Hit Them on Both Sides of the Head

One of our local newspapers is running a series on the problems of public transportation in the San Francisco Bay Area. The problem seems to be that ridership is well off of plan. The economy, and its attendant reduction in jobs and squeeze on commuter pocketbooks, has reduced demand.

Virtually all of the authorities in charge of the various modes of public transportation have found the same magic elixir for this sickness. They plan to reduce services and raise prices at the same time. Let’s see now. We find that demand is off and our answer is to reduce what people can get for their money (offer less) and to charge them more to get that “less.” How is this likely to work? This will work only if the authorities can raise the prices enough to offset the likely accelerated loss in commuter revenues that the Price increase and Performance decrease is likely to bring.

Let’s use a few simple concepts to express better what is taking place. Any business offers a Value to its customers. The Value is a combination of the Performance the business offers the customer plus the Price the business charges. The Performance includes Benefits such as Features, Reliability and Convenience of purchase. The company must beat its competition in offering this Value in order to grow market share. Right now customers are telling public transportation authorities that the current level of service for the price charged is not high enough to keep all of them using public transportation.

The business supports its Performance with its Cost Structure. The company’s Cost Structure must allow the business to make a margin on the sale of the product to the customer. Here again, the business must have a Cost Structure at least as productive as that of its competition or its margins will be lower than those of the competition. Most of these public transportation authorities are losing money. They may not be less productive than direct competitors because there are so few of those kinds of competitors. However, they are less competitive than the consumer’s alternative, perhaps even the consumer’s own automobile.

A business in a loss position has negative margins. Costs are greater than revenues. The business has two levers to pull in order to get out of this situation, other than stringent cost reduction on the current Cost Structure. First, it may raise Prices and hope that the additional revenues on the customers who stay will be greater than the revenues lost by customers who leave due to the higher price. Second, it may reduce the Performance it offers the customer as well as the costs that support that Performance. As costs come down, margins may increase, as long as customers do not defect. In extreme situations, a business may raise Prices and reduce Performance at the same time.

How extreme is this radical approach of raising Prices and reducing Performance at the same time (gutting the former Value proposition)? Over the years we have evaluated thousands of Price increases. We have found that companies are able to raise Price and reduce Performance at the same time in about 3% of the cases where Prices rise in an industry. When you see this kind of an action, you can usually assume that the industry has very strong pricing power. (See the Perspective, “Who Has Pricing Power?” on StrategyStreet.com.) For example, HP and Lexmark International launched lower capacity ink cartridges with smaller price tags to try and counter the growth of off-brand printer ink sellers. These cartridges had starting prices below $15 a cartridge but their cost per ounce of ink was higher than the predecessor products. In another case, the cable T.V. industry for years prospered by raising prices well in excess of inflation at the same time as forcing consumers to buy packages of channels, including many channels the customers did not want or ever use.

Occasionally, you also see the phenomenon of a raised Price and decreased Performance in an act of desperation to save the business. (See the Symptom & Implication, “New competition is entering a settled market” on StrategyStreet.com.) The airline industry has begun charging for previously free services, such as checking bags and serving onboard meals at the same time that its prices have gradually risen. The legacy airlines may have no choice. The difference, in this case, is that the airline industry is operating at higher levels of utilization and actually has a bit of pricing power today. Newspaper publishers have raised prices and reduced coverage in their print products to stay alive. The outlook for public transportation, and some other industries in desperate need, such as newspapers, is grim.