Watch Out For the Red Zone
of Pricing Strategy
It's been a great run of profit and sales increases for a lot of businesses lately. But if you listen to the leading economists, the party might be over for a while. Projections for 2007 and beyond are for slowing growth in many markets and declining profits. Unfortunately, most managers have a terrible habit of overreacting when this happens and use price discounts to solve the problem. The more they discount, the more competitors will discount, all to the joy of customers. In this cycle profits don't just decline, they disappear as price wars escalate during what we call "the Red Zone" of pricing strategy. Before we delve into the Red Zone, let's discuss the pricing strategies and when they work.
There are only three possible pricing strategies for products or services: skim, penetration and neutral. Skim pricing is pricing high relative to competitors to reflect the high value or exclusivity of a product. This is a common tactic with consumer products and is seen in a wide range of areas such as watches, clothing and fashion accessories. Penetration pricing is pricing low relative to competitors and is a common tactic in high growth markets. Neutral pricing is pricing close to competitors and is a good tactic in slow/no growth markets. It should be a common tactic, but it isn't.
The pricing strategy represents a decision on the part of a pricing, market or product manager after he or she evaluates market growth, competitive intensity and the relative value of an offering versus the competitor. It should really be this straightforward but few firms in the business-to-business space even have a pricing strategy. An informal poll at a recent gathering of professional pricing managers showed that less than 15% had a pricing strategy. Now consider how few have a plan for changing the pricing strategy as the offering moves through its lifecycle.
When conditions change, a strategy, especially a pricing strategy, needs to change. As an example, penetration pricing works in growth markets but usually devastates the firm in mature markets because demand is no longer responsive to changes in price. Under prior CEO Jerry Sanders, AMD used a penetration pricing strategy against Intel. Back then it worked because the market was still growing and lower prices drove demand in the market. It all blew up in 1999 when the market slowed dramatically. It took AMD several years and a new CEO to move to a neutral strategy for most products and a skim strategy for their leading edge Athlon micro-processors. During that time, they lost hundreds of millions of dollars in market value by employing a penetration strategy in a mature market - we call that the Red Zone.
The Red Zone occurs when market growth slows, price increases don't stick, and price discounts don't buy you any more volume. Lower prices work great in growing markets because they cause increases in demand. But the longer managers use them in slowing markets, the more damage they do to company profitability and the market.
The problem gets worse when managers get desperate and begin offering price discounts on high-value products and services. This undermines pricing leverage and commoditizes those products and services. When markets return to some level of growth, those price discounts have created a commodity and price-oriented mindset in the firm and similar expectations with customers. This is quite difficult to stop.
How can the company's leaders help? The first step comes out of an old fire safety book - don't panic. When a manager panics because he or she isn't going to hit their quotas and begins to use price discounts, the value proposition that the firm spent years building evaporates faster than you can say "price war."
The simple advice is:
This year, we'll be hearing about more price wars then ever. To ensure your company doesn't fall into the Red Zone, relentlessly monitor your competitors, provide leadership guidance and do the necessary advanced planning. Start by developing an effective pricing strategy. Once that job is done, leaders should be attune to market changes and be ready to change the price strategy as market conditions dictate the need to do so. Don't let your competitors dictate price in your markets.
Reed Holden is the founder of Holden Advisors, a consulting firm focused on aligning price with customer value. We work with companies facing new product launches, commoditization, discounting, or market share loss. Utilizing our rigorous, proprietary process, the Value DisciplineSM, we deliver advice on quantifying customer value, identifying offering and price bundles, defining price policies and controls, and integrating sales and marketing. Our clients consistently experience 30 to 50% operating income growth following our work. Visit www.holdenadvisors.com for additional information.
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