How to Win a Price War

Price war! How can you win without destroying your own profitability? Fire a bigger weapon? Outlast your competitors?

Any way you look at it, a price war is the ultimate in self-destructive, lose-lose behavior – but it is one of the most common of all management problems and concerns.

Paradoxically, not only is a price war devastating for you and your competitors, but it is very bad for your customers as well. When a customer forces its suppliers to focus on price competition, it loses the opportunity to work with its suppliers to increase its real long-term profits in two crucial ways: (1) by reducing the joint costs of doing business together, and (2) by helping the suppliers to find creative ways to turbocharge their customer value proposition.

In short, the real win strategy – for both customers and suppliers – is to turn the price war into a value war.

Powerful tactics

When confronted with aggressive competitor pricing, the instinct is to respond with a price cut.

After all, why lose the business? Even worse, if you lose those customers by failing to respond, you could be in danger of losing them permanently, sacrificing the lifetime value of the relationship. This concern pushes managers to respond even more aggressively, and before long the pricing discipline of the competing businesses collapses, and with it goes the company’s profitability.

What can a manager do?

The best tactical answer is to attack the hidden assumptions that frame the price war.

For example, if a competitor quotes an uneconomically low price, why not suggest to the customer that it demand a five-year contract. After all, the price certainly will rise back to former levels once the incumbent is out of the picture. This demand will force the attacker to back down because the losses would be too great over a multi-year period.

Another effective tactic is to rein in the instinct to respond where the attack takes place. In most price wars, the attacker aims at your most lucrative accounts and products – your Islands of Profit. By responding where you are attacked, you effectively do the most damage to yourself – and often the least damage to the attacker.

In fact, in most price wars, the attacker is funding the price war by maintaining a very lucrative, protected portion of its business – its Islands of Profit – as its core source of cash flow and profitability.

The answer? Strike back at the competitor’s source of cash flow.

A classic example comes from the airlines a few decades ago. Some carriers, like United and American had very lucrative east-west routes (e.g. NY-LA), while others, like Delta, had very lucrative north-south routes (e.g. NY-Miami).

When an east-west carrier tried to enter a north-south route with low prices, the incumbent’s most common response was to match the price reduction, thereby losing a huge amount of money in its lucrative north-south routes – routes in which the attacker had little to lose but much to gain.

Instead, the smart response was to strike back by entering the attacker’s prime east-west routes with low prices – attacking the source of cash flow that supported the price war. This very quickly ended the price war. (Remember that it is illegal in the US to actually conspire with a competitor to set prices.)

Preventing price wars

These tactics are effective in framing an effective response to a price war. But how do you actually prevent one?

I was asked this question a few weeks ago by a writer who was working on an article about distributor branch pricing.

She asked how much “wiggle room” branches have when it comes to differentiating themselves from the competition based on price, and whether there is an argument for price matching if a customer comes in demanding a cheaper price they may have received down the road.

The answer is that there is a progression of three increasingly effective ways to respond to a price war – match the price, lower the customer’s total cost, or increase your value footprint.

Price. The seemingly obvious, and instinctive, way to respond is to simply to match the competitor’s low price.

This is an invitation to lose your profitability for two reasons: (1) your competitor probably will up the ante with another price cut, setting off a vicious cycle, and (2) you are essentially training your customers  to hammer you on price at every turn. After all, you’re showing them that you will fold under pressure.

The more effective counter-tactics mentioned earlier – shift the time frame or shift the locus of attack – are much more effective than simple price matching. But it is even more effective to proactively act to prevent a price war. You can do this in two ways: reducing total cost and turbocharging your customer value proposition.

Total cost. The second – and much more effective – way to respond is to systematically find ways to reduce the cost of doing business with your most important customers. By reducing costs for both your customers and for your own company, you can create real new value that will endure in the long run. Smart customers will strongly gravitate toward this process.

You can take measures to reduce your customer’s direct cost. I outline and discuss these profit levers in my book and in many of my blog posts. They range from operations cost reductions (e.g. flow-through supply chains) to product/category management (e.g. product rationalization).

Conversely, customers can create surprisingly big cost reductions for the supplier. For example, by helping the customer smooth its order pattern, you can reduce your supply chain costs, often by 25% or more. Better forecasting offers similar gains, as does a limited but well-aimed product substitution policy. These profit levers benefit both the supplier and the customer – by much more than a simple, temporary price cut.

Smart suppliers pass a big portion of their savings back to their customers in price reductions. Here the customers know that the price reduction is fully warranted by real savings, and therefore can endure over time.

Customer value. The third, and most effective, way to “win” a price war is to prevent it by waging and winning a customer value war. Yet all too many managers think of this last, if they consider it at all.

Think about the example of Baxter’s Stockless business that I have often cited in my book and blog. For example, see: Profit from Customer Operating Partnerships.

Several years ago, Baxter was stuck in a price war, with its products like IV solutions, viewed as commodities mostly bought on price by low-level hospital purchasing staff. Baxter mapped the joint hospital-Baxter supply chain, and discovered that it could enormously reduce both businesses’ costs by sending a supervisor into a major hospital to count the needed product, then picking orders into ward-specific totes, and delivering and putting the product away on the patient floor or clinic.

This was the forerunner of vendor-managed inventory, which many companies offer today. Incidentally, Cardinal ultimately bought this business from Baxter, and Cardinal’s ValueLink offering is still an extremely effective business run in many of the best major hospitals.

Stepping back, Baxter developed a way to permanently “win” the price wars that raged in its business by converting them into a one-firm race to lower the total cost of the joint supply chain, passing this saving to the hospitals. And this saving was so large that it dwarfed the pennies at stake in the price wars.

However, Baxter packed even more into this business initiative. In the prior period, before the Stockless/ValueLink was developed, the hospitals were reluctant to operate a large network of off-site clinics and surgical centers. Many top hospital managers did not have confidence that their materials management staff could handle the complex scatter-site network of critical products.

The new partnership with Baxter enabled the hospital executives to gain confidence that the newly created supply chain, managed by a supply chain expert like Baxter (now Cardinal), could support the evolving network of facilities. In short, Baxter created a fundamentally new value proposition for the hospitals – enabling them to radically change the way they operated to bring huge new value to their customers – the patients.

The progression was incredibly powerful: from price matching, to total cost reduction that competitors couldn’t match, to partnering with the hospitals to create a fundamentally new and much more effective value proposition for the patients, which again the competitors could not match.

Baxter did not just win the price war – it eliminated it.

Baxter won the customer value war.

A Lesson from GE

GE is a very insightful, innovative firm. GE managers are trained not just to compete effectively, but to relentlessly search for fundamentally new and better ways to do things – winning by changing the competitive game.

A prime example of this is the decision of the GE aircraft engine group to change its product offering. In the past, the company offered traditional but effective product centered on aircraft engines and spare parts.

However, insightful executives stepped back and reflected on what GE’s airline customers really wanted: not just engines and parts, but rather, hours of engines effectively powering their aircraft. After all, they were in the business of flying passengers.

In response, GE developed a fundamentally new offering: “power by the hour”. GE wisely combined its prior offerings – engines, parts, and related services – into one offering that directly addressed its customers’ needs. Much as Baxter did for the hospitals.

Not only did this new “power by the hour” offering meet the customer needs much better that any competitive offering, but importantly, it combined a package of products and services that no competitor could match.

GE redefined its market so it had virtually no effective competitors.

Baxter did the same. So did Southwest Airlines.

The key imperative is very clear: Once you have a lead, step on the gas – and the most effective way to do this is by turbocharging your customer value proposition.

Islands of Profit

Winning the customer value war is most often surprisingly easy because your competitors rarely think about it. All too often they focus on tactics like price optimization, rather than accelerating their customer value proposition.

This is especially critical for securing your Islands of Profit – your high-revenue high-profit business. These customers are most susceptible to a competitor incursion, yet these also are the customers that are most receptive to innovations that fundamentally reduce your joint cost structure and transform your customer value proposition.

Your Coral Reefs – your high-revenue low-profit customers – on the other hand, are usually the most price-sensitive. Yet, many can be converted into Islands of Profit if you develop a compelling value proposition.

The same goes for your Minnow customers – low-revenue low-profit – especially those that are someone else’s big customers and are just using you to discipline the competitor’s prices.

The Essential Question

The essential question is: Are you so busy with tactical issues like  price wars that you “do not have the time or resources” to systematically and relentlessly build your customer value proposition? Especially for your Islands of Profit Customers?

Winning the customer value war is the only way to permanently prevent price wars and really secure your future.

May 23 Webcast – Accelerate Profitability through Transformative Customer Service

I will be presenting a live webcast, “Accelerate Profitability through Transformative Customer Service”, on Thursday, May 23 from 1-2 p.m. EDT, offered by Modern Distribution Management. There is no charge for this webcast.

Here is a link to register for this event:

https://cc.readytalk.com/cc/s/registrations/new?cid=bii2lorbfrto

You can also view the webcast at a later time by using this link:

http://www.mdm.com/events/ and select “Archives.”

I hope you find it helpful.

Assessing Strategic Investments

Recently, I was involved in a discussion about a major strategic investment that a company was contemplating. This investment was a possible game-changer involving the development of an important new business capability.

The key question on the table was: Will the prospective benefits exceed the costs, yielding returns greater than the cost of capital? What could be more obvious?

Two critical questions

In fact, assessing investments using the cost of capital, often called capital budgeting, is not obvious at all. It is a process that seems like second nature to virtually all managers, but one which only a few use correctly.

And it is critically important. If you get it wrong, it can lock your company in place, block your most important initiatives, and prevent you from getting in front of competitors.

Two key questions lie at the heart of sound investment assessment: (1) What is the cost of capital? and (2) How should I assess the value of investments?

Not so obvious

Let’s start with the first question: What is the cost of capital? Just look it up in a Finance textbook. It is the weighted average of the company’s cost of debt and cost of equity (with a few minor adjustments). Obvious, right?

In fact, the answer is not so obvious.

This seems like a technical question, but in reality it is a very important management issue because it tacitly determines a company’s asset productivity.

The cost of capital is actually a composite. It is the weighted average of the risk/return profile of the company’s portfolio of investments (ranging from buying new machines to developing new product lines) that together constitute the existing business. This portfolio is comprised of some investments that have a very low risk and low return, other investments that have a very high risk and high return, and many in between.

Contrast an investment in a well-tested new machine to improve the efficiency of an existing process, with another investment to develop a new product line. The former investment has a low risk profile, and thus is a sensible investment even if it generates returns that are lower than the company’s composite (overall) cost of capital. The latter has a high risk profile, and thus requires a higher return than the company’s composite.

Here’s the key point: it is wrong to evaluate each investment by the standard of the company’s composite cost of capital – instead the right measure is how its risk-adjusted return compares with relevant investments, those with similar risk/return characteristics, in the company’s portfolio.

As a practical matter, I think of three levels of risk/return: low, medium, and high. This makes the task of specifying a hurdle rate (the appropriate cost of capital) much easier.

Strategic vs. tactical investments

The second question – How should I assess the value of investments? – is vitally important to a company’s competitive success. The bottom line is that assessing strategic initiatives is fundamentally different from assessing tactical investments.

Tactical investments, which produce incremental improvements to the business, are the appropriate domain for traditional capital budgeting, featuring net present value (NPV) and return on investment (ROI) analysis setting well-understood costs against benefits over time. (Remember that even here, most companies’ capital budgeting processes fail to differentiate between low risk/return investments that warrant a lower hurdle rate, from the high risk/return investments that require a higher hurdle rate.)

In the world of major strategic investments, a completely different financial assessment process is needed: one that goes beyond simply adding up costs and benefits to also reflect strategic relevance, the prospective cost of capital, and the payback period.

Bad profits

Should you make all investments that pass the cost of capital recovery test? I wrote a very popular blog about this: What are Bad Profits?

The heart of the blog was this illustration:

The essential point is that in assessing investments, profitability alone is not enough – and this is especially true of major strategic investments. The other critical dimension is whether the investment is strategically relevant.

For example, investing in offering a service that is demanded by only a few customers, but not most customers, probably is not strategically relevant and, if so, you should avoid it even if the investment is profitable. On the other hand, investing in a showcase project to discover an important new customer need in your main line of business may well be very worthy in the long run, even if it does not offer immediate returns.

Yet, a simple business case would favor the former investment and discourage the latter. How can this be right?

Consider a profitable investment that is not strategically relevant, which would indeed pass the cost of capital test. What’s really happening is that this situation has two hidden costs that typically do not appear in the business case calculation.

First, an investment in a new service almost always exponentially increases the complexity of the business in unforeseen ways, and this increases the cost structure of the whole business. (In general, increasing the volume of existing business creates arithmetically increasing costs, but increasing the complexity of the business creates geometrically increasing costs.)

Second, an investment of this sort generates an inexorable future demand for more resources. Why? Because top managers generally do not really act for purely economic reasons – after all, how can you really estimate the costs and benefits of a service offering five years from now? Rather, at the executive level, they often act to ensure “fairness” – i.e. the executive in charge needs an opportunity to show what he or she can do with this new opportunity. And, it is much easier to start trying to grow an opportunity than to end it because the former is easy to measure, while the latter is difficult because turning it around is “just around the corner.”

These issues are central to growing profitability in a robust, lasting way.

Past or future cost of capital?

Let’s return to the question of the strategic investment at the opening of this blog. Here the investment was being judged by the current cost of capital, a measure that is backward-looking by definition since it reflects the current portfolio of investments made in prior periods. Yet the investment in question was being made to have a quantum effect on the company’s future.

For a strategic investment that will really change the business, the right measure really includes the prospective cost of capital, because it will change the basic shape of the company’s risk/return portfolio of investments into the future. It makes no sense to gauge it solely by a measure that doesn’t take into account what the strategic investment is designed to accomplish.

Consider a major strategic investment that promised to really change the company’s relationship with its key accounts – its islands of profit – accelerating major account profitability by increasing the value footprint, and growing high-potential underpenetrated accounts. In this situation the company would have a high likelihood of actually lowering its cost of capital, and a lower likelihood that the cost of capital would stay the same.

Viewed from this perspective, the proper cost of capital to use to evaluate the investment would be a blend of the current cost of capital with the prospective cost of capital – the cost after the strategic investment was made, and not solely the cost in the absence of the game-changing investment. After all, if the strategic investment has the effect of reducing the cost of future investments, shouldn’t this be counted as a major benefit?

This consideration is especially relevant for major strategic investments in public companies, where investment bank analysts’ views of a company’s prospects can have a major impact on the company’s stock price and multiple.

The practical-minded retort is that it is prohibitively difficult to estimate the prospective cost of capital for every possible investment. This is true and compelling. But, it certainly is possible, and indeed feasible, to estimate it for the occasional critical strategic investments that will really change the business.

Managing big risks

So, how do top managers actually assess major strategic investments? An important study conducted a number of years ago found that one of the most important measures actually used by top executives was the discredited measure, payback period.

Payback period is simply the number of years needed to recoup an investment. It is discredited relative to NPV and ROI because it fails to account for the time value of money: two investments may have the same payback period, while the first generates most of the benefits right away and the second generates most benefits at the end of the interval. Clearly, the first investment is superior, even though they both look the same by the payback measure.

So why do top managers pay so much attention to payback period in evaluating major strategic investments? Because a major strategic investment by definition changes the paradigm of the business, creating new value and often provoking competitive response. Therefore it is extremely difficult, if not impossible, to gauge the costs and benefits. It also may well absorb the company’s ability to undertake major change for some time. In this situation, a key top management question is: When will we able to make another major strategic move? Payback period provides an important insight into this critical question.

Cost of confusion

I remember working with a major telephone company in the early days of deregulation. The company served a broad area that included a major metropolitan area with a number of global companies clustered in a few dense locations. These companies were a prime target for new emerging competitors.

As the competitors entered the city and gobbled up the telephone company’s islands of profit customers by deploying fiber and offering new services, the incumbent was hobbled and couldn’t respond. It lost block after block of its most important business.

Why? Because its traditional business case process required an explicit estimate of costs and benefits for each investment (a holdover from the days of regulation). And, preventing a competitor from taking existing business – preventing the erosion of critical customers – was deemed by the finance group as not counting toward investment benefits because it was too “hard” to quantify.

Here, the erroneous use of a tactical investment evaluation process for evaluating strategic investments nearly cost the company its most lucrative business.

Profit maps into action

Thoughtful assessment of investments is the key to maximizing both asset productivity and strategic success.

For tactical investments, the key is developing a hurdle rate that reflects the right cost of capital for the risk/return profiles of the respective investments. As a practical matter, try bundling the candidate investments into three groups: high risk/return, medium risk/return, and low risk/return. Each group requires a different hurdle rate reflecting its different cost of capital. In this context, the traditional assessment measures, NPV and ROI, are very useful.

Strategic investments, however, are fundamentally different from tactical projects. They require a very different assessment process – one that goes beyond traditional cost/benefit analysis to reflect the strategic relevance, the prospective cost of capital, and the payback period.

The strategic relevance incorporates the important hidden costs of complexity and future opportunity costs, the prospective cost of capital embraces the possibility of game-changing gains that fundamentally alter the company’s risk/return profile, and the payback period speaks to the chess-like issue of when the company will be in a position to make its next major strategic move.

In the critical process of converting a profit map into results, wisely assessing investment opportunities is critical. And getting strategic investment assessments right makes all the difference between long-run success and failure.

Great Books for Winter Reading

In my prior blog post (Logistics Clusters – a terrific new book by Yossi Sheffi), I reviewed Yossi Sheffi’s terrific new book – Logistics Clusters – which explains how supply chain dynamics are transforming both company competitive advantage, and regional economies. This book is a must-read for all business managers, supply chain service providers, and government officials. It is fascinating, fast-paced, and packed with compelling factual examples.

Three other great books

For additional great reading, I suggest three other books: Reckless Endangerment, Turn Right at Machu Pichu, and The Seven Daughters of Eve.

Reckless Endangerment, by Gretchen Morgenson and Joshua Rosner is subtitled: “How Outsized Ambition, Greed, and Corruption Created the Worst Financial Crisis of our Time” – and the book certainly lives up to this description.

It is a gripping narration of the forces that led to the near-collapse of the US economy, complete with a blow-by-blow history and names. The really chilling issue is that most of these individuals are still in power, and history appears to be repeating itself in the current fiscal cliff and budgetary crisis.

Turn Right at Machu Pichu, by Mark Adams is a delightful tale. Adams interweaves the history of Pizzarro’s conquest of the Inca Empire, with the story of Hiram Bingham’s fascinating discovery of the ruins of Machu Pichu, with Adams’ own treks in the area tracing the respective histories and stories. The result is a wonderful amalgam by a great writer. By the way, Hiram Bingham is the Yale professor whose story reputedly formed the basis for the character, Indiana Jones.

The Seven Daughters of Eve, by Bryan Sykes, is an incredibly compelling scientific detective story. In this book, Sykes, a professor of molecular genetics at Oxford, describes his ground-breaking genetic investigations into human origins in a very understandable, compelling style that is hard to put down.

His investigations solve long-standing mysteries ranging from the origin of the polynesians, to the story of global human origins. He traces the development of his pioneering genetic techniques that enabled him to trace the lineage of all contemporary humans back through the shrouds of time to just seven women, whom he calls the “seven daughters of Eve.”

Logistics Clusters – a terrific new book by Yossi Sheffi

Logistics Clusters – Yossi Sheffi’s terrific new book – explains how supply chain dynamics are transforming both company competitive advantage, and regional economies.

Why did Singapore rise to international prominence? Why did Memphis outshine its regional neighbors? Why do competitors win by locating near each other and even sharing facilities? How will the transformed Panama Canal affect commerce on entire continents?

Sheffi answers these questions and more in his insightful and fast-paced book. The book’s focal point is an explanation, with multiple examples, of the power of clusters of supply-chain related businesses. These logistics clusters offer compelling advantages for carriers, for customers, and for regional economies.

The book is a must-read for all business managers involved in operations, supply chain management, and strategy – it systematically shows the decisive gains from locating in a logistics cluster.

The book is a must-read for all supply chain service providers – it details the powerful advantages from participating in a logistics cluster, and conversely the problems that result from failing to take advantage of this essential configuration.

And, the book is a must-read for government officials seeking to turbo-charge their economies and upgrade their labor force in a recession-proof, outsourcing-proof, sustainable manner.

This book is written in a fast-paced style that draws the reader through the fascinating story of why logistics clusters are so important to so many top managers and government officials, what benefits they create for all participants, and how to participate to harvest the value.

This is a very important book that reads like a novel. After all, who else but Yossi Sheffi could tell this fascinating story that starts with Roman-era supply chains, continues with the rise of Singapore and the demise of the Erie Canal, and encompasses the founding of Federal Express, the just-in-time distribution of spinal surgical kits, and the economic transformation of the Spanish Province of Aragon?