The hidden cost of price cuts

Price wars are on the up all over Europe, says a new survey. But they may be impossible to win.

Last Updated: 31 Aug 2010

A hefty 52% of firms across Europe were involved in a price war last year, says a report from marketing consultants Simon, Kutcher & Partners. 1,200 senior execs in eight countries were polled, with the results suggesting that the front line of the battle is to be found in Spain, where 63% report donning their commercial tin-hats for a price war during the course of 2009.

The Netherlands and Germany manage rather better at 56% and 51% respectively, while the good news here in Blighty is that a ‘mere’ 36% say they have been involved in a price war recently. Although as the precise definition of the phrase is unclear, it may just be that Brits are more used to the rough and tumble of competition than some of our European oppos. One thing unites them all: 95% say that it wasn’t their fault and that battle was engaged by a rival firm. One person’s price war is another’s sales volume protection, after all…

Now, we know some of you will be thinking that this is another example of research from the Department of the Bleedin’ Obvious: as demand falls, of course prices come down in a recession. But bear with us, there are more subtle and much more significant corollaries to this central fact.

For one thing, price wars may be easy to get into but they are very hard to get out of, and even the ostensible ‘winners’ can find themselves in a worse position than they were at the outset – selling the same stuff only for a much tighter margin, facing the giant task of pushing prices back up again. That’s before we even start to think about what kind of message round after round of price cuts sends to customers about the quality of your offering, or whether the business is even capable of sustaining itself at ever-lower price points.

Which makes it all the more alarming that, despite the apparent prevalence of price wars, it seems the economics of pricing are but dimly understood. As any good economics student will tell you, the relationship between price and profit is governed by a larger multiple than just about any other in business. For example, a rise in fixed costs of 10% reduces profit by, you guessed it, 10%. But cutting prices by the same 10% reduces profit by a whopping 50%.  Ouch. 

Shame then that 74% of those polled strongly underestimated this factor. Only a miserable 4% got it spot on.  The rest had better line up outside the FD's office for six of the best with a slide rule.

At MT we reckon that psychology as well as economics is at work here. Companies prefer to squeeze costs rather than maintain prices because they think it’s easier to dictate to suppliers and employees than it is to customers, who can generally buy elsewhere if they choose.

But people will pay a premium for a product or service which best meets their needs, even in hard times. Surely getting that magic pricing multiple working for rather than against you is a better use of management time than shaving a few more quid off the stationery budget?

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