Sunday, September 05, 2010

Price-Cutting

As a consumer, I am a huge fan of all forms of price-cutting and discounting. As a student of business, however, I often wonder about them. This article about Pizza Hut says that they have cut prices across-the-board, and business is up as much as 10%. But does that really pay?

Net profit margins are typically pretty thin. Gross profits margins are somewhat better, but still, if you look at the math, it is tough to see the payoff. If you have a gross margin of 50%, and you cut prices by 15% (which I think it the minimum to be really noticeable), then business has to increase by over 40% before you break even. (The narrower the gross margin, the more unfavorable the math, of course--because your price cut comes off the top.)

Just to make the picuture bleaker, that is a purely static, purely quantitative analysis. Competitors will almost invariably respond to price cuts. So unless you think you have a strong and sustainable cost advantage, and you think you can permanently claim market share from your competitors (e.g., Wal-Mart), all you are likely to do is incite a price war. From the brand-equity side, any form of discounting and price-cutting tends to sully the brand.

Like I say, as a consumer, I love this kind of competition. But when I think back to strategy books I have read, such as Michael Porter's stuff, it seems mis-guided. Something I heard in business school has always stuck with me:
 In an extended simulation exercise, CEOs would sacrifice up to half of annual profitability, in order to "win"--with winning defined in terms of market share.
I think Apple would be the ideal counter-example to this behavior.

I have searched for citations of this study, and never been able to find them. So for all I know, this is apocryphal. However, it certainly rings true to me. I have some theories to explain it...in part, I think it is tied to male over-competitiveness (most CEOs being male). I also think is an interesting question as to whether the economy and society, as a whole, are better off or not, for this behavior. Those will have to be blog posts for another day.

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