company, take a "guilty until proven innocent" approach. The burden of proof must rest with the advocates of the price cut or loyalty incentive. Their proof must have hard profit numbers to support it, not just political weight or philosophical conviction.

· · · ·

Summary
You should not overindulge your customer. Instead, make sure that you extract fair value for what you deliver. Aggressive and acquiescent actions hinder your own efforts to pursue higher profits. [C]ustomer giveaways, value attacks, and aggressive price cuts represent a huge transfer of wealth from you to your customers.

Value attacks occur when you provide customers with increasingly better quality, but fail to charge for it adequately. Loyalty programs make sense only when competitors cannot easily duplicate them, which means they cannot provide the same benefits to the same degree. Even then, you need to do the math to make sure the investment in loyalty programs earns a sufficient return.

Price cuts make sense only when they earn you higher profits. Most don't. When the Toronto Blue Jays lowered some prices [. . .], they had hard analyses to show that the lower prices in certain sections would earn them more money. It is unlikely that Universal Music Group had similar analyses in the case in this chapter.

Take a "guilty until proven innocent" approach when someone suggests that you offer a customer giveaway, make a value attack, or cut prices. The risks to your profit are too great.

Keeping your team on the path to higher profits requires more than rhetoric. It demands the alignment of goals across the organization, with incentives to cement that alignment.

Excerpted by permission of Harvard Business School Press from Manage for Profit, Not for Market Share: A Guide to Greater Profits in Highly Contested Markets. Copyright 2006 Frank F. Bilstein, Frank Luby, and Hermann Simon. All rights reserved.

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Hermann Simon is founder and chairman of Simon-Kucher & Partners Strategy and Marketing Consultants (SKP) in Germany. Frank F. Bilstein and Frank Luby are partners in SKP's Boston office.

Footnotes:

12. Ethan Smith, "Universal Slashes Its CD Prices in Bid to Revive Music Industry," Wall Street Journal, September 4, 2003.

13. Brian Carney, "Price Cuts Can't Save the Music Business," Wall Street Journal Europe, September 22, 2003.

14. David Kirkpatrick, "CD Price Cuts Could Mean New Artists Will Suffer," The New York Times, September 20, 2003.

15. Ethan Smith, "Universal Slashes Its CD Prices in Bid to Revive Music Industry," Wall Street Journal, September 4, 2003.

16. "2002 Consumer Profile," Recording Industry Association of America (RIAA), Washington, DC.

17. Ethan Smith, "Music Industry Sounds Upbeat as Losses Slow," Wall Street Journal, January 2, 2004.

18. Ethan Smith, "Why a Grand Plan to Cut CD Prices Went Off the Track," Wall Street Journal, June 4, 2004.

19. Janet Whitman, "Sony Aims to Improve Ties Between Products, Services," Wall Street Journal, November 5, 2003.

20. "Wiedeking's Strategy for Porsche: Image Builds Business," Automotive News, November 18, 2002.

21. Diana T. Kurylko, "Porsche Again Offers Incentives," Automotive News, November 2002.