For virtually all companies, competing on price hurts more than it helps.
On the surface, Jetsgo was every bit the entrepreneurial success story. The upstart Canadian airline had lured customers away from the big boy on the block Air Canada thanks to an emphasis on discount fares. Founded in 2002, Jetsgo had become Canada’s third largest carrier in less than three years, capturing 10 percent of the Canadian domestic market. With 19 destinations in Canada, 10 in the U.S. and 12 charter flights to the Caribbean on the weekend, Jetsgo seemed poised to be an industry player for years to come.
And then, in March 2005, Jetsgo simply . . . vanished. Thousands of travelers were left scrambling for alternate transportation when the company abruptly ceased operations during the height of spring break. Angry customer and industry pundits alike wondered, “What happened?”
Price happened. Jetsgo had burst onto the scene thanks to bargain basement fares, but ultimately its unsustainably low prices killed the airline. Company execs had hoped increased volume would offset the cost of keeping prices so low, but it never happened. And since the entire company’s identity was predicated on offering the lowest prices in the industry, there was no way out of the trap.
Eventually there simply wasn’t enough money to keep its planes flying.
Resist the Urge to Discount
Pricing is the most difficult decision for any business, regardless of size. And virtually every company wrestles with the temptation to lure consumers from competitors and create market differentiation with low prices. Unfortunately, very few businesses can sustain a low price strategy focus over time. The sands of the marketplace are always shifting: competitors become more efficient, new technologies affect production, consumers’ expectations change. And occasionally a company like Jetsgo rolls out a completely incompetent pricing strategy that hurts everyone in the industry.
Low price can be a valid strategy for companies that have invented a new way to go to market (Dell’s direct buying model) or for those with business systems expressly designed to sustain this revenue strategy over the long term (Wal-Mart’s focus on efficient replenishment and superior cost reduction systems). In both these cases, however, pricing was a result, not a premise.
And that’s the secret: your ability to price either up or down is the ultimate measure of the effectiveness of your business strategy, not the foundation of it. Wal-Mart and Dell focused first on more efficient operations, which in turn has allowed them to be profitable at a lower price point than their competitors. Even for them, though, that’s an elusive advantage. Ultimately, businesses that emphasize low pricing must maintain superior cost dynamics over the long haul; for those companies, cost reduction usually becomes the single overriding focus.
Despite the rarity of successfully competing on price, most businesses still attempt to use pricing as a differentiator. Don’t! The last thing you should focus on is price — precisely because so many others do so. Instead, focus on building value for your customers and creating real differentiation for your product or services, which will allow you to support a price premium. Your real objective should be to support the highest price possible, not the lowest.
The insidious nature of price discounting is that it usually seems to work in the short term. Price down and volume generally does go up. But appearances can be deceiving. There are two reasons why discounting ultimately almost always costs more than it’s worth.
The first reason is that it usually attracts the type of customer you could well do without: the price “cherry pickers.” These are the 10 percent or so of any market that are single-mindedly focused on getting the cheapest price. They are price loyal, not brand loyal, which means that they’ll bolt the second they see a better price. They don’t care one bit about whatever value-add you provide — and they definitely won’t pay for it. Too often I’ve seen companies spend an inordinate sum to retain these cheapskates, only to get burned when someone else rolls out an inexpensive knock-off.
The second reason that pricing is insidious is that it can undermine your differentiation and actually reduce your ability to fund value-adding activity. By using discounting you are, in effect, teaching your customers to buy on price. Over time, they develop a “resistance” — they need increasingly higher discounts to motivate them to buy at their previous levels. It’s a slippery slope, and the effort required to pull back is very, very difficult.
Here’s an industry example of that phenomenon, with the names changed to protect the innocent. A company — let’s call it Company X — was enjoying moderate success. Volume and profit were good, but share growth was languishing. The leadership team determined that they needed to accelerate their top line in order to demonstrate to the market that they had answered the competitive call and turned the corner. As so often happens in these cases, they chose the most expedient way to boost volume: price discounting.
To “fund” the discount, Company X instituted a one-year reduction in marketing and advertising expenditure. It wasn’t a big cut, mind you, just a simple five percent reduction. But they had planted their corporate feet on the discounting slope.
The next year, the company budgeted a return to its previous spending, split between marketing and discounting. To the leadership’s dismay, volume growth during the front half of the year declined. They shouldn’t have been surprised; they were comparing the current volume against a time period in which volume had been artificially inflated by discounting. But since they couldn’t afford to miss plan, they further reduced value-added spending (in the form of advertising and marketing) in favor of lower pricing initiatives during the back half of the year. Year two was more of the same, and when the dust had cleared they had spent even more on price discounting. The slide had begun.
Within five years, the company gone from spending 15 percent of its revenue on price discounting to over 26 percent. Despite this increase and the sacrifices it entailed (marketing support and innovation was slashed to fund the difference), Company X’s market share had actually declined! Moreover, consumer research showed that the “quality” of the company’s customer base was also lower than it had been five years earlier.
In the end, Company X was saved from utter disaster only through the actions of a new CEO who understood that in pursuing a discounting strategy, the company had mortgaged its future. He shifted the focus back to investment in real, sustainable top line growth through product innovation and customer-focused value. Slowly, painfully, the company pulled itself back from the brink and put itself back on course for long-term financial success.
CV = Q/P
Up to this point, our pricing discussion has focused on larger businesses. But for small and medium-sized companies, pricing is an even more difficult decision. The stakes are if anything even higher, and SME owners often feel tremendous pressure from their customers to deliver lower prices or lose their business. With lower reserves and ability to sustain even short-term loss, this may mean the difference between survival and bankruptcy.
Desperation drives these owners — desperation rooted in the fact that most of them have not developed a differentiated and sustainable position. Pricing, they too often think, is the only tool they’ve got.
But you must avoid the price trap. Instead, focus on building value by increasing service or product quality. If you ever find it necessary to reduce price to maintain your market position, it’s a warning sign that your business is losing its value and isn’t well-positioned for long-term sustainability. Unless you correct the “value problem,” chances are that you won’t be around too much longer.
The relationship between value and price can be best represented in a very simple equation: CV = Q/P. In English, that means Customer Value is equal to Quality divided by Price. Raise the price relative to quality and you lower the customer value; they’re getting less by paying more. To increase value, either raise quality faster than price or lower price relative to quality (or both). Who said building value was tough?
One last point about how to price, especially for a smaller business: it’s not always easy to determine the right price. On the one hand, a quick agreement with a customer on price leaves you wondering about how much money you inadvertently may have left on the table. Could you have priced higher? On the other hand, pricing too high can jeopardize business.
I always found this a difficult question to answer for my clients until I stumbled across the concept of value pricing. Simply put, value pricing is estimating the potential revenue and profit impact that your product or service could have on your customer and setting your price accordingly. The more impact you have, the higher you should price. Don’t be afraid or ashamed — the clients that are worth having will understand and pay the premium gladly. As for the rest, well, send those cherry pickers to the next orchard. You’ll be glad you did.