Monday, January 26, 2009

Growth Rates that Count

No matter the rate of growth in a market, the key growth measures to watch are those of the various Price Points. Here is an example.

The U.K., as the U.S., is in a recession. As a result of tougher times, customers are trading down their purchases in retail stores, including grocery stores. A beneficiary of this trade-down in the U.K. is the supermarket chain, J. Sainsbury PLC. Sainsbury is the U.K.’s third largest food retailer. It picked up customers from some of its more upscale grocery competitors.

Sainsbury has three lines, or Price Points, in its market. These Price Points grew at significantly different rates than the company grew during 2008. The company’s “Basics” brand is the smallest of its three Price Point labels. It is also the least expensive. This brand reported a 40% rise in sales in the third quarter from a year earlier, as customers traded down to less expensive groceries. The company’s higher Price Point brand “Taste the Difference” saw a decline in sales during the same period. The company’s sales for stores open for at least a year grew 4.5% in 2008. But the growth rates at the two Price Points were very different from the company overage.

In any market, whether growing or declining, a company should know the growth rates, not just of the industry as a whole, but of the Price Points in the industry. The real growth or decline story comes at the Price Points. And it is at the Price Points, rather than at the overall market, where the company focuses its decisions.

Thursday, January 22, 2009

Pricing Taken Too Far

In the early 1990s, I was involved with a company that faced a very competitive price environment. The company felt it could not increase the prices on its standard product. Instead, it raised its prices on the ancillary services it offered to all customers, though not all customers used these services. The company felt, at the time, that it could continue to raise these prices until the market took note and complained bitterly, or until its prices notably exceeded those of its competitors.

We now may have an instance, several years later, where that approach to pricing has begun to wear out its welcome. A recent article on cruise ship travel took two newspaper pages to help readers avoid the ancillary price increases on cruises.

The article noted that the advertised price for a particular cruise was an attractive $699. However, many customers of this cruise line end up paying over $1200 for that same cruise because of these ancillary fees. (See the Perspective, “Is Your Industry Right for Hostility?” on These fees include port fees, trip insurance, airport transfers, automatic gratuities, internet access and others. The typical customer uses most, if not all, of these extra services and ends up paying a price for the cruise 70% over the advertised cruise price.

This is a good example of pricing going too far. If the cruise industry keeps this up, no one will believe their advertised prices. Nor should they. Those advertised prices bear no relationship to the real price the customer will pay for taking the cruise.

Tuesday, January 20, 2009

"Illogical" Pricing

How can pricing hit zero? This has just happened with container freight rates or shipments from South Asia to Europe. Other rates are not much better. Container shipment fees from North Asia to Europe have fallen to $200, taking them below the shippers’ operating costs. $200 per container is bad, but how to you get to zero?

Our previous blog (“Why Overcapacity Often Gets Worse” below) discusses pricing in overcapacity. The price in a commodity industry is equivalent to the cash cost of the next person to enter the industry or the last person to exit. So, what do these prices tell us about costs? Are they “illogical”?

First of all, the prices are not what they seem. In addition to the “price” there are other charges for fuel, called bunker costs, and other fees. So, even at a zero price for the container shipment, the shipping company still makes some cash contribution. Second, the cash costs of operating ships are largely fixed. One observer noted that idle ships are now stretched in rows outside Singapore’s harbor. These are ships whose cash cost of operation are higher than those ships that are now sailing, even though shipping rates are “zero”.

Third, the industry is in severe overcapacity. This overcapacity is the result of a significant fall-off in export demand. Exported container movements have fallen between 25 and 40% in Japan, Korea and Taiwan. Even China is now seeing a contraction in shipments. Activity in the U.S. ports is also falling. Shipments from Long Beach and Los Angeles, which are America’s two top ports, have fallen nearly 20% from a year ago.

Container fees from North Asia, at $200, represent a demand level relative to capacity somewhat better than that from South Asia. Still, few, if any, shipping companies are making an operating profit at $200 a container.

This situation is likely to continue until demand begins to grow again. (See the Symptom and Implication, “Prices are rising as the industry runs out of capacity” on Overcapacity ends in one of two situations. In the first situation, price competition stops despite there being more capacity than the industry needs. This occurs when a maximum of four competitors gain control of 85% or more of industry capacity. Furthermore, these four competitors must refuse to discount against one another in search of additional sales volume. In the second situation, industry demand grows by enough to sop up excess capacity and prices begin to rise in order to attract new capacity into the market. By far, the most common way that industries exit overcapacity is through demand growth. (See the Perspective, “What Ends Hostility” on

Thursday, January 15, 2009

Why Overcapacity Often Gets Worse

The global semiconductor industry is in severe overcapacity today. There are two causes for this current overcapacity: competitor expansion and a fall-off in demand. Competitors expanded rapidly over the last few years when demand was relatively high. New semiconductor capacity comes on stream in big chunks, produced in factories costing more than a billion dollars. Now, many of those factories are running at half their rated capacity as demand has fallen off in the last year. The situation is bad enough that, today, no company can make a profit on standard semiconductor memory chips.

So, why don’t semiconductor manufacturers reduce industry overcapacity by closing plants? The answer lies in the cost structure of these factories. Seventy percent of these factory costs are fixed. They neither rise nor fall with short term changes in demand. As a result, these factories continue operating as long as their operators can make a cash contribution to fixed costs.

These high fixed costs explain why semiconductor prices fall so low in overcapacity. Prices have to fall low enough to discourage someone from producing. That discouragement has to include pricing through the level of any fixed cost. In a commodity-like market, such as semiconductor memory chips, the industry price is equivalent to the cash costs of the next person into the market. As a market expands, the cash cost of the next addition to capacity sets the price. In a market that is shrinking, the cash cost of the last person to leave the market is a pretty good estimate for industry prices. The last person to leave the market is usually the high cost producer. So, a declining demand industry sees industry prices fall below the cash costs of the high cost producer until enough high cost production is taken off-line to balance demand.

Even once a plant reaches the stage where it can not make a cash contribution on sales in its present structure, there are still instances where that capacity does not close permanently. Instead, the capacity recycles in the industry as another competitor, often with a lower cost structure, acquires the productive facility and keeps it operating at a lower cash cost. (See the Symptom and Implication, “Industry profits are low but downsized capacity remains” on

Once productive capacity exists, it goes away with difficulty, even in an industry downturn. High cost capacity may not go away permanently until it is unable to compete with the cost structure of newer, more technologically advanced plants, even in a rising price environment. (See the Symptom and Implication, “The industry is adding new more efficient capacity in the effort to reduce cost” on

Monday, January 12, 2009

Price Competition in a Falling Price Environment

The fight is on in retail pharmacy. It started with Wal-Mart. In 2006, Wal-Mart introduced a $4 generic prescription for a one month supply of hundreds of unbranded drugs. This move attracted a lot of buzz and new customer volume.

There are three major players in the retail drug prescription business: Walgreen, CVS and Rite Aid. Each of these companies have responded with their own drug plan. Walgreen started its Prescription Savings Club, which provides discounts on generics and five thousand branded medications, and rebates on Walgreen-branded products. CVS introduced a ninety-day supply of more than four hundred generic drugs for $9.99, and a 10% discount at the company’s store-based clinics. Rite Aid rolled out a national program offering a prescription savings card covering hundreds of generic drugs at $8.99 for a thirty-day supply, or $15.99 for a ninety-day supply, plus discounts on branded drugs. All three of these major pharmacy competitors claimed that their programs have attracted new business to their drug stores. Still, they are feeling more margin pressure in what used to be a very profitable business. (See the Symptom and Implication, “Customers are more price sensitive” on

It is worth noting several observations about this market evolution:

Wal-Mart, as the leader, started the discounting program. This is unusual. Most market leaders would rather sit on profits from high prices than discount to attract more customers. In Wal-Mart’s case, however, the additional customers it attracts from monthly prescriptions brings with it other purchases.

All three of the major players focused their sales efforts on customers who could buy a large number of pills at one time. The pricing the companies offered were “bundled” products, containing thirty or ninety day supplies, more than the average prescription would normally cover.

None of the three major players matched Wal-Mart’s low price. These companies believe that they can charge a premium for their more convenient locations.

Products and prices vary among the three largest competitors. This is an industry where comparison shopping is still developing. Most customers buy locally and do not spend a great deal of time trying to fine tune the price they pay by going shopping at numerous competitors.

All the three major competitors gained volume in this business. The losers, from a volume point of view, have been the independent pharmacies and the regional drug store chains. (See the Symptom and Implication, “As large competitors match low prices, other competitors face difficulties” on Most of these share-losing companies did not go along with the low prices for bundled generic products.

These pricing battles are taking place in the uninsured customer market. The insured customers tend to purchase through mail-order programs, such as those offered by Caremark, Medco and Express Scripts, where prices are already lower.

Monday, January 5, 2009

The Causes and Symptoms of Overcapacity

Overcapacity, where an industry can produce more than customers currently demand, is the result either of a fall-off in demand or the expansion of competition. During the 80s and 90s, three quarters of the industries that went into overcapacity did so as a result of expansion of competition. Industries such as semiconductors, airlines, mini-computers and even orange juice went into hostility as competitors expanded faster than demand grew.

More recently, though, most of the industries going into overcapacity have suffered from a major fall-off in demand as the world-wide economy slips into recession. Any industry associated with residential building is now in overcapacity, as new housing starts to plummet. Mall owners are suffering as retailers go out of business.

Even very low cost competitors in an industry suffer when the industry goes into overcapacity due to a fall-off in demand. During the 80s, much of the U.S. domestic textile industry shifted off shore to low-cost producers such as India. But in this latest economic crisis, even the Indian textile industry is suffering from overcapacity. Textile employees in India in the least-skilled jobs may earn only $2.00 a day. But many of them are losing their jobs as European and American clothing retailers slash orders.

No matter how an industry enters overcapacity, it will follow a common evolutionary pattern. (See the Perspective, “Success Under Fire: Policies to Prosper in Hostile Times” on There are six phases to this evolution:

Phase 1: Margin pressure. Competitors begin discounting to maintain their utilization rates. As a result, prices and margins fall throughout the industry.

Phase 2: Share shifts. Some competitors, often the leaders in the industry, refuse to go along with the price declines spreading throughout the industry. We call this phenomenon the Leader’s Trap. (See the Perspective, “The Leader’s Trap” on This occurs early in overcapacity and causes significant early share shifts from high-priced to low-priced competitors. Following this early shift in shares, the industry will see additional shifts in shares due to the flight quality from less reliable to more reliable competitors and due to acquisitions.

Phase 3: Product proliferation. The industry floods the market with new products in order to reignite customer demand. These new products include bundling of benefits in an attempt to upgrade the product by adding additional features or functions, and product unbundling, where the innovator seeks to remove product features to reach a new, lower price point.

Phase 4: Self-defeating cost reduction. Inevitably, companies face the need to reduce their costs. The less successful companies reduce costs at the customer’s expense. They do so by conscious decisions leading to feature failure, where the company delays matching popular new product features, quality slippage, where the company does not keep pace with the industry’s quality and delivery standards and distribution conflicts, where manufacturers seek to shift their margin pressure away from themselves on to their channels of distribution.

Phase 5: Consolidation and shake-out. Over time, the industry goes through several waves of consolidation and shake-out where new, stronger companies emerge and weaker firms are absorbed.

Phase 6: Rescue. Once an industry enters overcapacity, it can stay hostile for a number of years. The American automobile industry and the airline industries have been hostile for well over twenty years. An industry is rescued from hostile conditions by demand growth in most cases. The industry demand gradually catches up to industry capacity and prices rise to encourage new investment once again. A few industries see a rescue from the consolidation and rationalizations in the industry that reduce industry competition to three or four players who control more than 80% of the total market. Often, these industries will develop “gentlemanly” competition where true price competition is rare. Industry prices then rise to attractive levels. The industry is no longer in overcapacity because competitors will not discount against one another to use marginal capacity.