In many mature markets, very often, one will find 2-4 established players representing a significant majority of the market, each consolidating their own loyal customer base behind their brand. These incumbents are occasionally challenged on price. The switching curve, as explained here, presents a method to assess the incumbents` and the challenger`s position, quantify the impact of a challenge, and derive the appropriate pricing measure in response. The article explains how branding protects the price, and how tendering disrupts branding and the switching curve rationale, how it remixes the market, and by this abolishes many of the “emotional” elements associated to a brand. The article discusses also risks and implications which result from tendering for both the customer and the supplier such as a change of focus away from innovation towards imitation.
Barriers to Switching Brands
Usually, a brand owner will enjoy a certain degree of protection with his own customer base, and unless there is not a significant advantage or benefit perceived in the offering of a challenger, a customer will stay loyal to his current supplier and brand. The customer`s reluctance to switching brands is known as the brand premium which defines how much lower on price a challenger has to go to convert a customer to his own brand or product/offering. On the other hand, a price premium defines how much more a brand owner can charge above his competitors without losing his customers. By definition, this price premium equals the value of a brand. One can think of several factors which prevent a customer from switching brands:
- Established practices
- Familiarity with a product
- Portfolio compatibilities
- Supply reliability
- Aligned commercial processes
- Prospect of innovation
- Relationship of trust
Many of these elements carry an emotional component, but some are also indeed tangible. An established track record of supply chain reliability and support in solving issues are more than just a perceived experience that leads to established trust. The same is true for a track record of innovation where a customer enjoys being partner of a supplier who invests into product and solution improvements, into better linked commercial processes, etc., all of which can, in interaction, benefit the customer, provide him with a distinctive advantage in his own market, make his own processes, products and services more efficient and distinguished.
In case of switching to a new brand and a supplier a customer`s workforce will often need to be re-trained on the use of the new brand, gain experience, before being able to employ the product properly. The customer would also need to re-align his commercial processes to the new supplier, deal with new people, different documentations, systems, etc. In the beginning, after switching to a new supplier, some disruptions are almost certain. Thus, to give up an established relationship of trust, and a positive track record and experience in exchange for a “somewhat” better price might be risky and even more costly than any benefit which results from a lower price.
That said, there still are limits to brand loyalty, mostly defined by the individual experience of each customer with his supplier/brand, the specific pressure on the customer`s budget, acute pressure and needs to reduce costs, etc. There is a (price) point where brand loyalty will end, and this price point is usually very individual.
Switching according to the S-Curve
In business economics, switching can ideally be displayed by the S-curve or sigmoid curve. Here it is employed as a mean to model switching behavior induced by pricing. In this example, the x-axis is showing the delta (discount) to the price of the incumbent starting at 0% and ending at 100%. The y-axis represents the market, with the percentage of customers/revenues being converted to another brand at each of the discounted price points – the relation of the two parameters drawing the S-curve.
Accordingly, the curve shows how many customers/revenues (in %) a price challenger can convert if he positions his product at a discount towards the incumbent`s current sales price. On the lower left side, the most price sensitive customers will only start to switch if a “certain” price benefit is seen. This lag phase of the curve equals the level of brand protection and is often referred to as the “brand premium.” The upper end of the curve displays the maximum conversion, where a total conversion will almost never be possible, and 100% hardly ever reached. Experience shows that some customers will never switch their favorite brand even if the competitive product is offered for free.
Deferred due to the brand premium, the curve will start flat showing that hardly any customers will be converted until a threshold discount level to the incumbent`s price is reached. Having reached the level of the brand premium the curve will start to rise faster and faster, and up to the point where it reaches a maximum increase with an increasing number of customers/revenues responding to lower price. Thereafter, the curve will continue to climb but, eventually, it will fall back to an increasingly smaller ascension until it flattens off completely again.
Limitations of a price challenge
Following this pattern, it becomes evident that a new entrant has the highest incentive to engage in a price game at the inflection point, the price difference with the maximum increase of the curve. Before this point, the price impact is more modest or at even much smaller price discounts indeed very modest or not even existent. After the inflection point the revenue impact starts to get smaller while the higher discounts will have an increasingly negative impact on profits and revenues. For example, if a challenger has already gone 35% below the incumbent`s price to reach 20% of conversion, he may not stop going another 5% lower to achieve 50% of conversion, but he might be reluctant to go another 20% down to reach just 60% of conversion. Thus, the optimal price range is defined, between the brand premium and somewhere after the inflection point. Such can be called the “game zone” which offers the highest impact on conversion for the lowest price difference possible. This price range will usually be in the focus of a challenger in order to convert a part of the incumbent`s customer base. The game zone will be defined by the exact parameters and shape of the curve, and costs.
That said, a reduction of a price which induces customers (and revenues) to switch has always to be seen also in relation to revenues and profits. If a challenger is attacking in a mature market which already sees low profits, his room to challenge becomes very limited. Offering even slightly lower prices might not yield sufficient profits in return. In fact, the challenger may be only destroying the market by decreasing prices. This is because the curve starts with a lag, and room for a price challenge is thereafter extremely limited in a low-margin market. That explains also why in a mature market the customer base is usually split between very few and sometimes only two established players with not much of brand switching seen at all.
The situation might change, however, if a new entrant is joining from a low-cost country with a significantly lower cost position, and with an additional room to challenge on price. In such case, the incumbent is not forced to match the challenger`s (new entrant`s) price to maintain his position, but only needs to decrease his price to that level where the curve is shifted to the right, again out of the so-called game zone, by this making the price of the challenger again unattractive to most of his own price sensitive customer base, and at the same time this may at some point discourage the challenger who may not get enough in return. It is important that the incumbent does not match the challenger`s price as this would contribute to the destruction of his own market, set a lower reference price across, and it is even not needed to successfully fight off the challenge!
Schematic display of a switching curve, showing the relationship between customers switching brands in response to a lower price. The lag phase is associated with a brand premium, the game zone defines where a price challenge makes sense, and the inflection point shows the price point with the maximum increase in switching
What is true for a mature market applies also for a growing market with more attractive margins with the only difference that the room for price challenges becomes bigger, and occasionally even established players see here an opportunity to challenge each other on price. Here again, matching the challenger`s price is to be avoided. To protect his own customer base, for the incumbent it is perfectly enough to lower the price only to the point to keep the challenger outside of the game zone
To Know your Customers: the formula and the shape of the curve
In order to predict the outcomes of a price challenge, the knowledge of the exact formula behind a switching curve is crucial. The one with a better picture of it, be it a new entrant, an established competitor or the incumbent, will have an advantage in the game. To identify the curve closest to the truth requires significant industry, business and market experience. It requires also significant insights into the customers. Usually, there will be such experience with an incumbent who has a longer and more successful presence in his own market. Remaining uncertainties can be dispersed by applying an S-curve dedicated market research aiming at identifying the exact relationship between brand loyalty and price. For a new entrant, market research will often be inevitable.
The switching curve shows that a new entrant is at significant disadvantage because he has to price lower in order to gain market share and volume. Also, there is substantial risk for the new entrant since he doesn`t know how the incumbent will react to the challenge. The price discount stays only valid if there is no reaction from the incumbent. If the incumbent, however, decreases his price in response to the attack of the challenger, then the curve will shift to the right by exactly this price decrease. For example, if the incumbent follows with a price reduction of 10%, then the game zone and the inflection will also shift to the right asking for more price reduction for the same impact. Or, in a numerical example, if the new entrant would reach the inflection point by being 50% cheaper compared with the incumbent, he would then have to be around 60% cheaper to have the same impact. That means also that his profits will decrease more. A challenge of such a magnitude might become uninteresting. Hence, the shape of the curve, a challenger`s cost position and his profit requirements as well as the incumbent`s response will define if and to what degree a price challenge will occur.
With lowering the price even more, and shifting the curve to the right, the incumbent may fight a new entrant completely off taking from him any incentive whatsoever to enter. This point is called – the point of no entry. It equals the new entrant`s profit target break-even point, from which on the new entrant would only encounter losses or not gain any substantial profits to justify the challenge. Such a defense will not come cheap to the incumbent either, because with every price decrease, profits and revenues will erode for him as well, but potentially they will still be less expressive than letting many customers go and lose a leading market position.
The incumbents` price defense strategy should be based on its own profit maximization. This means that the incumbent might be eager to keep the challenger outside of the game zone, but he may not go as far as to maintaining 0% of conversion. Is the lag phase in the beginning long? A modest response may suffice. Is the curve in the game range extremely steep? Then the response has to be strong. Is the lag phase short and the curve ascends slowly to reach the game zone? Then letting some price sensitive customers go may make better sense.
Tendering and the switching curve
The S-curve concept and its implications as shown here are exactly the reason for the occurrence of tenders, which is the case if the customer is several different entities, such as with the user and the payor being different parties on the customer side. This is often the situation in industries such as utilities, military defense systems, healthcare, etc., and where the public hand is involved. In fact, tendering aims at re-opening the market to competitors by abolishing (potentially costly) brand premiums.
While the user would indeed prefer to follow the S-curve rationale, value brand and the supplier relationship, avoid risks associated with switching, etc., the payor aims to abolish any “emotional” components of a brand which may “inflate” the price. Quality and performance of a product will still matter in a tender environment, but once this is given and somewhat guaranteed (by specifications, evaluation, and testing), and if competing products are perceived as “similar” or even “interchangeable,” the focus will be put solely on price. This can be achieved by the introduction of tenders or in extremis by the means of reverse auctions.
As tendering is often applied at an aggregated customer level, across an entire geographic area, a region or even at the national level, it consolidates the market across and can reduce the S-curve even to one single price point which becomes then valid for all customers of a market. Thus, the rationale of brand loyalty will be abolished, and defensive pricing cannot be employed any longer. There is, however, also an upside for the incumbent who, before, might have represented only a portion of the customer base but with the introduction of tendering he gets now the chance to be awarded also the customer bases of the other established brand owners which he would not have been able to challenge in a non-tender situation. Hence, sacrifices on price on his own customer base may be somewhat rewarded by gains on volume from the competitors` customer bases.
Implications of tendering for the customer
In tenders, the value of the emotional components associated to branding is, however, often underestimated. Risks associated to the supply chain reliability may not be sufficiently reflected, especially with new entrants from low-cost markets which may still need to prove their manufacturing, logistics and supply works. Further down, established processes may get disrupted and the new supplier`s processes may need to be integrated first. They may malfunction, causing trouble for the users, and put the customer`s business at risk. Often, switching costs are also underestimated as well as service and training components which might not get enough consideration in the overall tender assessment. Thus, tendering does not only abolish “emotional” elements which may “inflate” a price but often also neglects some “true value” which would indeed justify a price premium.
Although many tenders would include performance criteria and apply specifications and testing to consider only comparable offerings, it is almost impossible that they account for all components and to project all consequences related to switching brands. Much of it is only discovered after.
The value of innovation
One aspect which is often underestimated in tenders is the value of innovation which can significantly contribute to branding. A good example where branded suppliers are often charging a significant brand premium comes from non-tendered technology and consumer market, the mobile phones. Here, a brand premium is not always justified by superior performance of an actual product but rather a significant portion of it is related to the track record of innovation a brand owner can present. With mobile phones price premiums are also paid because the consumer expresses his trust in the innovation of a specific supplier. The consumer can expect updates, new applications, regularly improved devices, compatibility, service/support, etc., all of it based on the strong track record of innovation of the manufacturer. Or, in other words, if everyone knew that a provider`s technology would be outdated soon, hardly anyone would be paying that premium, as it was seen with several suppliers which first lost the edge, and then the market. For the consumer, loyalty to a system and supplier may pay off with always staying up to date along with the latest and most advanced brand. The price premium as such becomes a ticket to a journey of innovation. And indeed, leading mobile device brands are investing much of the profits from their brand premiums into fueling innovation. Thus, innovation becomes a major factor around building a strong branding.
On the other hand, switching to cheaper, non-branded devices may soon cut off a consumer from this flow of innovation. The investment in practice, knowledge and experience with a specific system might be disrupted, and new investments in gaining knowledge with another system will be needed while the new supplier would still need to give proof of innovation, and a perspective for the future. This may make many consumers reluctant to switch from a branded to a non-branded technology even if the price might be tempting and a device performs at equal levels.
What is true for technology and the consumer markets is also valid for many other industries and any market where innovation is involved. While in tenders, the focus is often put at the actual product and the current pricing, the innovation track record of a supplier can be heavily disregarded. This albeit it is widely accepted that customers benefit and perform better if they engage with innovative suppliers. One reason for this omission is that innovation is something of a prospect and as such somehow speculative. Hence, it can be easily seen as “just emotional.” Indeed, the only proof which can be provided here are the supplier`s track record and his financial power to invest further into innovation.
For branded suppliers, even if tendering addresses mostly established products, and not any highly innovative or even patent-protected ones, tendering can severely reduce profits on their core business pillars. For a brand owner, profits from such high-volume, mainstream products are often the main source to fuel innovation because other innovative and emerging products of the portfolio may not have the uptake yet, to contribute significantly to the business. If profits on the cash cows get reduced, innovation will suffer. Further, innovation occurs often in a close partnership between the supplier and the customer. If this relationship gets disrupted or is seen at risk, as it is with tenders, the supplier may be reluctant to invest. Hence, innovation will be slowed down while at the same time the focus will shift towards imitation. In a tender environment the attention will be put on the minimum requirement and on reducing any costs which may be associated to anything not being perceived as of value or being rewarded accordingly. For brand owners, tenders mean usually a big step back, and a complete change of the game.
In summary, while in a non-tendered market brand premium will protect prices and brand owners, tendering opens the market to all parties, including the competitors with a low-cost position and weak branding. By abolishing emotional price components related to an offering, tenders reduce the market request to a very homogenic and basic one. This causes brand owners to decrease their engagement, services, etc. in order to lower their costs and turn more price competitive. Hence, in a tendering environment, an innovative incumbent may be more forced to adapt to an imitating challenger than vice versa. Through tendering, the customer may indeed benefit from lower prices but at the cost of his supply of innovation, process improvements, and other advantages, all of which a brand would usually bring along.