Lately I have been asked a common question, “We’re in a recession and my volume is off; should I lower prices?” Of course, the answer is never simple, but there are a number of questions that can help us think through the problem and come up with a reasonable answer.
- What is happening with prices in general? What is happening with your raw material prices? Although the Producer Price Index is often quoted as a single number, it is made up of thousands of price indexes for commodities and labor. It is important to consider what is happening to your raw material and labor costs. If your costs are not decreasing, any price decreases you offer will just lower your profit, and those price decreases may be a greater reflection of your fear rather than the real market dynamics.
- What is happening with demand for the types of products you sell? If demand is decreasing, will it be stimulated with lower prices? How do you know? I think about the restaurant business as an instructive example. We have read how much restaurants are hurting due to a dramatic reduction in the number of diners. Some chains have lowered prices to try to win more business, but what they are getting are lower margins and fewer diners. It appears that people are not choosing between restaurant options based on price, they are choosing not to eat out at all. In that case, lowering prices just further lowers profitability. Conversely, those that choose to eat at restaurants do seem to be ordering less of the higher priced wines. In that situation, rather than reducing your prices on high-end wines, consider offering fewer of those and adding more moderately priced wines.
- What is happening with supply? If the supply of products in the market is still as high as it was when demand was more robust, prices will most likely have to decrease to reach economic equilibrium. However, market supply is a broad concept, and there are often many micro markets within the broad market. If some of the micro markets have a more balanced supply/ demand equation, it would be unnecessarily costly to reduce prices in those balanced micro markets.
- Can you help balance the supply/ demand equation by reducing supply? This is obviously more relevant to firms that make up a larger part of the market, but it is exactly what OPEC does. When demand falls, oil prices come down, but the OPEC members try to offset that by restricting output.
- Are your competitors lowering their prices? Are they winning more market share? Clearly if your competitors are taking market share from you with lower prices, you will have to react. But if competitors are not lowering their prices, do you really want to lead the market down? You will only be able to take market share if you have a cost advantage and the competitors can’t match your price moves. If you have cost parity, and everyone lowers prices but volumes don’t increase, the result will be lower profits for all.
- If competitors are lowering prices, are they doing it for all customers and all geographies? Are they lowering prices on all products? Is the product a stripped-down or generic version? Are you competitors changing product availability or service levels to partly offset the lower prices? Be careful that you don’t misinterpret competitor actions and react broadly to some moves that were targeted or inadvertent.
- Are the lower prices you are contemplating or seeing from your competitors greater than your incremental variable cost? That means you have a cost to acquire a product or make it, plus handling, shipping, selling, invoicing and other indirect costs that you will only incur if you make or sell a product. If the prices you are contemplating are not even that high, don’t do it. Each sale would further detract from your profitability, rather than add to it.
These are just some of the questions that should be asked if you are thinking of lowering prices because of the recession.
Beyond those questions, don’t forget the sound pricing principles that apply in boom and bust times. Not all customers are equally price sensitive and you should not treat them as if they are. Odds are you already have the data to let you determine which customers are price sensitive versus service oriented, versus relationship driven. Make sure you understand who is who. Similarly, customers are not equally price sensitive on all products. Make sure you understand which is which.
- Maintain discipline in your process. It is common and easy for your sales team to be fearful of losing volume and give out discounts freely. Even if your overall price levels come down, it is important to be disciplined and monitor which customers are getting which discounts and why. Offering discounts in situations that do not warrant them is wasteful.
- Service the heck out of your customers that value service. The more your customers feel like you serve all their needs and they like doing business with you, the less anxious they will be to look for lower prices or to switch suppliers.
- Make it a two-sided bargain. If you have to make price concessions, ask for something in return. Each time you grant a price concession to a customer, you are reinforcing the statement “Ask and ye shall receive”. So get something in a trade-off for the concession, such as a larger order, incremental volume, product extensions, quicker payments, etc.