Salem

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 Hermann Simon, Frank F. Bilstein, and Frank Luby

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