Friday, April 10, 2009

Strategic Planning Analogy #252: The Price is Wrong

Back in the 1990s, the warehouse industry was starting to explode. Firms like Costco and Sam’s Club were growing like crazy, taking market share away from traditional supermarkets.

I worked for a traditional food retailer who believed that the clubs were getting an unfair advantage. The belief was that traditional supermarkets were paying full-price to the manufacturers for product.

By contrast, it was believed that the clubs were getting preferential pricing. The manufacturers were spending extra money to bundle their products into larger “club packs.” Yet even though the manufacturers took on extra costs to make these club packs, the clubs were paying less money for their product.

The rationale? The club business was seen by the manufacturers as a small incremental business. As a result, they were only charged for the incremental additional cost to serve them. The core expenses for development and infrastructure were only passed on to the core supermarket customers. At least that’s what they thought at the company where I worked. And they didn’t like the idea of subsidizing the manufacturer so that the clubs could get a cost break.

To test the theory, we opened up some warehouse clubs of our own. That way, we would be able to see the actual types of prices being charged to the clubs. If we could prove the theory, we were going to make a big stink about it.

Well, the manufacturers figured out what we were up to, so most manufacturers either refused to deal with us or they offered the identical deal that they were giving to our supermarkets. Soon thereafter, we had to shut down the experiment.

Of course, it didn’t take long for consumers to see the lower prices in the clubs.

What’s happened since then? Well the combined sales of Costco and Sam’s Club are now over $115 billion. Traditional supermarkets have lost a ton of market share. Clubs really aren’t incremental business any more.

A key part of strategy has to do with pricing. What is the best pricing strategy? Price too low and you forego potential income. Price too high and sales may vaporize.

A key part of pricing struggle comes when you are pricing your product into two different distribution channels, like clubs versus supermarkets. Manufacturers in the early years appeared to give the clubs a price advantage by treating them as incremental business that only needed to cover incremental costs.

Of course, when you give one channel the advantage, you are creating a market dynamic which favors one channel over the other. Market share shifts will follow. In the long run, that can be a problem, because if the core business shrinks too much, there is nobody left to cover all of the core costs. Incremental pricing won’t pay all the bills.

The principle here has to do with understanding the long-term consequences of incremental pricing. This is particularly important in this digital age. The incremental cost of adding a digital component to a core business is virtually free. Adding a digital news component to a newspaper company adds virtually no incremental costs. Adding a digital sales channel for selling songs adds virtually no additional costs to the recording label. Adding a digital sales channel to a travel agency adds virtually no additional costs. And so it goes in the digital world.

The problem comes when these new digital channels are priced out at the incremental cost added by that channel. Since the added costs are virtually free, one can charge virtually nothing and still appear to be putting extra profit on the bottom line.

Of course, this only works if the core business can still absorb the core costs. Although a digital newspaper may be virtually free to produce if you have a healthy newspaper to cover the core costs, what happens if the paper version of the newspaper goes away? That news-gathering organization is very expensive. Somebody has to pay for it. If you give away the digital version, it cannot absorb these costs.

This is a real problem today. Large newspapers like Denver’s Rocky Mountain News and the Seattle PI are gone. The Detroit newspapers only home deliver a couple of days a week. Tons of smaller papers have or will soon be calling it quits. There are rumors that even big papers like the Boston Globe and San Francisco Chronicle may soon cease to print newspapers.

It used to be that newspapers had one of the largest profit margins around. Traditionally, the most profitable part of the newspaper was the classified section. Digital sites like took away the job classifieds and other sites took away the car classifieds. Others, like Craig’s List and EBAY took away a lot of the rest.

Then the younger generations stopped buying the papers and got their news off the internet for free. So the newspapers lost their most profitable advertising and a big chunk of their customers. And when newspapers lost a generation of customers, they became less desirable for other advertisers. Suddenly, papers like the Seattle PI were losing $14 million per year.

The same thing is happening in the entertainment industry. With the sales of CDs vaporizing, there is not enough money coming in to pay the bills in the music industry. The small, incremental prices for music (often free) on the internet are not making up the difference. People are scrambling to find a new business model. Although there is no consensus on what that new model will be, there is an agreement that the profitability of the entire music ecosystem has permanently shrunk and there is a lot less money to share with all the players.

Digital travel sites were priced so low that the traditional travel agent industry is virtually gone.

So, what can we learn from this?

RULE #1: Price Favoritism Eventually Leads to Market Share Favoritism If one channel is given a pricing advantage, it will eventually get a market share advantage. The channel that only pays the incremental cost gets an advantage. It can price cheaper in the marketplace, because it isn’t burdened with its fare share of the non-incremental costs.

Consumers tend to prefer paying less rather than paying more, so market share shifts to the one with the pricing advantage, be that wholesale clubs, digital news, digital music, digital travel, and so on. It might not happen overnight, but it will happen.

As the subsidized product gains share from the non-subsidized channel, eventually the whole idea of incrementalism becomes invalid. The subsidized product is now too large to be just incremental business. It is becoming the new core. Conversely, the old core business is no longer large enough to cover the core costs.

RULE #2: Once a Low Price Has Been Established as the Norm, It Gets Sticky
Now, one has a problem. Expectations have been set. People expect digital products to be essentially free. This expectation becomes sticky in the mind of the customer. They are resistant to start paying a lot more for something that they used to get for a lot less.

Therefore, it is extremely difficult to raise prices to cover the core costs once the lower incremental price has been set. As a result, supermarkets are going away, newspapers are going away, travel agents are going away, and so on. The business model is broken and it is very difficult to fix.

The solution?

1. Consider the potential long-term market share shifts when pricing to a new channel. Ask what happens when this little side business becomes the main business. Does the model still work?

2. Try to work early in the conversion to set the pricing expectations for the new channel, since it is difficult to change expectations after they are set.

3. Look for ways to reinvent the core, so that it can still be supported. This may require a whole new business model, where costs may need to be shared with competition, or revenues may need to come from new sources (like advertisers).

4. If the business model looks like it could be in serious trouble due the channel shift, sell out early. The folks who sold out of the newspaper business a few years ago were the smart ones.

When new distribution channels show up, keep in mind that your near-term decisions on how to price to that channel can have serious long-term consequences. Think out the whole scenario before making a hasty pricing decision just on incremental costs.

Many young cartoonists have recently given up their profession. Newspapers cannot afford to take on new, unproven cartoons. The new cartoons are all over the internet for free. Without an income, these cartoons are disappearing. And that’s not funny.

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