Pricing Followers

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Pricing strategies for market followers

by

Jean EstinPresident, Estin & Co

Pricing strategies for market leaders are simple (see article of January 20021):

- Reduce prices to win market share (where economies of scale are high);- Or optimize prices and margins according to supply-and-demand cycles (in areas where

structural costs are very similar amongst competitors).

These strategies depend on the type of business concerned and must be optimized on the basis

of direct and indirect competitors' costs, not just on those of the market leader. Any strategythat is not consistent with the type of business activity concerned will prove fatal. Any pricingpolicy based on the costs of the market leader rather than on those of competitors isexpensive, because it is under-optimized (see article referred to above).

The generic strategies for market followers (competitors whose market share is significantlylower than that of the market leader) are also few in number. Unlike those open to the marketleader, they are independent of business type.

Whether or not the market share has a value, the market follower can never compete directlyacross the board with the market leader on the basis of price. If the market followers costs arehigher than those of the leader, such a strategy is too expensive and unsustainable in themedium-term. If their costs are identical because there are no economies of scale involved,

such a price reduction strategy will be worthless.Except on rare occasions, the market follower has no ability to influence average marketprices (unless, as a marginal player, it closes its production capacity completely or, as amajor player no. 2 or 3 in the market it increases or decreases its production capacitysignificantly).

Market followers therefore have only three real strategies.

1. To catch the market leader napping

This first strategy is simple and risky. It is based on the assumption that the market leader isbadly managed and can be rapidly overtaken. It consists of lowering prices faster than themarket leader to gain market share at the latters expense.

Conducted head-on and consistently, such a strategy is expensive and has little chance ofsuccess. In most cases, it simply leads to a price war that proves expensive for both playersand/or results in market followers with high cost levels running out of steam unless theysubsidize their policy with margins made in other areas of the business.

It is all the more risky when the market is mature and enjoys low growth. It can only succeedin high-growth business sectors.

1 Published in la Jaune et la Rouge, November 2002


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2. Individualizing costs and re-segmenting the market

The market leaders strength lies in that companys ability to control the core of a market andoffer the most competitive range to that core market, whilst covering the other marketsegments to a greater or lesser degree.

This strength is also its weakest point, since it is always difficult to maintain a range that isequally suited to every segment of an established market. It is even more difficult to identifythe specific costs (production, service, logistics, marketing, image, etc.) attributable to thesesegments and to set the corresponding prices in a sufficiently differentiated way.

The costs involved in managing the complexities of a broad product range, a varied portfolioof customers and geographical areas, special products and services and limited-production runitems are often averaged across total sales and not fully allocated to the products andcustomers responsible for generating them. Where costs are allocated correctly to customers,it can be seen that some of them generate very high margins (higher, in fact, than managementcontrols would suggest), whilst others, despite appearing profitable, are actually seen to makeheavy losses when the complexity they generate is fully and correctly allocated.

A market follower specializing in particular customers or products may have more adaptedand more clearly identified costs and prices (see table 1).

In simple segments, the market follower can then set prices lower than those of the marketleader, whilst still remaining profitable. That company will then gradually squeeze the marketleader out of these segments.

It would be even easier to put the market leader out of these segments as the latter sees itsmargins and market share falling (and its sales teams start talking about competitors dumpingproducts on the market), whilst on the other hand, its sales teams and customers stress thecommercial value of its products and services and the strength of demand in more complexsegments (especially since none of them are paying the price for this complexity!).

Eventually, the market will become segmented and the market follower will have established

a position of profitable leadership amongst simple products and customers by pushing andmarginalizing the market leader into more complex, low-margin customers, products andservices.

The areas in which such a strategy may be applied are limitless: broad and varied productranges (with different levels of complexity, different stock rotation periods, small or largeproduction runs), different service levels (delivery times, payment terms, installation costs,preliminary studies, etc.), varied customer types (small customers vs. key accounts, etc.),multiple access channels, different geographical areas (different transport costs, differentmarketing costs and different price levels as a result of specific competitive balances),distribution networks (air, rail, etc.) with different densities and traffic types, etc.

Such strategies systematically exploit the headroom on margins that exists in any givenmarket. Market followers in any industry must understand this concept of margin headroomand appreciate the relative delivered price and cost positions for each customer whencomparing itself with the market leader .

Gaining this level of understanding requires ad-hoc investment in analysis (detailed costanalyses to a level beyond that normally used for management control, quantifying the costsgenerated by short production runs, low stock rotation, special modifications, indirectmanagement costs, etc., benchmarking and modeling competitors cost structures, etc.).

This opportunity may be grasped not only when the market leader has a poor perception of itsown costs (which are too high due to poor allocation), but also when those costs are genuinelynon-competitive in the segments concerned.

One example of such a strategy would be to analyze the total landed costs for a given

customer and compare them with those of the market leader by geographical area (where


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transport and sales and marketing costs are significant), or even by major customer in order toidentify the consequent headroom on margins and the corresponding targets (see table 2).

These approaches require an understanding of structurally different production costs,transport costs and marketing costs by geographic area for both market leader and marketfollower.

Such strategies are applicable to a range of product areas (chemical products, cementproducts, building products, etc.) where the transportation costs represents a significantproportion of total costs. Profitable market conquest strategies involving differentiated pricingpolicies can then be implemented by geographical area or even customer-by-customer.

Another example is in P&C (property and casualty) insurance where detailed analysis of therisks, the costs imposed by both front- and back-office has enabled new market entrants toidentify and conquer niche markets (customers with very high car insurance policy surchargesand household insurance for high-risk urban areas) by offering prices below those of themarket-leading general insurers. These specialist players are profitably eroding thehistorically strong positions of the market leaders, segmentby-segment.

3. Individualizing value and re-segmenting the market

The same strategy of individualization can be applied to value as well as to costs.

A market leader that controls the core of its own market may find it difficult to understand theindividual considerations that make certain customers value in particular product niches,distribution channels, quality levels and service levels.

Market leaders' ranges and prices tend to be too uniform, ignoring the fact that somecustomers are willing to pay significantly more in return for the right range of tailoredproducts and services. Leaders may not always be interested in doing so, since they may(rightly or wrongly) see these specialist segments as being too complex to manage in relationto the potential benefits.

A market follower may therefore offer more closely-tailored products and services in return

for price premiums that are way above the cost of making such specialist adaptations (seetable 3).

The market leader will often find it difficult to react to such a strategy, being reluctant toincrease product and/or service range complexity or to create an entirely new and specialistarea of activity.

Conversely, the market follower may offer a range of products or a business concept thatshort-circuits part of the market leaders cost chain and radically changes the nature of theindustry: simplified access channels in financial services (mutual insurance societies;telephone and online banking, etc.), discounters and low cost operators in retailing and airtravel, etc.

Market leaders will either have a hard time or be late in reacting, since the new approach risks

cannibalizing its existing cost and investment structures.Such strategies may be applied in an unlimited number of business areas (broad-rangemanufactured products, transport, services, consumer goods, fashion, luxury goods, etc.), withthe ultimate value depending as much, if not more, on the type of customer as the type of

product or service: high or low price sensitivity, value of different service levels, value ofproximity and commercial intensity, value of quality and those factors that define quality,the value of innovation, actual value of the brand, etc.

As before, this strategy also requires ad-hoc investment in analysis to provide a factualunderstanding of those aspects of the range which are actually valued (or not) by specificcustomer segments.

Trade-off analyses provide a quantitative measurement of the value of different product

offers (including service, price, access mode, brand, etc.) for a specific customer segment and


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supply the building blocks required to redefine a more closely-tailored product offer andprice.

The critical issue for market followers (as for the market leader) is to use their knowledge ofcustomer preferences to determine if the new approach, whether premium- or discount-based,is likely to capture between 20 and 25% of the market (or more), or whether it will remain

marginal.

4. Conclusion

Individualizing costs and/or value by re-segmenting the market and setting pricessignificantly lower or higher than the market are both effective survival (and even success)strategies for market followers.

They enable market followers to raise their structural profitability to the same level as themarket leader (and sometimes higher), but on lower volumes.

As is always the case with strategies, the worst outcome is to copy the market leader andfollow the industry average.

Jean Estin

May 2003

Estin & Co is an international strategy consulting firm with offices in Paris, London andGeneva. It specializes in assisting CEOs and senior executives of European and North

American corporations in the formulation and implementation of growth strategies.


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Table 1

- Individualizing costs and prices -

The market leader is gradually squeezed out of the simple segments by the specialistmarket follower and pushed towards complex, non-profitable segments.The leader loses market share and sees average costs rise much faster than prices

Unit price andcosts

Market leader price

Apparent costs

Actual costs

Highcomplexity

Lowcomplexity

Range of products, services and customers

The market leader offersproducts and services at a price

that does not reflect its true costs.Customers and sales teams stress

the demand for such productsand services

(for good reason!)

The market leader offersproducts and services at a price

that does not reflect its true costs.Customers and sales teams stress

the demand for such productsand services

(for good reason!)

The actual costs are well

below market prices. A specialistmarket follower can offer prices

lower than those of the leaderand win market share,

whilst remaining profitable

The actual costs are well

below market prices. A specialistmarket follower can offer prices

lower than those of the leaderand win market share,

whilst remaining profitable

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Market follower price


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Table 2

- Individualizing customer landed costs -

Market leadersplant

ESTIN& CO

Market leaders zone ofcompetitive advantage

x

Market followers zone of

competitive advantage

Zone of equalcompetitiveness

Marketfollowers

plant

x


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Table 3

- Individualizing value -

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"Premium"market

follower

Price

Product B speciallydesigned for a

customer niche

Product A withmarginal

modifications and

produced in shortproduction runs

Product Acore market

Costs

Marketleader

Price

Product Clow cost

Costs

"Discount"Market

followerPrice

- What costs and investment structures are required?

- How does the customer value each aspect of the product, service, channel and brand?

- What is the best compromise and therefore the best proposition for each customersegment?

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Pricing Followers