Price Changes

After developing their pricing structures and strategies, companies often face situations in which they must initiate price changes or respond to price changes by competitors.

In some cases, the company may find it desirable to initiate either a price cut or a price increase. In both cases, it must anticipate possible buyer and competitor reactions.

Several situations may lead a firm to consider cutting its price. One such circumstance is excess capacity. In this case, the firm needs more business and cannot get it through increased sales effort, product improvement, or other measures. It may drop its "follow-the-leader pricing"—charging about the same price as its leading competitor—and aggressively cut prices to boost sales. But as the airline, construction equipment, fast-food, and other industries have learned in recent years, cutting prices in an industry loaded with excess capacity may lead to price wars as competitors try to hold on to market share.

Another situation leading to price changes is falling market share in the face of strong price competition. Several American industries—automobiles, consumer electronics, cameras, watches, and steel, for example—lost market share to Japanese competitors whose high-quality products carried lower prices than did their American counterparts. In response, American companies resorted to more-aggressive pricing action.

A company may also cut prices in a drive to dominate the market through lower costs. Either the company starts with lower costs than its competitors, or it cuts prices in the hope of gaining market share that will further cut costs through larger volume. Bausch & Lomb used an aggressive low-cost, low-price strategy to become an early leader in the competitive soft contact lens market.

A successful price increase can greatly increase profits. For example, if the company's profit margin is 3 percent of sales, a 1 percent price increase will increase profits by 33 percent if sales volume is unaffected. A major factor in price increases is cost inflation. Rising costs squeeze profit margins and lead companies to pass cost increases along to customers. Another factor leading to price increases is overdemand: When a company cannot supply all its customers' needs, it can raise its prices, ration products to customers, or both.

Companies can increase their prices in a number of ways to keep up with rising costs. Prices can be raised almost invisibly by dropping discounts and adding higher-priced units to the line. Or prices can be pushed up openly. In passing price increases on to customers, the company must avoid being perceived as a price gouger. Companies also need to think of who will bear the brunt of increased prices. Customer memories are long, and they will eventually turn away from companies or even whole industries that they perceive as charging excessive prices.

This happened to the cereal industry in the 1990s. Industry leader Kellogg covered rising costs and preserved profits by steadily raising prices without also increasing customer value. Eventually, frustrated consumers retaliated with a quiet fury by shifting away from branded cereals toward cheaper private-label brands. Worse, many consumers switched to less expensive, more portable handheld breakfast foods, such as bagels, muffins, and breakfast bars. As a result, total American cereal sales began falling off by 3 to 4 percent a year. Thus, customers paid the price in the short run but Kellogg paid the price in the long run.¹⁴

There are some techniques for avoiding this problem. One is to maintain a sense of fairness surrounding any price increase. Price increases should be supported with a company communication program telling customers why prices are being increased. When possible, customers should be given advance notice so they can do forward buying or shop around. Making low-visibility price moves first is also a good technique: Eliminating discounts, increasing minimum order sizes, and curtailing production of low-margin products are some examples. Contracts or bids for long-term projects should contain escalator clauses based on such factors as increases in recognized national price indexes. The company sales force should help business customers find ways to economize.

Wherever possible, the company should consider ways to meet higher costs or demand without raising prices. For example, it can consider more cost-effective ways to produce or distribute its products. It can shrink the product instead of raising the price, as candy bar manufacturers often do. It can substitute less expensive ingredients or remove certain product features, packaging, or services. Or it can "unbundle" its products and services, removing and separately pricing elements that were formerly part of the offer. IBM, for example, now offers training and consulting as separately priced services.

Whether the price is raised or lowered, the action will affect buyers, competitors, distributors, and suppliers and may interest government as well. Customers do not always interpret prices in a straightforward way. They may view a price cut in several ways. For example, what would you think if Joy perfume, "the costliest frangrance in the world," were to cut its price in half? Or what if IBM suddenly to cut its personal computer prices drastically? You might think that the computers are about to be replaced by newer models or that they have some fault and are not selling well. You might think that IBM is abandoning the computer business and may not stay in this business long enough to supply future parts. You might believe that quality has been reduced. Or you might think that the price will come down even further and that it will pay to wait and see.

Similarly, a price increase, which would normally lower sales, may have some positive meanings for buyers. What would you think if IBM raised the price of its latest personal computer model? On the one hand, you might think that the item is very "hot" and may be unobtainable unless you buy it soon. Or you might think that the computer is an unusually good value. On the other hand, you might think that IBM is greedy and charging what the traffic will bear.

A firm considering a price change has to worry about the reactions of its competitors as well as those of its customers. Competitors are most likely to react when the number of firms involved is small, when the product is uniform, and when the buyers are well informed.

How can the firm anticipate the likely reactions of its competitors? If the firm faces one large competitor, and if the competitor tends to react in a set way to price changes, that reaction can easily be anticipated. But if the competitor treats each price change as a fresh challenge and reacts according to its self-interest, the company will have to figure out just what makes up the competitor's self-interest at the time.

The problem is complex because, like the customer, the competitor can interpret a company price cut in many ways. It might think the company is trying to grab a larger market share, that the company is doing poorly and trying to boost its sales, or that the company wants the whole industry to cut prices to increase total demand.

When there are several competitors, the company must guess each competitor's likely reaction. If all competitors behave alike, this amounts to analyzing only a typical competitor. In contrast, if the competitors do not behave alike—perhaps because of differences in size, market shares, or policies—then separate analyses are necessary. However, if some competitors will match the price change, there is good reason to expect that the rest will also match it.

Buyer reactions to price changes: What would you think if the price of Joy was suddenly cut in half?

Here we reverse the question and ask how a firm should respond to a price change by a competitor. The firm needs to consider several issues: Why did the competitor change the price? Was it to take more market share, to use excess capacity, to meet changing cost conditions, or to lead an industrywide price change? Is the price change temporary or permanent? What will happen to the company's market share and profits if it does not respond? Are other companies going to respond? And what are the competitor's and other firms' responses to each possible reaction likely to be?

Besides these issues, the company must make a broader analysis. It has to consider its own product's stage in the life cycle, the product's importance in the company's product mix, the intentions and resources of the competitor, and the possible consumer reactions to price changes. The company cannot always make an extended analysis of its alternatives at the time of a price change, however. The competitor may have spent much time preparing this decision, but the company may have to react within hours or days. About the only way to cut down reaction time is to plan ahead for both possible competitor's price changes and possible responses.

Figure 12.1 shows the ways a company might assess and respond to a competitor's price cut. Once the company has determined that the competitor has cut its price and that this price reduction is likely to harm company sales and profits, it might simply decide to hold its current price and profit margin. The company might believe that it will not lose too much market share, or that it would lose too much profit if it reduced its own price. It might decide that it should wait and respond when it has more information on the effects of the competitor's price change. For now, it might be willing to hold on to good customers, while giving up the poorer ones to the competitor. The argument against this holding strategy, however, is that the competitor may get stronger and more confident as its sales increase and that the company might wait too long to act.

If the company decides that effective action can and should be taken, it might make any of four responses. First, it could reduce its price to match the competitor's price. It may decide that the market is price sensitive and that it would lose too much market share to the lower-priced competitor. Or it might worry that recapturing lost market share later would be too hard. Cutting the price will reduce the company's profits in the short run. Some companies might also reduce their product quality, services, and marketing communications to retain profit margins, but this will ultimately hurt long-run market share. The company should try to maintain its quality as it cuts prices.

Active FIGURE 12.1	Assessing and responding to competitor's price changes

Alternatively, the company might maintain its price but raise the perceived quality of its offer. It could improve its communications, stressing the relative quality of its product over that of the lower-price competitor. The firm may find it cheaper to maintain price and spend money to improve its perceived value than to cut price and operate at a lower margin.

Or, the company might improve quality and increase price, moving its brand into a higher-price position. The higher quality justifies the higher price, which in turn preserves the company's higher margins. Or the company can hold price on the current product and introduce a new brand at a higher-price position.

Finally, the company might launch a low-price "fighting brand"—adding a lower-price item to the line or creating a separate lower-price brand. This is necessary if the particular market segment being lost is price sensitive and will not respond to arguments of higher quality. Thus, when challenged on price by store brands and other low-price entrants, Procter & Gamble turned a number of its brands into fighting brands, including Luvs disposable diapers, Joy dishwashing detergent, and Camay beauty soap. In turn, P&G competitor Kimberly-Clark offers its value-priced Scott Towels brand as "the Bounty killer." It scores well on customer satisfaction measures but sells for a lower price than P&G's Bounty brand.¹⁵

Fighting brands: Kimberly Clark offers its value-priced Scott Towels brand as "the Bounty killer." It scores well on customer satisfaction but sells for a lower price than P&G's Bounty.