Don’t see an immediate need for defensive pricing? Demand is good, and competitors are behaving reasonably? But what if the economy should experience a material downturn? This article describes the pricing logic and capabilities which can protect a business and its pricing from competitor attack. Rob Docters has been Lecturer in Management at Yale School of Management, teaching pricing. Before that, he led BCG’s Asia/Pacific pricing practice, based in Singapore. He has also been a Senior Partner at Ernst & Young Canada. He is now Partner Emeritus at Abbey Road Associates, and can be reached at RDocters@AbbeyLLP.com.

The Journal of Professional Pricing, March 2020

There is no ideal price for a product or service. While it would be convenient to have an ideal price, this is unlikely to reflect the different needs of the business over time. In most industries, competition varies in intensity and focus both unexpectedly and frequently. This article describes the pricing logic and capabilities which can protect a business and its pricing from competitor attack.

Don’t see an immediate need for defensive pricing?  Demand is good, and competitors are behaving reasonably?  But what if the economy should experience a material downturn?  The recent stock market correction may presage a downturn, and even without a virus pandemic such an event is considered likely by observers such as The Economist and Wall Street ^[1][1].  If so, defensive pricing will become more important. Typically, in a recession there would be a reduction in demand, and a fight for the surviving client spend.  Price might be a lever used by some players, and overall price levels generally suffer.

Yet even without a downturn, defensive pricing may be necessary to preserve a lucrative business model.

Case Example

An excellent example of defensive pricing comes from the leading South African equipment leasing firm. As you might expect from a natural resource-based economy, the company’s core clientele is mining companies who need aerial work platforms and loaders for operations. The need for this equipment varies with activity levels, e.g. blasting new veins or inspecting retaining walls.

Initially, this company priced based on its costs. Long-term leased equipment enjoyed low rates, because utilization was high, so amortization and unit training costs and related expenses were low per vehicle. ^[2] Short term rentals were priced higher per day because they did not enjoy these cost advantages.

Unfortunately, however, this structure paved the road for competitive entry. Competitors were able to undercut the daily rates of marginal equipment. Once they had a toehold at a customer site, they were able to learn about the overall equipment needs, build relationships, and compete for core long-term machinery lease. While it meant offering equipment at marginal prices, this was well worth the opportunity to invade.

After noticing the increasing number of competitive inroads, the leasing company reconsidered its pricing. To avoid making it attractive for customers to use competitors for daily equipment rentals (peak load requirements) the company embarked on two strategies.

First, it rebalanced the two categories of pricing. It lowered the daily rates and increased the baseline yearly rentals to preserve profitability. This made customers less likely to invite in competitors.

The rebalance did cost some 2% of revenues, but this was a reasonable investment. Losses were offset somewhat by increased daily lease volume. More importantly, it would have taken only one major competitive loss to equal eight years of the revenue impact.

Next, the company migrated their largest customers to a “requirements” contract. This meant that, based on joint planning with the customer, one fixed rental amount would cover all the equipment needed. Effectively blending the two rates and changing volumes from per-aerial lift to per-customer site meant that competitors could not make an effective price argument. Since the company had relatively good service, this meant that competitors were closed out.

Tailor your offer package for defense and downturn

If customer spending is constrained, your company will be faced with several challenges. Often, in a downturn, companies shift their spending from new investment (capital dollars) to maintenance (expense dollars). This means that sellers with growth goals must capture customer expense budgets for new revenues. As an example, one leading data vendor reduced the price of its databases and increased the yearly “maintenance” fees for updates and software fixes/patches.

The competitor response was predictable: point up the higher maintenance fees. But this did not matter as the initial capital cost dominated the buyer decisions. Critically, the success of this tactic depends on the strength of the linkage of the two services. Where the capital and the expense can be separated (e.g. in fleet leasing and maintenance) a different strategy is required.

Another defense strategy which can work well is bundling. For defensive pricing, the idea is to link together weaker offers (which are likely to be cut) with a stronger offer which is indispensable. An example of this comes from the Belgian legal publishing market, were the market leader linked its flagship products with three weaker products. This boosted the volume of the weaker products so that overall the bundle improved revenues of Company A’s offer by almost a third. (See illustration, where each dot represents $10 of revenue, and the inner box on the right shows the bundle.)

The core of this strategy is that “must have” products could not be cut, so the bundle could not be cut. Customers ended up cutting products from the competitors. Thus, in this illustration of the actual market evolution, the leader ended up increasing revenues and the weaker competitors suffered.

There were some tactics the competitors might have used to counter the leader’s strategy. However, they were late to the game. First movers have an advantage, because when (new, lower) budgets are set, it is very difficult to reset them according to new bundle offers. Budgets often cross company divisions, and rarely can a vendor organize a re-set. Additionally, good bundling is a skill, which requires both practice and some statistical skills in which many management teams are often lacking.

Price structures are central to defensive pricing. Another familiar example of defensive pricing comes from online retail. Amazon’s Prime plan helps foreclose competitors through “free” shipping on any given order. This is important because one study found that most of Amazon offers could be obtained more cheaply through another vendor.^[3]

By creating a structure where the charge (the annual fee) is separated from the purchase, Amazon has enforced a skewed comparison. You do pay for the shipping, but that is not discernable when you compare (e.g.) Etsy’s 19.5 inch Mayan Arts Turquois necklace for $44 to Amazon’s identical offer for $44. If price is the deciding factor, a Prime member will choose the Amazon purchase because shipping appears to be free or a sunk cost.

Points of failure

A common point of failure in defense is using price tiering. This is because defensive price tiers tend to actually encourage lower spending. A global packaged goods company based in the UK sought to tier its skin lotion offers so that consumers had a choice of how much to spend. Different price levels corresponded with graduated amounts of product. After experiments in several Asian countries, they scrapped the new structure. Customers bought – and paid – less than before!

A conceptual challenge for businesses in defending their revenues is moving from a desire to scale (i.e. grow homogenously) the business, to measuring share and pricing success by market relevant units no matter how small or heterogeneous. For instance, one national hardware chain was focused on store growth and filling in contiguous markets. However, when a larger competitor started expanding by opening stores in the same towns, the focus shifted to defense. In that case, the chain identified a group of products which were used by shoppers to compare pricing. They lowered those prices but left the other pricing intact. This proved effective in blunting competition and seemed to divert competition to other geographies.

Implementation of such a plan is not easy. For instance, in the case of the hardware chain, they had to decentralize some of the purchasing and procurement functions. Headquarters was not familiar with local needs and focus while store managers were. However, store managers did not have deep functional expertise. Further, local management did not have access to the information used by headquarters planners. This meant that newer, more user-friendly inventory and market systems needed to be developed, and store managers need to be taught and encouraged to use those systems.

Capabilities

This evolution of pricing decision-making is more difficult than many managers expect. New systems and tools are often not greeted with enthusiasm. At one company, uptake of a proven tool ran less than 15% of target users on the first try. In addition, they had to unlearn some managerial habits. Local managers were much more prone to drop prices as a response to competitors compared with the central pricers.

Three tactics which help build capabilities and improve success are:

• Formally pairing central pricers with local managers so each learns from the other,
• Making comparisons across geographies, with consequences for local management if they drop prices disproportionately, and
• Structuring review and compensation to discourage price drops, but not preclude them, and ensuring responsible management is sophisticated enough to execute in a controlled manner.

A related tool which assists this process is usable market segmentation with clear distinctions between promotional tools and ongoing pricing.

An excellent example of sophisticated management comes from the The Coca-Cola Company. Just before the Great Recession, Coke had invested in a new “World of Coca-Cola” pavilion. When the recession hit, the question arose whether to drop admission prices in order to preserve traffic. Fortunately, Coke had performed a segmentation of visitors, which showed that only a few classes of visitors were steered by admission price. Others, such as out-of-town visitors, saw the admission price in the context of airfares to Atlanta and other factors, which meant that varying admission price by a few dollars would not impact customer choices. For instance, on top of a $1,300 airfare, a $10 change in price would not lead a visitor to switch from the World of Coca-Cola to a botanical garden.

For the segments which were price sensitive, Coke had already engineered price breaks which made the exhibit less pricey. One example aimed at local visitors was a discount if you brought an empty bottle in for recycling. Coca-Cola’s segmentation and price approach proved correct, as visitor counts did not change unreasonably during the recession.

The broader capability challenge is how to convert the entire organization into an agile organization which can spin from broad market share gain initiatives to surgical defensive strikes. Simply asking market managers to focus on defense will not usually accomplish the objective. Management spans of control, market research and data, and support are probably optimized for broad strokes. Many believe that a focus on surgical market initiatives is not possible without an unwelcome increase in management headcount. The solution to the challenge, however, lies in delegation. Senior marketers must be able to focus on vulnerable markets while remaining confident they can delegate other routine tasks to their teams.^[4]

This means having the courage to split pricing policies by new criteria. A famous example of this comes from the airline industry. When a new competitor tackled American Airlines and United Airlines on the Chicago—Phoenix route, there was a notable difference in defensive pricing tactics. American lowered prices for all flights leaving within an hour of the competitor, and so minimized the revenue damage, and the impression of a price level collapse. United responded less adroitly by lowering the price of all of its flights to Phoenix. Both actions discouraged the new competitor, but the American response was best practice. It divided price actions by a new factor: adjacency of a particular competitor. Previously, pricing had been based broadly on city pair and another competitor’s general pricing.

Conclusion

Does your company have the ability to effect defensive pricing in an optimum way? This is difficult to know without a test. Obstacles may emerge from any number of steps in the pricing chain: systems, managers, media, sales or product management. The first step in building the necessary capability is to conduct a market trial. Scenario planning is a useful foundation for this. Where do you expect the greatest pain when the market turns? Testing a narrow price change with narrowcast messaging means that the trial does not need to be expensive or risky.

One aspect of such a trial is to understand competitor reactions. For instance, do they understand the purpose of the trial? Who in the competitor management structure is the likely source of a price reaction, and can they be “trusted” not to over-react? Where approved by legal counsel, messages to shareholders can be a good mechanism for communicating and framing the test to competitors. If not that, another approach such as a geography or channel, must be developed and tested. Don’t wait until it is too late.

1. [1] “The Market Surged Last Year. Don’t Expect the Same in 2020”, New York Times, Section B, p. 2, January 2, 2020.  “Christmas Bonus.  The causes of a booming stock market are unlikely to last through 2020,”  The Economist, January 4^th, 2020, p. 51.↑
2. Client company records tracking fully allocated and incremental cash costs (disguised), 2017. ↑
3. Laura Heller, “Whey Amazon is isn’t always the cheapest,” Forbes, May 27, 2016 ↑
4. See R. Docters, M. Barzelay, Contextual Pricing, McGraw-Hill (2011), Chapter 13. ↑