Saturday, January 19, 2008

The Low-Price Strategy

One of the most common (and misused) pricing strategies is: "Price it Below the Competition." If you are a significant market presence, one of two things can happen when you adopt this approach - if you do so strategically and in a market whose structure and customers make the lowest-price approach viable, you may carve a hard-to assail competitive advantage for yourself, like Walmart did. If not, there will likely be a price war that will leave both you and your competition with lower margins and lower profits than before.

So when can the Low-Price Strategy become a viable long-term approach?

I. Economic structure of the Market

Industries where the Low-Price Strategy is viable are typically characterized by relatively high fixed costs and low variable costs. Retail is an excellent example: The fixed costs are high (cost of the facilities, staff, etc), but the variable costs (the cost of goods sold) are low in comparison. So, the more you can sell with your fixed infrastructure, the less the average cost of each article sold is.

To illustrate this, let's imagine a hypothetical widget store. Running the store costs $500K per month regardless of how many widgets are sold. Each widget is built in-house and costs $100 to sell. So the average cost of a widget is a downward sloping curve; at one extreme, if you sell only one widget, it cost you $500,100. This average cost goes down with every widget you sell, so that, at the other extreme, if you sell an infinite number of widgets, they cost you infinitesimally above $100 each. So, the more you sell, the less it costs you to sell a widget. This also means as you sell more, you can price lower and still maintain (or even grow) profit margins.

But the benefits of volume in this industry are reaped by everyone who can drive high volumes. In a pure commodity business, this is exactly what happens - the market consolidates into an oligopoly, with each player producing at least their Minimum Efficient Scale. But market structure alone doesn't yield a strategic advantage to low price - the prices are driven down by competition.

If your business is not characterized by high fixed costs and low variable costs, a low-price approach is unlikely to be successful.

II. Direct Benefits of Volume

In order for a low-price strategy to yield a sustainable long-term advantage, volume should also reduce the variable (or marginal) cost of goods being sold. For the hypothetical widget store, this means that the cost of each widget being built and sold isn't fixed at $100, but rather, reduces as additional widgets are built and sold.

This reduction in variable costs can be driven by a number of factors, some of which are:

1. Learning: As you sell more products, you learn how to build an sell them more efficiently.

2. Negotiation Leverage with Suppliers and/or Distributors: In many cases, suppliers and distributors will be willing to offer deep discounts to purchasers who buy large volume. This is particularly true if they are selling commodities, or if they are not operating at their minimum efficient scale. One example of this is the bandwidth business. If you search online for metered bandwidth, you may end up paying $200/Mbps or more. However, firms that drive a lot of traffic negotiate with their vendors and get prices as much as an order of magnitude lower (or more) by offering large commitments (guaranteed use).

3. Cost of Customer Acquisition: Driving high volumes can strengthen the brand and reduce your average cost of acquiring customers. When this happens, every incremental customer you bring in costs you less in marketing and sales dollars.

III. Price should be a key driver of Value

The costs are based not on the product you're selling but the value you're selling. So, while Walmart can execute this strategy effectively, Nordstrom can't. The market segments they serve are different. Nordstrom's value proposition is based on the shopping experience and service, which is not a scale business. Similarly, McDonalds can execute a volume strategy, but Chez Panisse can't, because McDonalds sells fast, cheap food, while Chez Panisse sells a gourmet meal experience. The value they're selling is different, even though they're both in the same industry.

There is also the perception value of price to consider - luxury products are expected to be exclusive and cost more. A cheap luxury product isn't really a luxury product because it's not exclusive.

If benefits (tangible or intangible) rather than price are the key driver of value in the segment you're targeting, the low-price approach is the wrong one.

When the economic structure of the market yields significant volume benefits that are further supplemented by additional volume benefits, a low-price strategy can work well to gain a significant, sustainable advantage in price-conscious customer segments. This is particularly true when products are seen as commodities and price is the key driver of value.

In most other cases, you're better off gaining an edge on your competition by creating a unique value proposition that makes your product worth more than the competition. Walmart will never unseat Norstrom, because they can't offer the same value (experience, service) as Norstrom does, nor will people stop going to Chez Panisse even if McDonald's decided to offer the same food for a tenth of the price at McDonald's.

Finally, commitment to a Low-Price Strategy requires a relentless focus on keeping costs and prices down. It requires the discipline to resist the urge to let prices creep up (if you're a public company, this will often mean ignoring Wall Street), and a relentless focus on identifying and implementing new cost-reduction strategies. Jim Sinegal, the CEO of Costco, sums it up nicely:
"When I started, Sears, Roebuck was the Costco of the country, but they allowed someone else to come in under them. We don't want to be one of the casualties. We don't want to turn around and say, 'We got so fancy we've raised our prices,' and all of a sudden a new competitor comes in and beats our prices."

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