Know your enemy
There’s a lot of information available on pricing, price wars and war gaming, and there has also been a lot written on the strategies and tactics required to avoid or deal with a price war. However, most of this information is in the context of large businesses that are often well-funded and have professional managers, who have the requisite tools and capabilities to deal with a price war. There isn’t much help for small businesses. While it’s true that the guiding principles are the same for all “for profit” companies, but some of the solutions are not apt for small businesses.
Before anything else, it is important for SMEs to carry out the required groundwork and understand their industry structure, market trends, and define and develop a purposeful pricing objective. Only then can they determine their pricing strategy, let alone deal with or avoid engaging in a price war.
Strategic context of pricing
I have often wondered about how much thought SME owners and marketers have given to their pricing strategy. Pricing strategically is a core requirement that will determine the long-term sustainability of a small business. It is the purse strings of any company. You mess with it and you are doomed! Most small businesses that I have interviewed do not consider aspects beyond cost plus pricing to price their goods and services. There are multiple tools and frameworks that an SME owner or marketer can deploy to sustain and win in the market place. Before we get into the different pricing frameworks, strategies and tactics to deal with a price war, it is important to consider a small businesses’ position in the market place, relative to the overall market.
Market structure: Entry barriers
In discussing real world competition which most small businesses encounter daily, it is important to first focus and truly understand the market structure.
Market structure in essence is the number of companies in the market and the overall barrier to entry for others to enter your space. For example, no small business can realistically aspire to be a utility or telecom operator as the initial investments are untenable and beyond the reach of most SMEs. In addition, meeting government and regulatory requirements requires investment in a battery of lawyers and regulatory experts. Additionally, hiring professional managers competent in the relevant technology or commercial aspects of the industry are certainly insurmountable for a small business investor. Of course, most SMEs are smart and will not venture into such an endeavour. I am only attempting to illustrate an extreme example of what an entry barrier truly means.
If the entry barrier is low, then the prospects for long-term profits are low as well. So remember that when you develop your plan; keep in mind that there are many others who can enter and disrupt the profits in your market space.
Measuring industry structure
First, here are some basics that small business owners must be aware of – perfect competition with an infinite number of companies and a monopoly are polar opposites. Monopolistic completion and oligopoly lie between these two extremes. Monopolistic competition is a market structure in which there are many businesses selling differentiated products. Oligopoly is a market structure in which there are a few interdependent firms. Most global industry structures, where small businesses operate, fall almost entirely between monopolistic competition and oligopoly — perfectly competitive and monopolistic industries are few and are nearly nonexistent.
Marketers in large companies often use one of two methods to measure the industry structure. They are the concentration ratio and The Herfindahl index.
The concentration ratio: This is the percentage of industry output that a specific number of the largest companies have. The most commonly used concentration ratio is the four companies’ concentration ratio. The higher the ratio, the closer the industry structure will be to an oligopolistic or monopolistic type of market structure.
The Herfindahl index: This is an alternative method used by marketers to classify the competitiveness of an industry. It is calculated by adding the squared value of the market shares of all firms in the industry. I personally prefer this method. There are two advantages of the Herfindahl index – it takes into account all companies in an industry, as well as gives extra weight to a single company that has an especially large market share.
Also, the Herfindahl Index is the method used by the US Justice Department for allowing or disallowing mergers to take place. If the index is less than 1,000, the industry is considered competitive, whereby allowing a merger is actively considered.
The relevance of industry structure
By now you must be wondering why all this is important. Classifying the industry structure is important because structure affects a company’s behaviour. The greater the number of sellers, the more the likelihood that the industry structure in which a small business operates in is competitive. The number of businesses in an industry plays a role in determining whether small businesses explicitly take other companies’ actions into account. In reality though, when there are many sellers as in monopolistic competition, they do not take into account their competitors’ reactions.
If you are running a retail store or restaurant, this might not be very important for you. However, in the UAE and the Middle East region in general, there are many traders and distributors for large manufacturers or technology companies ranging from cell phones, computers, servers to sophisticated telepresence and medical equipment. In addition, there are many boutique management and technology consulting companies competing with well-known global brands. I am sure that businesses competing in these market spaces could see the relevance of really understanding their industry structure.
A word on monopolistic competition
By now you must also be wondering why a hyper-competitive industry structure is called monopolistic competition. It seems so counter intuitive. It is so, because the “many sellers” characteristic gives monopolistic competition it’s competitive aspect. The need and capability for business proposition differentiation gives monopolistic competition its monopolistic aspect.
The relevance to SMEs is that they should ensure that their proposition is truly differentiated and these unique value propositions should be communicated in the market.
This is a fundamental rule for any small business. Most operate in an environment where the entry barrier is very low and where there are many sellers in the market. In such a scenario, if there is no unique value proposition or if it is not communicated, the business will struggle.
Pricing objectives and strategies
Before a small business dwells into the different pricing aspects, it is important to truly reflect on the real objectives of a pricing approach in the market. There could be many reasons for such a pricing move. Before we summarise the different profit objectives, it is important for an SME to consider the following:
What are the market trends?
• Factors and questions that an SME should consider are:
• Is there a flood of new propositions or model introductions in the market?
• Is there an increased availability of bargain and generic brands in the market?
• Are your competitors using price cutting as a strategy to maintain or regain market share?
• Is there a general decline in consumer confidence (such as after political upheavals, terrorist attacks, stock market crash, and so on)?
• What stage is your proposition in the product life cycle? Is it matured?
• What is the competitive intensity in your market space? What is your distribution strategy?
• Direct, indirect or hybrid sales approach? What is your promotion or communications strategy?
• What is the perceived quality of your proposition relative to your competitors?
Only after truly understanding their industry structure and the market trends, should SMEs consider and define their profit objectives. These questions can help determine the intentional pricing objectives:
• Survival mode: Are you just trying to survive to generate enough cash flow to remain in business?
• Maintaining status quo: Are you trying to maintain the status quo in the hope of avoiding a price war?
• Cost recovery: Are you seeking only partial cost recovery?
• Quality leadership: Are you seeking to signal a higher quality of the proposition?
• Profits: Are you seeking to maximise current profits?
• Revenues: Are you seeking to maximise current revenues and not the profits?
• Quantity: Are you seeking to maximise quantity to recover long- term costs?
• Profit margins: Are you seeking to maximise profit margins knowing well the impact it has on the demand for products and services?
Now that you have a reasonable view of the industry structure, the prevailing trends in the market and a purposeful pricing objective, it is time to reflect on what your strategic pricing approach would be.
As also explained by my fellow columnist Dr. Mahate in the subsequent article on pricing for exporters, there are many different types of pricing strategies that an SME can follow; some are more prevalent than others. Here are a few of them:
The strategic objective of this type of pricing is to increase sales and gain momentum in the market soon. For example, a small business distributor of consumer electronics goods might use this strategy to pre-empt a competitor launch which is some time away.
The small business owner can set an initial high price, and then gradually lower the price to make the proposition available to a wider market. The strategic objective for a skimming approach is to skim profits off the market layer by layer. If you are a small software games developer or a distributor of toys or consumer electronics, skimming might be an excellent approach, if the main festive season buying is some time away.
The objective of this is to set a price in comparison with the competitors. Needless to say, a small business has three options and these are to price lower, price the same, or price higher.
Product line pricing
The strategic objective of this is to price different products within the same product range at different price points. Examples of this would include hotel room rates.
The SME can bundle a group of products at a reduced price. Common methods are to buy one and get one free. Other creative methods could include offering a set menu for restaurants, bundling complementary products like movie tickets and pop corn, and so on.
In this pricing method, SMEs can offer large volumes or buckets of the same proposition for a fixed period commitment. A small business restaurant owner, hotelier, or a transportation company, can offer bucket pricing for a fixed fee on a monthly or annual basis.
When pricing their propositions, SMEs should consider the psychology of price and its positioning within the market place. This is the reason why you see a lot of $1.99 or $999 and so forth type of pricing all around.
The strategy for this pricing approach is to set a price high to reflect the exclusiveness or the premium quality of the product. This is commonly used by retailers and sellers of premium goods and services.
In this approach, the SME can sell optional goods or services along with a main proposition.
Cost based pricing
In this pricing approach, the SME takes into account the cost of sales and distribution and then applies a mark-up for the intended profit, before deciding on a final pricing framework.
Cost plus pricing
The objective of this is to add a percentage to costs as a profit margin.
Loyalty based pricing
In this approach, the proposition offered uses all of the above pricing methods, and then prices are discounted to entice commitment and therefore loyalty over a commitment period.
A note on the people who price
I recently met the owner of a company selling software over the Internet to SMEs. Prior to this endeavour, this gentleman was a very senior manager in a well-known global software giant. What baffled me the most was his pricing strategy.
In my mind, he truly lacked an understanding of his customers’ needs and what they could afford. More importantly, he failed to understand that his potential customers did not have the necessary cash flow for such upfront investments and that his only value proposition, relative to his other competitors in the market, was offering his customers an OPEX model versus a CAPEX model.
Most SMEs often mistakenly request the good folks from the finance department to handle pricing for their propositions. This is a grave mistake.
The pricing strategy and the tactics have to be set by someone who understands customer needs, perceptions, market conditions, and has a well-rounded view of the business. As pricing is the purse string of your business, it is important that there be checks and balances. This means any strategy will, of course, need to be validated and approved by independent functions like finance or accounting. However, the big picture must be kept in mind.
Small businesses need to know that most customers buy their propositions not for their features (for example, a phone) or their specific functionalities (camera pixels), but rather for the perceived benefits that the propositions delivers.
Features and functions, which are often the focus of product design specifications, are simply the packaging for delivering the benefits that are desired by customers.
Customer perceptions are critically important. A proposition may pass the required functional criteria, but a small business only “gets credit” if the customers recognise (that is perceive) that the product delivers the benefits.
Similarly, potential customers make purchase decisions considering a proposition’s perceived price. That is, how much a customer thinks that a product will cost them? These perceptions may or may not accurately reflect reality.
Keep in mind that the perceived value is either the difference between the perceived benefits that a product delivers and its perceived price, or the ratio of the perceived benefits and the perceived price.
Comparison of perceived values
SMEs should know that customers often make a choice not to pay more than a certain price. They make these choices by comparing across a set of references explicitly or implicitly for unscientific perceptual benchmarking (for example, this type of product should cost roughly this amount, say, an Apple iPad versus a Blackberry Playbook).
Customers also compare among substitutable products that may be directly or indirectly competitive. For example, Colgate and Close Up toothpastes are directly competitive. Colgate toothpaste and mouthwash are indirectly competitive (since both serve a different purpose and are dental hygiene products – unless someone only uses mouthwash for their dental hygiene, and I’d hate to dwell on that!).
John Lincoln has over 20 years telecommunications experience in the USA, Japan, Europe, India, Dubai, Malaysia, Latin America and various other countries. He has extensive senior expertise in international telecommunications sales, marketing, business development and customer service delivery. John also has executive experience with general management, marketing, P&L, product development and revenue management responsibilities in both consumer and enterprise segments for both the fixed and mobile sectors. In addition John has an impressive operational and management portfolio of established proven expertise in incremental business value creation and management of large multi-cultural teams in Vodafone Global in the UK, Japan Telecom in Tokyo, AirTouch and Pacific Bell (now AT&T) in San Francisco and Tokyo, Airtel in Delhi and other telecom and technology companies. Additionally he has extensive large scale business development, M&A and operational project experience across the USA, Europe, Asia and Latin America. John has an MBA and MS in Telecommunications from the Golden Gate University in San Francisco, California, USA. You can find John’s personal blog at johnlincoln.blog. com. He can be contacted via: john.lincoln@ gmail.com, Twitter: @lincolnjc.