Chapter 2
Why Value Matters Less with Competition
The single most important decision [you have] is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business.
—WARREN BUFFETT, CEO OF BERKSHIRE HATHAWAY, INC., 2010
If you could read the thoughts of your competitors, you would frequently find the same concerns present in your management team. Just like you, your competitor is also tasked with revenue, share, and profitability goals—perhaps not the same figures, but often tending in the same direction. The interaction between your company and a competitor’s is shaped by how you and your competitor differ, and how you are alike.
Typically there are more similarities than there are differences. The profit objectives are quite similar, the balance between share and profits are not radically different, the ethical standards pretty uniform, etc. The only exception is that if there is a new entrant, either with or without a new technology, they might have quite different profit objectives in the short run, or if there is a distressed player either in or near bankruptcy.
This similarity is, overall, a good thing for the players. It tends to lead to very “civilized” competition. It’s unlike Harry Potter versus He-Who-Must-Not-Be-Named: neither has to die. That does not mean that over time there is not a winner who pulls ahead, only that the pricing rarely degrades into a price war.1
Understanding Your Competitors
While mutual incentives to avoid annihilation are fortunate for your company, the typical competitor standoff is not foolproof, especially with a combination of unfortunate circumstances. One example of this was a skirmish between two service providers. Because of budget, systems inadequacy, and management inclination, the lower market share service provider had no profitability measures for its “small customer” regional managers. Freed from profitability measures, one of the regional managers (in the Midwest) launched a share campaign involving lower prices. The larger market share service provider, which has very good reporting systems and a strong profit orientation, felt the resulting pain immediately. The larger provider also had a national management structure for its small customers, and so happened to strike back with lower prices on the U.S. West Coast. To the larger company’s surprise, doing so did not send a signal to the smaller competitor: the attacks in the Midwest continued. Only after it learned that it had to retaliate inside the same competitor region, to get that attacking manager’s attention, did retaliation end the potential price war.
Any price actions must reflect competitor decision processes. Management must have a view on how competitors make their pricing decisions.
Competitors’ costs structures, timing, reporting structures, and objectives must be understood and either accommodated or exploited. Another well-documented example of the consequences of misunderstanding competitor-decision processes took place in New York City, where the alternative data carrier Teleport Communications Group found financing based on its ability to undercut the incumbent telephone company’s high rates for service within distances of five miles or less. After Teleport built its network, the incumbent telco lowered its prices for these distances but then raised prices for distances beyond five miles to compensate. This maneuver simply made Teleport revise its business case to include share capture in the next five-mile radius so as to capitalize on the new rates. Eventually, the incumbent reluctantly lowered its overall metropolitan business rates, but by then it was too late: simpleminded and inadequate reaction had allowed a competitor to gain a foothold in the market. The incumbent, now part of Verizon, had ignored the contexts of geography and decision process, and so preventative action had come too late.
Not that we are advocating massive reaction to competitors, just intelligent reaction. For instance, two major airlines with large Chicago hubs found themselves under price attack from a start-up carrier based in Phoenix, Arizona. One of the two major carriers responded by lowering all of its prices to Phoenix. The other major carrier responded by lowering prices to Phoenix only on flights leaving within 25 minutes of the start-up carrier’s flights. The first defensive strategy cost that carrier a lot more money than the second, smarter pricing strategy. Timing is a key context for schedule-based industries, and so time must be central to pricing approaches.
Decision Contexts
Contextual pricing dictates that only where there is little or no competition can managers take the absolute value of a product and use it for pricing. This is because in competitive markets, only a fraction or even zero percent of the absolute value can be captured. The rationale for this is well known. Typically if a competitor can win business at any price over attributable costs, it is better off. As each company competes on improving the price/value ratio of its offer, each will be incented to lower its price—in some cases to approaching zero incremental margin over costs. Therefore, unless you have a monopoly for a product/market, a value approach to pricing probably won’t work in most markets.
That logic is pretty depressing, but it’s also limited. A more balanced view is that competition does put downward pressure on prices, but rarely do prices collapse. The reason that prices do not always race for the bottom lies in context. So better to develop a contextual model that actually answers the questions needed in price management.
Context captures the relevant forces shaping price. These are:
Relative value, how much more value does one side offer?
Corporate objectives and management compensation.
Cost positions: how much room to cut before implicating margins?
These factors are why, in a competitive situation of two or more competitors, the degree of value each will capture will always fall short of full value capture—sometimes 100 percent short. But outcomes will generally also rise above the cost-based floor—frequently well above.
Consider a classic competitive situation: two companies with fairly similar offers and shareholder expectations, but some differences in value proposition, and costs. Each competitor’s offer may provide a lot of value to the buyer, but thanks to the competition, neither one will capture all that value (absent price fixing). Why? The answer lies in looking at a typical competitive situation between two companies, imaginatively named Company A and Company B. As diagrammed in Figure 2-1, there are some normal differences between these two companies.
Figure 2-1 Price pressures and floors: the impact of competition on value realization.
In this case, Company A appears to offer greater value than Company B. Perhaps it’s a data processing device that runs 30 percent faster or an advertising vehicle that reaches viewers whose household income is higher on average than Company B’s vehicles, or perhaps it’s a flight monitor with a larger display and lower power consumption. For whatever reason, Company A provides greater value.
Typically, such a product should command a premium for its incremental value, and we have generally been able to prove the existence of such a premium when a thorough competitive comparison is performed and all elements of competitive offers are included. For instance, at one software firm, its superior backup capability was said not to be valued by the market. It turned out that most of the market did not, in fact, value the incremental capabilities. The one segment that did value the capability, however, was indeed paying a generous premium. Client product management had failed to segment and had also not properly communicated the competitive difference.2 Differential value should be recognized by the market because when the two competitors have whittled away the similar value component, the less valuable competitor (Company B) has nothing to offer the buyer to neutralize the higher value offered by Company A.
In some cases management complains that its quality premium or differential product attribute is being ignored by the market. Assuming that the quality premium is meaningful to the market, there are ways to make sure that the market recognizes it. One way is to tier the product with and without the attribute in question. By pricing the “without” product similar to the competitor’s “without” product, you force buyers to value the upgrade. Of course they will want the upgrade for free, but that is part of buyer negotiation. The offer gives your company better leverage and frequently turns the tables, since the burden of justifying the difference has effectively shifted from you to the buyer. Your sales argument can now take on the role of dispassionate expert advice.
Look to context and segmentation to explain why a differential in value does not appear to be valued. As an example, consider the telecom equipment market of a few years ago. During the 1990s the leading manufacturers of PBX (private branch exchange) equipment included Lucent, Nortel, and Siemens. These manufacturers produced reliable, scalable, and durable systems that handled calls within large buildings and companies. Scarcely noticed in the market were “inexpensive” machines, which bordered on the disposable, by Panasonic.
Yet for a period of three years, the Panasonic machines commanded the highest price per user line, representing the utter inversion of product value and price. This was because the “low value” PBX market was subject to the context of relatively lower supply and higher demand per vendor. Product specifications did not drive value because higher value equipment tiers were locked into destructive price battles. Panasonic was not.
Management needs to clearly communicate value differences in price terms. One such method is offering the product at the competitor’s price, minus the value-add component—this squarely places the choice with the customer.
Costs play an important role, although in an indirect way. Looking at the cost represented at the bottom of the bars in Figure 2-1, you’ll find that there are very few examples where competitors have sold below variable costs. For high-margin industries, that would represent quite a discount: for some information services the prices would have to drop 90 percent or more before incremental (variable) costs are implicated. Similarly, both sides will resist pricing below incremental (or variable) costs of sale because typically neither Company A nor Company B has management that is incented to go cash-negative.
We often see sales below fully allocated costs, but that is less of a source of alarm both because it represents less of a drop and because allocations are usually not situation-specific anyhow. In addition, in extreme cases, there is a somewhat self-regulating aspect of pricing. The lower the price, the fewer buying decisions will be made on price. For instance, as the costs of promotional giveaways (e.g., branded pens and mugs) become small, buyers will simply order such goods from whichever supplier they have a relationship with rather than put the order out to bid. Hence, in addition to the financial pain of going below costs, there is often no market reason for competitors to get down below variable costs.
The middle sections of the chart columns are the most interesting areas for pricing. Either or both competitors could choose to push price down to variable cost, which is why product value can never be a reliable guide for pricing in competitive markets. The absolute value of a product can disappear in smoke. The question any pricing approach must answer is: how much of the value in the middle section of the chart columns can be captured through the adroit use of context?
While the middle part of the column could disappear totally, there are typically strong incentives for competitors not to engage in mutual self-destruction. These are:
Management incentives include profitability incentives.3
Managers facing powerful competitors are concerned about starting a price war.
Even when seeking share growth, cash flow is typically a factor.
Together these, and many other factors, comprise the universe of “context” and help keep market price from collapse. Context is a bridge between the value-oriented managerial-cost literature, which typically aspires to capture all or most of the product value, and more academic economic literature, which looks to economic returns and costs. The economic literature is ready to assume that costs and minimum shareholder returns are the only floor for pricing. Not true.
While management-incentive factors have been all but ignored in the classic economic literature, they are absolutely determinative in some pricing situations. The management team making the pricing decisions no doubt has a profit objective, and will hesitate to set prices which imperil that objective. In most cases, management will even insure that there is some cushion between minimum prices to achieve the profit objective and its target prices—many management teams enjoy having that cushion!
Part of context is the disposition of equity holders, which needs to be considered alongside management (although the two groups may be aligned). The equity holders can be a force for price disruption (e.g., private equity, LBO, venture capitalists) who need to show extraordinary profit growth, or they can be forces for profit conservatism (e.g., at one point telephone stocks were considered “bond substitutes for widows and orphans”).
Management incentives and equity holder objectives will directly shape market prices.
Cost in Commodity and Near-Commodity Markets
In most markets costs play a role, but they should not single-handedly determine prices. There are some industries in which costs play a very large role: commodity markets and cost-plus markets. In fact, even in these markets, costs do not constitute the entire driver. Special circumstances still clearly impact price. For instance, when one Ontario steel manufacturer experienced a “breakout”4 that shut down production, it obtained replacement product from a nearby mill to honor its contracts, but at a premium.
There are many reasons to vary price from cost in any industry, and some of the most common occasions for price premia in commodities all link to changes in context. Typical changes are:
New product. Even in the toughest industries, unique new products are an occasion to obtain higher margins. For instance, in the commodity plastic container industry, new hooking mechanisms for clamshells and resealable plastic bags both allowed material price premia for a while.
Rush orders. Every company in existence should have a delivery interval, and if customers want it sooner, then this is the time to apply the rush-order tariff.
Special orders. Whether or not they really incur material incremental costs, special orders are an opportunity to get more money. The premium could take the form of a price lift, or a longer-term volume commitment.
As usual, even if cost is not really the driver, the rationale of higher costs is a very good message to accompany the new higher price. It suggests that you have no choice but to raise price, and says that the price rise is not simply a margin grab. For instance, where dies and forms need to be set up to produce the new product, cost differences can in many circumstances be explicitly referenced as a rationale for a higher price or an accompanying volume commitment on that or another product.
Costs are often considered to be straightforward—a product or transaction has a cost associated with it. In fact, there are many different kinds of costs. There are many ways to measure costs and margins, and they often play a legitimate role in pricing,5 not in the simplistic way often portrayed, but in influencing the pricing behavior of competitors. The right balance of simple and more insightful costing is part of being a sophisticated pricer.
Different types of costs may be appropriate when considering your company’s costs or modeling that of competitors.6 For instance:
In utilities, where regulations limit pricing flexibility, knowing overall cost levels may be enough.
In more competitive industries (e.g., consumer nondurables), costs must be known at the product level.
In the most competitive industries, costs must be known by customer and by deal.
For example, in the commodity plastics business—Styrofoam plates, shopping bags, and wraps—most large orders are priced somewhere between incremental and average costs. In that industry you need to know costs by product, geographically, and by volume, or the bulk of the orders will damage the bottom line. Only pricing well above average cost when context (such as rush orders and competitor oversights) permits makes these businesses profitable.
Noncommodity businesses should also adopt the mind-set of searching for premium pricing opportunities. Messaging the rationale for premium pricing is important because the right message can avoid potential customer anger at higher prices. Having a posted schedule of events (contexts) which will lead to add-on charges is good practice among rental service companies and retailers. Making these charges public can also lead competitors to adopt the same charges to their pricing.
Many commodity industries earn little profit from the average transaction, but are ready to take advantage of situations where the context is favorable (e.g., rush orders). Context-driven premium pricing is a strategy which noncommodity providers should consider when the opportunity arises.
Summary
Management needs to know what prices a new or ongoing product will command. Basing that price blindly on the product’s average utility or value will not serve that purpose unless you have a monopoly in your market.
For all other markets, management needs to look at context to establish the price. The implications of context, put in the starkest possible terms, are almost painful to product developers who have given their blood, sweat, and tears to develop better products. Depending on the perceived frame of reference, or context, all products are valuable or worthless. To take an example isolated from the context of management incentives: a life jacket is worth a lot on board a sinking boat, but it is of negative value at a formal dinner party.
An interesting analogy to “value” comes from the Middle Ages. Then, scientists believed that there was a substance called “phlogiston.” This substance made things burn—supported fire. If something did not burn, it lacked phlogiston. Makes sense, right? The only problem was that it ignored a more complex (but useful and more accurate) explanation for fire—fire being the rapid oxidation of materials in an exothermic chemical process of combustion, releasing heat and light. Combustion requires two components: oxygen and fuel. We suggest that the best pricing requires consideration of context, which may include some form of value, or costs, or any number of other factors. Just like combustion, higher revenues do not come from one ingredient (value) alone.
Context is not just about customer perspectives, important as they are, but is also about competitor perspectives. Perception and context shape competitor pricing behaviors, and so the price obtainable in a market.
Notes
1. Robert G. Docters, et al., Winning the Profit Game, McGraw-Hill, 2004, pp. 84–85.
2. Another example of premia for unique value is in women’s fashions, where “me-too-ness …, has plagued retail for years,” according to Robert Drbul, an analyst for Barclays Capital. (“To Stand Out, Retailers Flock to Exclusive Lines,” The New York Times, February 15, 2011).
3. Fortunately. the vast majority of U.S. management is incented to avoid mutually destructive price battles. A survey found 74 percent of companies have profit performance incentives. See “Study of Performance metrics Among S&P 500 Large Stock Companies,” James F. Reda & Associates, LLC, March 2009, p. 10. Hence the disincentives to drive prices to cost.
4. Meaning that the molten steel burned through the continuous caster, and in that case 30 tons of liquid steel sloshed through the mill. The molten steel got into the electric motors for forming the steel, and production ceased.
5. R. Docters, “Improving Profitability Through Product Triage,” Business Horizons, Indiana University, January/February 1996, p. 71. Even cost-plus contracts (price = costs margin) do not yield similar results, since how companies approach tasks directly impacts outcomes (e.g., overheads such as whether they own or lease office space).
6. Variable, fixed, incremental, fully loaded (saturation), average, and other categories. As Professor Gordon Shillinglaw of Columbia University once commented, “If you ask me ‘what is the cost?’ I need to ask you ‘Why do you wish to know?’”