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Competitive Strategy - Avoiding Price Wars

This tip is based on the tip published in the December 2000 issue of the AWARE Marketing Tips Newsletter.

As competition between companies increases, the risk that some companies will cut prices in an attempt to win market share, also increases. In fact this is foolhardy and dangerous for the entire industry, as it forces competitors to follow suit - reducing the whole industry profitability.

As an example: assume that Company A is selling goods at $10 and sells 1000, at a profit of $5 per item. Company A thus makes $5000 profit on a $10,000 turnover. It then reduces prices by 20% to $8. To make the same turnover ($10,000), it needs an additional 25% in sales - 1250. However at the current level of sales, profits are now only $3750 ($3 per item). To make the $5000 profit the company needs a two-thirds increase in sales volume i.e. 1667. Even if customers are not particularly interested in price (i.e. are not price sensitive) this is a large increase. It is especially large, if the market is highly competitive, without much scope to gain new customers. In such cases, any sales gain will come at the expense of other companies. However other companies are unlikely sit back and allow their customers to be stolen, so instead they may reduce prices also. The end result is that everybody loses. Even though the first company may have gained in share, they are unlikely to have made it up by 66% and so in fact they also lose out in profits.

An additional danger in a price war is that it changes the way customers view the product. When all companies are charging about the same, customers tend to look at other factors - quality, service, etc. This is the case even if prices and margins are high, giving scope to reduce prices.

When one company reduces prices, more customers start selecting on price and look for the lowest price. For example, there were numerous price wars in the airline industry between 1989 and 1993. The end result was 120 airline bankruptcies, $12 billion in losses and 100,000 employees laid-off. Another example was the US retailer K-Mart which tried to take on WalMart on its own market ground in the early 1990s. WalMart's strength was its emphasis on low-costs and K-Mart tried to attack this. The result was that K-Mart's sales per square foot dropped, followed by its market share which fell from 35% to 23%. This led to a fall in share prices, and eventually, K-Mart's CEO was forced to resign.

What are the options if a competitor starts a price war?

The March-April 2000 Harvard Business Review published an article on what to do if a competitor starts a price war.

The first point to note is that price wars do not usually come out of the blue - there are normally clues to competitor intentions. Continual competitor monitoring is (or should be) an essential part of business practice. You need to think like your competitors.

• What is their current situation and what are their options?
• Has the competitor (or potential competitor) introduced new low-cost technology that will allow them to reduce prices.

Price wars are more likely to occur when firms from other industries or markets, with different technologies, can leverage cost advantages by entering your market and stealing share. So you need to keep an eye out for any new technologies, alliances and distribution channels that could affect your market. Look out for statements by senior competitor executives, and also keep an eye out for potential new entrants to your market. If a new technology becomes available, investigate it - and start using it. Otherwise you risk becoming uncompetitive if the technology does lead to cost reductions, allowing prices to fall.

You should also be aware of price sensitivities among some customers and potential customers. Some people are always willing to pay more for what is perceived as a quality item. (If this was not the case, then the designer-label fashion market would not exist). So, consider offering two products - a cut-price version and a premium product. A good example of how this can be done comes from 3M. A South Korean computer disk manufacturer - Kao - entered the US market selling low-price / lower quality disks. 3M responded with a new brand - Highland - that was almost the same 3M disk at a low price. This move ensured that 3M's own brand values were not damaged through price reductions.

This strategy is, in fact, very common. Within the UK, several companies operate such a multi-brand strategy. One example is Kingfisher – which owned B&Q, Comet and Woolworths. Although each chain had a separate product line, there was also a cross-over, with Woolworths selling some electrical and home DIY items.

A few years ago, the leading Jewellery company in the UK was a firm called Ratners. Following an injudicious statement from its chief executive, which irretrievably damaged its brand reputation, people switched from buying at Ratners shops to their two main high-street competitor’s - H Samuel and Ernest Jones. In reality the same company owned all the three store-chains! However such was the damage from this statement that all Ratners Shops eventually closed (or were replaced by H Samuel, etc.) However that is another story - and lesson. (Namely that every statement made should be aimed at enhancing brand values and that even jokes at your company's expense can be taken seriously.)

The above approach (differentiating and offering similar products at multiple price points - aimed at different price markets) is one of many that can be used to fight a price war. The key thing is to think laterally - and look for alternatives to a price cut, especially, where the company cutting price is much larger and can hold-out for longer or even absorb the price reduction. For example, a small commodity supplier once found that a larger competitor had lowered prices below its own costs. There was no way that the smaller company could have matched the larger company's prices and remained in business. Instead, the CEO of the small company took two actions. He called his customers to let them know about the better deals being offered in the market by the larger company. He also told them that these could result in him being forced out of the market, leaving them the larger company as a monopoly supplier. The CEO warned that should the competitor company then increase prices, the customers would no longer have a choice. The CEO emphasised that it was not in the customers long-term interest to select a supplier based on price alone - and that they should base purchase on quality and range. This honesty was rewarded when the small company's customers stayed loyal and ignored the larger company's price reduction.

Finally, not all "price wars" involve price reductions. When two companies continuously try and out-advertise the other, with continual, expensive promotions - or when companies continually look to offer new, improved products without any reference to actual customer needs, a de-facto price war is taking place. In these cases, although actual end-prices may not be reduced, the costs to the companies in outdoing the competitor advertising or enhancing products will have a similar on profitability to that seen when prices are reduced. In effect, both of these reduce the company (and industry) profit margins. (Nevertheless, it is always important to differentiate one's products and services, as this is how competitive advantage is developed. However this should match customer needs and should not be done without taking these into account. If the rationale is purely to counter the competitor action without any thought on customer requirements then there is a risk that an "advertising war" or a "product development war" could be starting. Both of these are actually "price wars" in all but name).

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