Beyond Price Cutting: Strategies for Pricing in a Downturn
A
manufacturing company faces declining sales in a softening economy. Customers
cancel or postpone orders. Competitors slash prices. Company managers
consider whether to cut their own prices to stimulate sales and compete
with rivals. Cutting prices could boost sales. This sounds logical, right?
But it could be precisely the wrong move, according to the academic directors
of Wharton's Pricing
Strategies: Measuring, Capturing, and Retaining Value program.
"Frequently in a downturn, everyone gets panicked and there is a general retreat in pricing," says Wharton marketing professor Z. John Zhang, academic co-director of the program. "That is the temptation. In some product categories, it might make sense to lower price, but in others you might raise the price. You have to look at the whole process and whether end customers are very price sensitive."
Risks of Price Cutting
Slashing prices can be a quick fix, but carries some risks. Like the overuse of antibiotics in medicine, even if it knocks out the immediate problem, it can lead to negative long-term side effects. For example, it may be very hard to raise prices later because of the "reference price" phenomenon. A customer who pays a low price figures out the seller's floor and will push to keep pricing at this level. The pricing recalibrates the buyer's expectations. After the economy comes back, the seller could be stuck with lower prices.
Another risk, particularly in consumer markets, is that buyers become trained to wait for discounts. Car buyers learn that manufacturers have end-of-the-year sales so they put off their purchases until these periods. Supermarket buyers wait to buy products until they are on sale. The overall sales for a company might not be much better because customers merely defer purchases or switch brands based on discounts. These cycles can become addictive for manufacturers, however. Given customer expectations, sellers need to keep discounting to make their sales numbers.
Differential Pricing
Price cuts often have a differential impact on customers. Some customers are less price sensitive. Some buyers are less profitable for the seller. "You have to realize that even when the market is going down, it doesn't mean the demand for everything is going down," says Zhang. "Not all customers are less willing to pay for the product."
To analyze cross-account profitability, sellers first need to understand the cost structures of their customers. For example, suppose the seller's product accounts for two percent of the total costs of Customer A. This customer will probably not be especially price sensitive. On other hand, if the seller's product accounts for 70 percent of the costs of Customer B, that buyer will likely watch every penny.
The seller then needs to consider the importance of each customer to its own overall sales and profits. Company A might account for the lion's share of the seller's sales and profits, while Company B generates only a small volume of sales. Cutting prices across the board might retain or boost sales from Company B. But it might not affect sales to Company A at all. Since Company A is the biggest customer, this would hurt the seller's overall profits.
"You can look at who is more price sensitive and what part of their cost structure is in the product," says Wharton marketing professor Jagmohan Raju, co-academic director of the program. "It is very scientific."
A group of managers from a major consumer products company used this approach to rethink their pricing during the Wharton program. They were able to recognize that the margins and profit contributions from different accounts varied widely. After the program, the managers took a proposal for a rationalized pricing strategy to their board. "It had a major impact on their pricing strategy," Raju says.
Invisible Price Cuts
While pricing should be tailored to the customer as much as possible, differential pricing should not be obvious. "You don't want to create a problem where one customer gets a discount and the other doesn't," Zhang says. "They may talk to one another."
There are ways to cut the effective price without changing the nominal price. Pricing differences or discounts could be based on volume, the type of business, or geography. The effective price could also be changed by bundling service with products. In consumer goods, companies might change package size or create "buy two, get one free" offers. These don't affect the unit pricing so they are easier than price cuts to reverse later. All of these levers affect the effective price but are much less visible to customers.
"You need to understand that price is multidimensional," Zhang notes. "When you talk about price, you are talking about the price for a certain unit of product, of a certain quality, with a certain delivery date, etc. You can change the size, the delivery time, credit terms, or enhance service. You don't have to change the nominal price."
Pricing also is not the only lever for boosting sales. Companies often cut their advertising and branding budgets in a downturn to save costs. These are easy targets because they might have little immediate impact on sales. But this might be precisely the time when companies should be investing in advertising and branding. As other companies cut back, advertising gains more visibility and costs less. Companies that build their brands during a recession will be better positioned to grow again after the market turns around.
Defining the Right Price Structure
Sometimes, however, customers will demand price cuts in a tough market. "If the price in the market cannot be sustained and all your competition is lowering price, you have to do something," Zhang says. "But even in that situation, different customers will have different willingness to pay, so you probably should not cut prices across the board. You have to do your homework and make facts-based price adjustments."
Raju points out that companies might actually raise prices in a downturn. "Cost structures are rising for many companies," he says. "The cost of steel is going up. Gasoline is going up. This may be the easiest time to justify a price increase." Even supermarkets may be able to justify raising prices, since people have to eat. Customers may now be weighing a trip to the supermarket against a meal out at a restaurant. While restaurants may suffer, supermarkets could find that their customers are less price sensitive.
In this regard, Zhang suggests that an economic downturn tests managers' pricing acumen. "While anyone can slash prices like mad, it takes a lot of smarts to identify the opportunities that will allow you to maintain or even raise your prices." One such opportunity, Zhang points out, comes from the depreciation of U.S. dollars. "As the dollar depreciates, imports become more expensive so that domestic import substitution industries can take a breather in terms of downward pricing pressure and export industries can gain a lot of leeway in terms of raising their profit margins."
Pricing Strategies: Measuring, Capturing, and Retaining Value provides a systematic way to think about pricing decisions. It helps managers assess the value of their products and services through customer and competitor analysis. Faculty also show how to analyze the price sensitivity and value of the product or service for individual customers. This analysis can then be reflected in the right pricing structure for the company and the market. "This approach is valuable in any environment," Zhang says. "But in a downturn, in particular, you have to have a good pricing structure."
