As sure as the tides rise and fall, the next recession will spur many companies to cut their prices indiscriminately. During the last recession, producer prices fell by nearly 8% and took nearly two years to recover. Why? Executives often assume that slashing prices and profit margins is the only way to keep their customers and market share. Salespeople, desperate to make their quota, fail to hold the line on discounting, and companies want to maximize their use of assets even when demand softens.
By Shihwan Chung, Ron Kermisch and Mark Burton
That perspective is shortsighted. Across-the-board price cuts can permanently erode a company’s profitability and strategic position. For example, during the last recession one global equipment manufacturer aggressively slashed prices. The executive team thought of the situation as a zero-sum game — unless they cut prices, customers would defect to competitors — so a contract at 80% of the previous price was better than no contract. Because the manufacturer’s contracts typically last five years, however, the decision hurt its profits for a long period and deprived it of cash to invest when the economy recovered.
By contrast, preparing for the next recession now on the following four fronts can prevent a broad-based price decline.
Know your place in the market and exactly what drives your profits.
In order to navigate the trade-offs between price and volume, well-prepared companies factor in their standing as a market leader or follower. Market share leaders have an outsized influence on how the market weathers the storm, with their pricing moves prompting many followers to behave similarly. Leaders have some responsibility to maintain order and ward off indiscriminate discounting. Followers, meanwhile, should take a measured approach, accounting not only for their own strengths but also for the market leader’s behavior. A follower may be tempted to take share by aggressively undercutting the market but doing so would risk losing a price war to the leader, thereby damaging everyone’s future earnings when the economy recovers.
Awareness of what drives profitability for both the company and its competitors at the individual customer level is particularly valuable. A major supplier of food ingredients facing a decline in demand assessed its major accounts in North America by modeling the profitability of each account against its competitors’ delivered cost for each. It became clear that for a substantial number of accounts, the company’s profits were below those achieved by competitors. For this group of accounts, competitors had lower prices but also lower logistics costs because their distribution centers were close to customers. The food ingredients supplier walked away from $60 million in revenue and, within 60 days, replaced that volume with more profitable volume —namely, where it had lower delivered costs than competitors.
Price through a segmented, value-based approach.
Different customer segments have different price sensitivity and value different elements of an offering. Pricing should reflect these variations in perceived value through a tiered offering, with each tier addressing a progressively higher willingness to pay for additional features.
Understanding each customer’s preferences allows a company to devise attractive bundles of products and services so that even if overall unit volumes drop during a recession, the company still can maintain or increase its market share with customers. Likewise, if customers buy complementary products from multiple suppliers, there may be an opportunity to grow share by trading modest price concessions for commitments to high volumes — especially before inventories get drawn down. If a customer worries about holding inventory when its sales volume outlook is cloudy, a supplier could offer repurchase terms or markdown protections.
In some cases, an effective move involves creating a separate brand and operation for price-sensitive customers. Dow Corning saw that silicone was becoming a commodity with the entry of low-cost competitors from China. When it did a fresh segmentation of the customer base, Dow Corning realized that a large segment of “price seekers” did not need all the high-value services bundled into the price of its product. Instead of cutting prices, Dow Corning launched the Xiameter brand, with a limited number of products, a minimum order size, limited technical support, and online-only orders. Xiameter proved successful as a standalone business, drawing in new customers rather than cannibalizing the existing customer base.
Patch the price leakage.
Price leakage is insidious, accumulating over time. Giveaways, such as free freight, longer payment terms or free customer support, often fly under the radar and collectively can bleed substantial profits.
Prior to the 2001 recession, trucking company Freightliner turned to heavy discounts and aggressive buyback guarantees to protect market share, and it wound up selling to unprofitable customers. Its operating profit swung from $900 million in 2000 to a loss of $1.2 billion in 2001 — far worse than competitors Paccar and Navistar, both of which had decided to be more disciplined in pricing, even if that meant losing volume. After that experience, Freightliner shifted gears to focus on securing profitable business rather than chasing market share.
Companies should check to ensure that they’re not giving away more than they are contractually obligated to provide. Salespeople who want to keep a customer often let these sorts of freebies slide. Strict enforcement of contract terms and discount policies, along with clear communications and training, help to keep the sales team honest.
Develop dynamic pricing where it makes sense.
When markets shift suddenly, the commercial organization should have the flexibility to adjust prices quickly. That requires laying the groundwork by having the right data, analytics, and monitoring program.
Companies that excel in dynamic pricing have access to real-time data on changing market conditions, which informs fast decision-making processes to push out price changes quickly and easily. True dynamic pricing depends on real-time variables, such as seasonality, inventory levels, and competitor pricing, and it is powered by automated digital tools.
One fuel distributor with aggressive goals to raise profitability was hamstrung by pricing that relied on dated protocols and analysts’ best judgment. The distributor gathered and linked data from multiple sources into one database and developed a dynamic pricing solution that accounted for more than a dozen variables. By testing and revising an algorithm through several iterations at filling stations, it refined its pricing recommendations engine to optimize pricing, having analytically derived the most relevant competitor sites and site-specific consumer price elasticities. The pilot demonstrated an improvement of 14 percentage points in earnings before interest, taxes, depreciation, and amortization, with only 1 point of lost fuel volume, and the distributor is rolling out dynamic pricing to other sites.
Companies that fare well during a downturn and surge ahead of competitors in the subsequent recovery have gotten their pricing house in order before the recession hit. Ideally, executives can build a profit cushion now through price discipline and cost reductions, then retain that war chest to help weather the storm.