Bad Prices Kill, Good Prices Sustain. Learn it or Bleed.

Novices to marketing often think that cutting prices to grow market share is a sound strategy. Somewhere between high school and the ranks of senior executives, most people do learn that cutting prices to grow market share may succeed, but at the high cost of profits. Unfortunately, the caveat is “most people”. Some people have demonstrated an uncanny ability to remain ignorant.

It is not that price discipline has grown more difficult. In fact, it is easy to point to cases where price discipline is practiced regularly with predictable, industry wide, positive results. It is rather that we individually continue to forget the fundamental truths that collectively took us decades, if not centuries, to learn. Unfortunately, the cost of individual ignorance is high.

This week, we look at two cases of pricing discipline and one case of price implosion.

FedEx and UPS Have Learned

In early November ‘06, FedEx announced a price hike across many of their shipping lines of business. Within that same month, UPS followed suit with a 5% price hike.

From the viewpoint of competition analysis, it is almost impossible to read these actions as something other than lockstep motion across the industry to manage prices and profitability. It is not that UPS and FedEx are friendly competitors. Rather, they are bitterly stiff competitors caught not only in their internal industry struggle but also in addressing the challenge of a new industry entrant: DHL.

Why would UPS respond in kind to FedEx’s price hike? Because it is in their best interest. Both parties profit from this decision and from the decision to compete for market share on dimensions other than price.

Philip Morris et al. Have Learned

In mid December ‘06, Philip Morris raised the price of cigarettes through a combination of price waterfall manipulation on premium brands and direct price increase on bargain brands. The effective result is a 10 cents-per-pack price hike. Most analysts expect other leading cigarette makers such as Loews and R.J. Reynolds Tobacco to follow suit.

Again, selling tobacco is a highly competitive industry. Again, we see a lockstep motion to manage prices and profitability. Again, new competitors from the likes of China and elsewhere are entering. And yet again, best interest compels the industry competitors to move ahead with the price increase and select alternative means to compete.

But Ed Zander of Motorola Needs to Return to School

Surely, someone as well positioned as Ed Zander, CEO of Motorola, could have done the same in the mobile phone market. Even if Mr. Zander could not have introduced lockstep pricing discipline, he should have known that using price to gain market share is a loosing proposition and that he should seek market share by competing on other dimensions instead. Yet, somehow, he seemed to have skipped school that day.

In 2004, Mr. Zander launched the Motorola RAZR at a retail price of $500. By 2006, the RAZR was given away free when bundled with a 2 year service contract. Industry analysts estimate the average wholesale price at the end of 2006 to have been a mere $125.

Did the large price cut deliver market share? You bet it did. It grew market share from 16.3% in the fourth quarter of 2004 to 20.6% in the third quarter of 2006, a whopping 4% more.

Did Mr. Zander need to cut prices to sell the RAZR? Probably not. Even in the current competitive industry, Apple is able to peddle their iPhone at the lofty price of $499. (I should add that unlike Mr. Zander, I would be very surprised if Mr. Jobs significantly reduced the price of the iPhone prior to launching a replacement.) Lest one claims that the RAZR is not iPhone, recall that the RAZR was perceived as a fashion icon and was quickly acclaimed as the fastest selling phone in history. The RAZR was, by all metrics, a technological and marketing success in the mobile phone industry.

Rather than drive the value proposition in his favor by maintaining the price of the RAZR, he had the bright idea of lowering the price in order to gain volume and take market share. Genius? Hardly. Market share came at the expense of profitability.

The result is now clear. First, profit warnings and investor dissatisfaction. Second, 3,500 jobs lost. I suspect that at least one of his subordinates warned him against cutting prices yet she found her tenure at Motorola cut short. Perhaps Mr. Zander’s tenure should be also.

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References and Notes

1. “UPS to Raise Rates by Nearly 5%”, The Wall Street Journal, November 20, 2006, p A2.
2. “Philip Morris Raises U.S. Cigarette Prices”, The Wall Street Journal, December 15, 2006, p B3.
3. The actions of UPS, FedEx, and Philip Morris can each be said to avoid price collusion legal issues because these actions can be interpreted as intending to set customer expectations or the expectations of sales channel members. Consult your lawyer for further legal advice.
4. L. Yuan and C. Bryan-Low, “IPhone Hinges on the Likes of Mr. Digate.”, The Wall Street Journal, January 11, 2007, p. B4.
5. S. Silver, C. Bryan-Low, A. Sharma, “Motorola Profit Warning Generates Unease over CEO Zander’s Strategy”, The Wall Street Journal, January 6, 2007, p A1.
6. R. Cheng and L. Yuan, “Motorola’s Strategy to Get an Overhaul”, The Wall Street Journal, January 20, 2007, p B4.

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Appendix: The Math of Price Cuts.

While it is difficult for an outsider to know the exact initial and current effective price captured by Motorola, we can estimate that the initial retail price represented a 100% mark-up on the wholesale price. Since the 2004 retail price was $500, we can estimate the 2004 wholesale price to be $250.

At the end of 2006, other researchers indicated that the average wholesale price at the end of 2006 was $125 with a COGS of $120, yielding a miserly $5 gross margin.

If all costs are variable, the change in wholesale price from $250 to $125 would have required selling 25 units at $125 to deliver the same profit as selling 1 unit at $250.

Almost no markets have that much elasticity of demand.