Countering Falling Prices with StrategyStreet

by Donald Potter

A low-end competitor is like a shark. It can appear unexpectedly from below, churning the waters by offering big savings to customers, taking a bite out of comfortable profits, and disrupting established ways of doing business. In its wake it can leave devastated industry leaders, flattened profits, and sometimes disgruntled customers.

No company is immune to such an attack, and most managers will face at least one and likely many during their careers. If there is a defense, it lies in knowledge – knowing what form the attack is likely to take, what conditions will encourage it to happen, and what response will be quickest and most effective in restoring market calm.

THE DYNAMICS OF A LOW COST ATTACK

Every industry has one or more Standard Leaders – large competitors who set the benchmarks for performance and price in the market. Typically a Standard Leader sells a mix of products that roughly mirrors the volume of sales in the industry. The most common price point in the market is the Standard Leader price point. There may be several price points above and below that price point. The total of all Standard Leader products controls from 35 to 80 percent of the total industry sales volume. General Motors fills this role in the automobile industry, Hewlett-Packard in personal computers, and Kellogg in breakfast cereals.

It is these Standard Leaders, or more precisely their sales volume, that the Low-End Competitor targets. The concept is simple: a competitor offers a substantially lower price point – usually 20 percent or more off the standard. In mainframe memory storage, EMC became a leader by cutting prices per unit of memory by 25 percent. The successful personal computer clones of the late-80s under-priced IBM by 30 percent or more. Cott sells private label colas and other soft drinks for at least 25 percent less than Coke and Pepsi. In the early 90s, Taiwanese knockoffs of Rollerblade's in-line skates were priced as much as 75 percent below standard. Private label breakfast cereals may command prices only half of those of the industry Standard Leaders. Where their price discounts are less than 20 percent off the Standard Leader product, successful Low-End Competitors offer a comparable customer cost savings in the acquisition or use of the product. For example, in the mid-80s MinitLube offered oil changes at a price only slightly below that of service stations, but the oil changes were completed in ten minutes, saving a customer the time and inconvenience of dropping off and picking up the car.

Of course, a Low-End Competitor nearly always has to make some reduction in customer benefits to lower its own cost and enable it to make a profit. An analysis we did on over 400 industries showed that less than 10 percent of publicly held corporations have pre-tax margins above 20 percent of sales; nine percent is the average. Few companies could afford to drop prices by even 10% without wiping out their profits – unless they reduced customer benefits at the same time.

What benefits can a low-cost competitor trim? There are three types of performance benefits: Function, Convenience and Reliability. Only the first two of these offer significant immediate savings opportunities.

• 
  Function
  refers to the characteristics of a product that affect how the customer uses it. In a manufactured or service product, it includes such aspects as size, power, speed, and styling – think of electronic fuel injection on a marine engine, processing speed on a personal computer and an ocean view at a resort. In a retail or distribution business, Function includes the choice of products customers may purchase and the ambience of the physical store or outlet. Examples include Timberland shoes sold at Nordstrom's, Owens-Corning insulation sold by a contractor/installer and the tuxedo-clad pianist at an upscale food court.

  Providing functionality in manufacturing entails the cost of purchased materials, labor, and capital investments. In retail or distribution, it encompasses the cost of the products offered and store improvements to create ambience – all of which can be significant.

• 
  Convenience
  refers to the ease of acquisition and installation, so that a customer can move quickly from wanting the product to using it.

  To offer Convenience, a company spends money on advertising to build customer awareness and to differentiate its product from others. It also spends to make the product readily available, by maintaining a sales force and specialized distribution or by operating retail outlets close to the customer. Again, these can be significant costs.

• 
  Reliability
  refers to the consistency with which the company keeps its promises. In a manufactured product, that means the product performs as promised, that the product will be delivered to the channel of distribution as promised and that the producer will maintain a consistent market presence with end-users and channels over time. In a retail and distribution business, it means that the range of products available to a customer will be predictably available, stock-outs will be minimal, and that returns and credits will be handled amiably.

  Reliability is most often part of a corporate culture, built over time by hiring and training good employees and building an appreciation for quality and good, predictable operations. A company can not easily cut the costs of reliability.

A low-cost competitor, then, is most likely to offset its low price by reducing functionality, convenience, or both. We have reviewed our work experiences as well as publicly available data from the last fifteen years on Low-End competitors to find patterns in the way they compete. And, although there would seem to be many possible combinations of price, functionality, and convenience that could be employed, our research suggests that a low cost competitor is most likely to be successful employing one of four strategies:

Stripper

Strippers offer a bare-bones product or service, reduced in Function, and, usually in Convenience as well. The substantial price reductions these products offer appeal to the most price sensitive consumers. Strippers, as a group, typically achieve only a modest market share -rarely as much as 30 percent and more often below 15 percent of market volume.

Competition from Strippers can appear wherever there is an opportunity to provide a basic product with cheaper components making up the functional benefits or with fewer functions or distinctly less convenience. They seem to be most common in service and distribution businesses where the industry leaders are particularly committed to their industry standard products.

JetBlue is a Stripper Product. It offers very limited choice of flights. It flies into secondary airports in large markets and serves only a small part of the domestic market.

Motel 6 is a Stripper Product. The company cut out features that the average business traveler wants, such as amenities and room service, and also built its motels outside major city centers, making them less convenient for business users. Yet what they offer, and their low price, was sufficiently attractive for senior citizens, military personnel, and others on a limited budget. Motel 6 is profitable because the company enjoys very low costs. They buy inexpensive land and can build a room for one quarter the cost of a traditional motel room. That enables Motel 6 to undercut its rivals' rates by up to 40 percent.

Costco discount stores are also examples of Stripper products. This chain of membership warehouse stores sells high quality, primarily nationally branded, merchandise at very low prices to businesses and individuals. However, the product choice it offers is a very small fraction of that of Wal-Mart or even of the average grocery store.

Predator

Predators offer a product with functions equivalent to those of the industry standard leader but at a lower price, which is possible because they can achieve a distinct cost advantage over the industry Standard Leader.

That can occur when the industry leader holds up a price umbrella. Predators often appear in industries with high sales, general and administrative expenses, including those with high research and development costs, high costs of maintaining brand names, or high expectations for product profitability. A long-term industry leader may have allowed its prices to rise to such a level that a relatively unknown company may simply produce a comparable product, using its own brand, and sell it profitably at lower prices than those charged by the industry leader. Clone personal computers in the early 1990's offer an example. IBM, the Standard Leader, maintained prices high enough to allow clone producers such as Dell, AST, Packard Bell, and many others, to offer comparable function benefits at prices 25-50 percent lower than Standard Leader IBM. Today, companies like AMD in semiconductors, Drypers in disposable diapers and Men's Wearhouse in apparel retailing follow the same formula.

More often, the Predator company exploits the brand name of a powerful distribution partner. Private label manufacturers such as Dean Foods in dairy, Ralcorp in breakfast cereals and Perrigo in non-prescription drugs, use this approach. In all these cases, the customer gives up the convenience benefits of widespread availability and of the manufacturer's substantial advertising to create awareness.

A Predator might find a different and lower cost approach to providing a product comparable to that of the Standard Leader. On occasion, a company develops a new, low cost technology for the industry's lower priced products. Throughout the 1980s and 1990s, Nucor grew into a power in the steel industry by using a low cost scrap metal-based manufacturing process to make basic products, such as reinforcing bars.

In another model, some companies rely on third party or government subsidies to reduce their costs below those of the Standard Leader. The free internet service providers, like Net Zero, and free photo-sharing services, like Snapfish and Ofoto, used this pattern. Most commonly, Predators, using an alternative low-cost approach, aggregate demand to achieve their very low costs by having better economies of scale than most or all of their customers. Outsourcing firms walk this path. Examples include Flextronics in semiconductors, Solectron in electronic components and Taiwan's Quanta in personal computers. As with all Predator products, each of these models requires the customer to yield convenience benefits, such as access to a broad product line or short order cycle times, to gain the low prices Predators offer.

Predators may begin their existence with relatively weak customers. If they are allowed to continue growing, however, they can become suppliers to the industry's largest and most valuable customers. For example, by 1987, Predator telephone company Sprint was already supplying Sears and challenging AT&T for the business of General Motors.

Reformer

Unlike Strippers or Predators, Reformers do not complete solely or even primarily on price. Many do enjoy a low cost structure and so offer a low price, but they challenge the industry Standard Leader by creating a product that has fewer Function benefits but offers some new Convenience benefit. Sometimes the new Convenience benefit comes, as well, at the expense of another Convenience benefit that the Standard Leader product enjoys. This combination of competitive or lower price plus additional savings from greater Convenience makes the Reformer's product attractive. We use the name Reformer because these companies change the way part of an industry does business.

Amazon.com is a Reformer. At a time when traditional bookstores are offering more Function amenities – reading nooks, coffee bars, and so forth – Amazon's on-line model offers the convenience of buying books, and other products, from any computer at any hour, with the click of a mouse. In the same vein, eTrade, Datek, Ameritrade and their ilk used the internet to replace the Function of proprietary research and the Convenience benefit of the advice of a personal broker with, for some, the even greater convenience, and lower price, possible when a customer does his own research and makes his own trades online.

The internet isn't an essential component for Reformers, though. Consider these other examples: companies like Jiffy Lube and MinitLube, both Reformers, pioneered the quick service oil change industry in the 1980s. Domino's played the same role in the pizza business. The 1990's saw the rise of Reformer Dollar General and Enterprise Rent-A-Car. Dollar General pares its product choices to the bare essentials to squeeze them into its tiny stores. Its small store footprint allows Dollar General to place its stores in locations more convenient to its lower-income customers. Enterprise avoids airports and their high cost. Instead, it locates in off-airport locations and offers delivery and pick-up services to its customers.

Reformers can emerge in any of three industry situations. First, the product may be ordered and delivered online. Second, the product's life allows it to be ordered by phone or online and delivered by mail. Third, the product may be unbundled into high and low cost Function and Convenience benefits and there exists a customer segment willing to forego some high cost benefits for more convenience. Reformers can appeal both to a segment of regular industry customers and to entirely new customers attracted by their new convenience. And they can expand the industry by creating new industry segments.

Transformer

Like Reformers, Transformers offer customers some new benefit – but here it is an advantage in functionality. A Transformer will offer more Function benefits than the industry Standard Leader, and will often also offer a lower price, made possible either because of an entirely new approach to serving the market or because of a technology previously unavailable. We call these products and companies Transformers because, if successful, they will transform the industry into a totally new market.

Most "category killer" retail concepts were originally Transformers. Companies such as Toys-R-Us, Home Depot, and Staples offered customers far more product choice than did their industry Standard Leader, while opting for less convenient locations and less service to keep their prices low. The result was years of sales and profit growth.

Powerwave Technologies offers a good example of a Transformer product. In the mid-1990s, the cellular telephone industry was enjoying explosive growth. At the time, the technology supporting cellular broadcast stations required a power amplifier for each channel, which broadcast the telephone signal to a subscriber. An amplifier was sold individually for each channel, and each amplifier put out a limited amount of power. One company dominated the merchant market for these single channel amplifiers. Then, Powerwave Technologies, though a relatively small follower in the industry, introduced an amplifier that covered several channels at one time. This new multi-channel technology was a Function innovation that put out as much as ten times the power of the single channel amplifier, making better use of the scarce and expensive frequency capacity and physical space at the broadcast station. And it accommodated both analog and digital signals.

Those were significant benefits – but multi-channel amplifiers cost several times as much per amplifier as the single channel versions. Powerwave addressed this problem by changing the way power amplification was priced. Instead of denominating its price per amplifier, the company priced according to the power the amplifier delivered. Each subscriber required about the same amount of total power. Since the multi-channel amplifier put out high power, it could cover the needs of more subscribers on the same channel. As a result, a cellular telephone signal broadcast station operating near its capacity could reduce the per subscriber cost of power amplification by more than 40 percent. Powerwave quickly became the leading merchant supplier of amplifiers, enjoying high growth and profits through the remainder of the decade.

The emergence of Transformers is difficult to foresee since so many of them emerge on the backs of new technologies. There do seem to be a few recurrent themes in many (but not all) Transformer products. The first theme is to create a market concept that reduces the user's time and cost to purchase and sell a product. Examples would include Home Depot and many of the business-to-business internet marketplaces where smaller sellers and buyers found new markets. The second theme is to use technology to save time, space and capacity. Powerwave falls into this theme, as do CD encyclopedias, Intuit's financial software and video conferencing. Another theme is to use technology to avoid costly exploration, including lithotripsy, arthroscopic surgical techniques and products used to see and diagnose conditions below the surface of an object. Unchallenged, a Transformer often enjoys very high growth rates and may create an entirely new industry around its approach to technology.

ADVANTAGE: SHARK?

With a threat possible from four directions, does the attacker have the advantage? Not necessarily. Standard Leaders have strengths of their own – if they are willing to use them.

The challenger's challenge

Any company taking on an industry Standard Leader faces challenges of its own that can be points of vulnerability.

First, a challenger will have to invest in creating awareness in the customer's mind. Regardless of its strategy – Stripper, Predator, Reformer or Transformer – it will have to spend generously in its early life to become known and to achieve at least minimal levels of accessibility.

And challengers may have to continue this spending to retain customers. Price sensitive customers are fickle, jumping from one competitor to another in pursuit of the industry's lowest price. To the extent that the challenger's appeal is based primarily on price, it must continuously ensure and then market its price advantage. These higher marketing costs may reduce the advantage it has gained by reducing its Function or Convenience benefits relative to the Standard Leader.

The value proposition of the Low-End Competitor requires a low price – meaning that margins will be slim and the challenger will need high sales volume in order to remain profitable. They cannot withstand much competition for their price-sensitive customer segments. Their natural market is too small. Strippers, Predators, Reformers and Transformers have all, to varying degrees, either eliminated, or do not have, some aspect of Function, Convenience, or Reliability that appeals to the average market customer, making it difficult for them to capture the heart of the market, where the majority of customer purchase volume resides.

Furthermore, until it becomes well established, the Low-End Competitor usually appeals primarily to the industry's weaker customers, who desperately need low prices for their own survival. For the industry's largest customers, on whom the Standard Leader's superior economies of scale depend, a Low-End Competitor is usually relegated to the status of minor supplier until it has achieved the scale and performance record to warrant buyer confidence. Most never achieve that standing; those that do often require years.

Keys to self defense

While the challenger has vulnerabilities, the industry Standard Leader has inherent advantages. It owns the known brand, often a household name. It has shaped customer expectations for Functional benefits and established its reputation for Convenience and Reliability. In short, unless the Standard Leader has some glaring flaw or failure, or a Reformer or Transformer offers some especially advantageous and unique new benefit, it offers the product or service that most customers would prefer, if the price gap versus a challenger were narrower.

And, in most cases, the Standard Leader has a better cost position with which to match Low-End Competitor prices and performance levels. Typically a Standard Leader begins with a much greater size, and the economies of scale advantage that size potentially confers. It already occupies a good position in relationships with many of the industry's large customers, a position of even greater competitive worth than most economies of scale. Often, it can add a price point or additional benefit onto an existing cost base, matching a Low-End Competitor's challenge while incurring only marginal costs rather than full costs. Finally, a Standard Leader often has the ability to subsidize a battle with a Low-End Competitor by using profits at higher price points in their portfolios of product offerings or from parts of the business not exposed to the Low-End Competitor's onslaught.

With these advantages, it would seem that the Standard Leader could not fail – indeed, that the challenger exists only at the leader's forbearance. Yet Standard Leaders often have a dangerous, sometimes fatal, weakness of their own: an intense desire to protect current profits. Faced with a succeeding Low-End challenge, the Standard Leader must improve its value proposition. That might mean adding costs to improve performance, introducing a new low-end product of its own that could cannibalize its current product line, or simply reducing its prices. Any of those actions would likely stop a Low-End Competitor's inroads – but would also reduce the Standard Leader's short-term profits. So many Standard Leader executives choose to ignore the challenge and continue with business as usual. But that only gives a challenger the time and the conditions under which it can grow stronger – posing a growing threat to long term profits.

GAME PLAN FOR SURVIVAL

Business leaders can hardly be faulted for wanting to guard short term profits – or at least not incur undue risk. The real challenge, then, is to determine the minimal response to a Low-End Competitor that is likely to be successful in blunting the attack and maximizing profitability long term and short term. Here are strategic alternatives available to most companies facing a challenge from below, beginning with the least disruptive.

Ride out the challenge

The least risk to the Standard Leader's current profits would occur if the company did not have to change its own value proposition. It may be possible to ride out the challenge in one of three ways:

• By ignoring the low end competitor
  
  The competitor might be safely ignored if it is unlikely to expand and gain significant share, because it lacks the resources to expand its products or the profits to finance further growth.

  An example of a constraint on resources occurred in the mining industry. Graymont, a lime industry Standard Leader faced a Low-End Competitor selling its lime for very low prices well below what the Standard Leader would normally charge. When the Standard Leader analyzed the Low-End Competitor, he determined that the Low-End Competitor was a cooperative venture, owned by several customers for the mined product. This co-op transferred most of its production to its owners' operations at cost. The Low-End Competitor then sold the remainder of its lime to non-owner customers at a very low price in order to ensure that it would sell easily. The co-op had no potential to expand further because it owned poor quality raw materials. It could not add capacity at the price it was selling the product because that price would not support the capital required to build the capacity. Graymont decided to allow the Low-End Competitor to sell this excess product and fill its available capacity. The Standard Leader kept its prices at an attractive level and accepted a smaller share of that market in return for better profitability there.

  As this example illustrates, one test of resource availability is access to good raw or purchased materials at competitive rates of cost. A second constraint that a Standard Leader might detect in a Low-End Competitor would be the cash or profits required to support expansion.

  The test of sufficient profitability is more difficult than is the test of available resources, but an analysis of the competitor's pricing structure can be helpful. On the one hand, the closer the Low-End Competitor price is to the Standard Leader price, the less reason the customer has to buy from the Low-End Competitor. So a higher price might suggest that the Low-End Competitor's profit potential might be limited by a lukewarm customer response. On the other hand, the greater the gap between the Standard Leader and Low-End Competitor prices, the more attractive the Low-End Competitor will be to customers, but the thinner will be the margins on the sales.

  Webvan was a Reformer Low-End Competitor with prices at the same level as its retail competition. The retail grocery industry largely ignored the challenge of the on-line grocers, such as Webvan. Webvan offered a Reformer product that saved a consumer's trip to the store but offered her prices that were the same as those of the Standard Leader national chains. The product attracted some enthusiastic consumers, but too few to support Webvan's cost structure. Webvan failed to generate an operating profit during the time of its existence. Once the company exhausted its initial capital, it had no continuing source of funding for its business.

  Free services undid several Internet companies. The free Internet service providers were examples of Stripper products that failed with very low prices. Several created customer bases in the millions. America On Line, the industry Standard Leader, ignored their challenges and even raised its prices during their heyday. These Low-End Competitors could not cover their costs on the paltry advertising revenues their services generated.

• By blocking the competitor
  
  If a competitor cannot be ignored, the Standard Leader may have an exploitable advantage that could be used to block competition.

  The law sometimes helps a Standard Leader. During the 1980s, the steel, wood products, motorcycle, and cement industries successfully used the law in the form of the International Trade Commission to win a declaration that some Low-End Competitor was dumping products in the domestic market and to gain tariffs on imports, effectively holding competition at bay. Patent and trademark law may also help. Predator consumer drug manufacturer, Perrigo, has been slowed several times by lawsuits claiming it was deliberately copying the look and feel of the branded products it strove to replace on the retailers' shelves. Both Apple and Compaq brought patent infringement suits against Stripper personal computer maker, Emachines, seeking to raise its costs. Car dealers across the United States have used local franchise laws to block the incursions of Reformer Internet auto distributors.

  Information is another font of advantage. The real estate brokers of the country have held off the development of true Reformer competition on the internet by controlling information. The brokers will provide internet sites with home specifications and prices, along with general locations. But, if a customer wishes to visit the home or make an offer, he needs a broker to take these steps.

  Another Standard Leader advantage is its reputation of quality products. The proprietary drug industry uses quality concerns as one of the many weapons in its constant battle with Predator generic drug manufacturers. Its salesmen have convinced many doctors of the important of prescribing a branded drug over a generic version because of the precision with which the dosage is controlled with the branded product.

  Pure size may also work to block a Low-End Competitor by raising its costs. In some industries, the Standard Leaders threaten not to buy from any supplier who offers the same product to a Low-End Competitor or sell to a distributor who carries the Low-End Competitor product. This thrust may force a Low-End Competitor to use a more costly form of distribution or to sell a less well-known brand. For example, optometrists control more than half the contact lens market. Many of them raise the costs of Stripper direct marketers, such as 1-800-CONTACTS, by refusing to release prescription information to them. Some contact lens manufacturers also refuse to sell their products to direct marketers for fear of upsetting optometrists. As the direct marketers emerged, Standard Leader Bausch & Lomb had its distributors sign agreements to market their lenses only to professionals. In another use of size against Low-End Competitors, Sun Microsystems barred the dealers who carried the company's products in the early 90s from also carrying Predator clones of its products.

• By acquiring the competitor
  
  A Standard Leader's final approach to riding out the competitive threat can be to acquire the low-end challenger, if that can be done for a reasonable cost. That requires investing capital, but the industry leader will also be able to scale down the aggressiveness of the competitors' sales activities or even raise its prices.

  A few years ago, industry Standard Leader, Shaw Group, bought the number two competitor in the pipe fabrication industry. This second ranked competitor was a Low-End Competitor, competing with low prices on bid jobs. Once Shaw acquired the company, it renegotiated the Low-End Competitor's backlog at higher margins and changed its pricing approach for future jobs.

  If acquisition isn't an option, the Standard Leader will have depleted its options for riding out the challenge. Faced with a strong competitor, who is likely to expand, the Standard Leader will have to respond more directly.

Strengthen your own value proposition

Active self-defense defines the next set of options, whose objective in each case will be to reduce the sales volume of the Low-End Competitor so that it loses profitability and cannot continue to grow. Now the Standard Leader may need to sacrifice some near-term profits to protect long-term market share and profitability. Again, though, it would like to do this at minimal risk, so the options below are listed to begin with the least disruptive.

• By adding a new price point
  
  Some Low-End Competitors do the industry Standard Leader a favor by tapping a hidden seam of new customers that can fuel market growth. A Standard Leader may be able to introduce a low-end product of its own, matching the competitor's price point while offering its own higher level of Reliability and Convenience. As a result, it can capture these customers while adding more revenues than costs.

  In the late 1990s, for example, Strippers such as People PC and Emachines introduced the sub-$1000 personal computer, which had strong appeal to customers who either could not afford to spend more than $1000 or would not spend more than that for a second computer at home. For two years, Standard Leaders such as Compaq, Dell, and Hewlett Packard resisted competing at that price point because it would reduce their average selling price and margins. Then they moved in with their own low-priced PCs for the home – and found they were able to earn better returns at this price point because they had better economies of scale and were able to charge a slightly higher price in exchange for their brand names and convenient distribution points.

  Standard Leader Pizza Hut dealt with Reformer Domino's in a similar fashion. Domino's built the home delivery pizza market by offering pizzas at a low price (made possible by cutting out the option of restaurant seating) with a guaranteed thirty-minute delivery time. But Pizza Hut responded with Pizza Hut Express, a stand-alone retail concept that mirrored Domino's in locations that would not support a regular store. In addition, Pizza Hut and other Standard Leaders began offering pizza delivery as another service from their traditional stores, thus making use of the low marginal costs of these convenient locations. These initiatives blunted the sales growth of Domino's and put the Low-End Competitor under financial pressure.

• By increasing your own level of benefits
  
  Suppose, though, that the Low-End Competitor does not create a new market segment, but instead carves share from the Standard Leader's core. Then the leader must consider changing the value proposition of its current product line, beginning with changes in performance. This can be effective especially against price discounts of less than 20 percent, and when the benefits enhanced are Function and Convenience, which customers will most readily notice.

  Shopping malls, for example, have been challenged by Strippers (strip malls and giant discounters), by Reformers (e-retailers) and by Transformers (category killer stores). In response, Mills Corporation, a regional mall developer, trademarked the word "shoppertainment" to describe its offerings. The idea was to add Function benefits. Some benefits would make the shopping experience easier, such as electronic kiosks at which customers could order hard-to-find items not stocked in-store. But most would focus on making the shopping experience more entertaining by encouraging mall stores to become more interactive with their customers. Some sporting goods stores added archery ranges and fishing ponds. Others added skate parks and off-road bicycle tracks for enthusiastic buyers.

  Often, Standard Leaders will counter Strippers and Predators with Function improvements that repackage or reformulate their products. For example, to counter Low-End Competitors, Heinz introduced a squeezable ketchup container while Proctor and Gamble created thinner disposable diapers. Proprietary drug firms have added extended-release versions of drugs coming off patent protection.

  Convenience innovations may also help fend off Low-End Competitors. Banana Republic staved off some Internet competition by adding a free delivery service during the holidays and free rides home for some of its customers. The large telecom companies have improved their abilities to offer global connectivity by forming joint ventures with their counterparts abroad.

• By dropping your own prices
  
  If performance innovation proves ineffective in retaining customers, the Standard Leader retreats to its last bastion of defense, a cut in the price of its product.

  How low does the price have to go? If the Standard Leader drops prices to the level of its challenger, it should win back essentially all customers, since the leader will clearly win on Function, Reliability, and Convenience. But few Standard Leaders want to drop prices that low – and they generally find that closing just part of the price gap is enough. For example, Standard Leader Caterpillar beat back a challenge from Komatsu in the 1980s by narrowing the price gap to less than 10 percent.

  Reducing price is a common response to competition of Predators, and one that often works. AT&T reduced its long distance telephone service prices to within 10% of Predators MCI and Sprint. Compaq reduced its prices by over 30% to counter the Predator personal computer manufacturers in the early 90s. Intel has continually met Predator AMD's challenge to its microprocessors with sharp price declines. For a number of years, the pharmaceutical industry Standard Leader competitors have held off Predator generic drug manufacturers by setting a lower price for their branded drugs shortly before they go off patent protection. The generic drug manufacturers do continue to offer their products, and at lower prices than the Standard Leader products, but their growth and profitability fall far below the levels that they were before the pharmaceutical industry adopted this practice. In each of these cases, the change in pricing policy stopped the market share loss of the Standard Leaders.

  These price declines may even allow the Standard Leaders to regain the offensive against Low-End Competitors, especially Predators. In the mid-90s, Procter and Gamble decided to take share back from Predator Drypers. The company slashed prices on its Luvs brand of diapers by 11%. Drypers responded with a 17% price cut of its own. But that was not enough. Drypers lost one fifth of its market share and suffered financially for some time afterwards.

  Price reductions can take many forms, including changes in the components of price, the discount structure, the basis of charge or the package of benefits offered. Ford offers one example of a price change through an altered benefit package. In l990, Ford faced serious challenges in its small automobile market from Low-End Competitors. Its response was to create four different special option packages for its Escort mode, each priced at $9,999 — very low for the benefits offered. These packages proved attractive to many customers of Low-End Competitors and allowed Ford a higher margin than it would have earned on a stripped-down Escort.

  But what if reasonable, creative price reductions don't work? The Low-End Competitor may have already established itself in customers' minds as equal to the Standard Leader on Function, Reliability, and Convenience. Then there is no option but to drop prices to meet those of the challenger – an unappealing option of last resort – or watch share continue to erode.

WILL YOU LIVE – TO FIGHT AGAIN?

Before taking any of the six possible actions above, an industry Standard Leader should ask a fundamental question: Will it be fighting a battle that it will only have to fight again? Any action, whether to ride out the challenge or to fend it off, will involve some cost and effort. Will the result be a restoration of market calm, and a viable business for the Standard Leader?

Have you discouraged future challenges too?

It is possible to beat back a competitive challenge, yet leave in place the conditions that allowed a challenge to arise in the first place. Before taking action, then, consider why the problem arose at all.

Three basic drivers lead to a challenge from below. The first is high industry pricing to end-use customers, which brings customer demand for lower prices, or declining demand overall. In the funeral services industry, for example, years of consolidation have resulted in higher rather than lower prices. As a result, the industry is gradually losing share of casket burials in favor of less-expensive, and less profitable, cremation. The greeting card industry raised prices aggressively throughout the 90s, but the result has been a steady drop in per capita greeting card purchases. Both industries face a choice of living with shrinking markets or reducing their rates of price increases for some time to come.

The second driver behind a Low-End challenge is a distribution channel in search of a product to carry – often, a channel serving the mass market and in need of a low-cost product unavailable from the Standard Leader. This situation existed in the personal computer market in the early l990s, when Standard Leader manufacturers refused to sell their products to mass merchandisers, relying instead on direct sales or specialized computer dealers. These mass-market channels then helped give birth and sustenance to such Low-End Competitors as Packard Bell, AST and others who would meet their needs. By the late 90s, Standard Leaders in the PC industry had to change course, meeting the demands of mass-market channels with products made just for them. As a rule of thumb, a consumer products Standard Leader must provide a product to mass market channels once the industry has matured to the point where the key Functions are comprehensible for the consumer and where the price of the product can reach consumer spending levels.

The final driver is the Standard Leader's own high cost structure, which demands high prices. In turn, high prices raise the value of any individual customer, requiring the Standard Leader to offer more services, at more cost, to keep each customer happy and loyal. Costs and prices continue their upward spiral, until Strippers and Predators emerge to unbundle the benefit package and offer a lower priced product. This Low-End Competitor gains market share and may throw the industry into price competition and lower returns for a few years. This is a recurring problem in many consumer packaged goods businesses, which often develop multiple product line extensions and new consumer and channel benefits, adding costs and pushing prices higher, until private label companies move in to take share. To stop this cycle, the industry must continually re-segment its customers to match more specifically benefits and product price points to customers who will pay for them and reduce prices for those who will not.

To avoid fighting the same fight again and again, an industry Standard Leader should take a hard look at its cost structure and its pricing and distribution strategies, and at taking action on these drivers even while battling back the immediate competition.

Are you better off making a strategic retreat?

Suppose, though, that this self-examination reveals a fundamental cost problem, not in the industry overall but in the Standard Leader itself. In that case, rather than fighting back competition the leader should consider withdrawing.

That could mean a withdrawal from a part of its cost structure in order to compete more effectively for the long term. In 1999, after years of wrestling with Asian Low-End Competitors in the bicycle business, the industry Standard Leader, Huffy, stopped manufacturing bicycles. Instead, it outsourced its manufacturing to lower cost providers. Huffy continues in the business, exploiting its capabilities in design, marketing and distribution.

Another option is withdraw from a product where that does not harm the company's relationships with other customers. In the late l980's, the May Department Store Company was the Standard Leader owner of brands spanning a price range from Lord & Taylor to discount houses. The company decided that two of its discount brands, Caldor and Venture, promised unattractive profits against low-end competition and sold the businesses.

The Standard Leader may withdraw from a customer group that it views as permanently unattractive. In the late 90s, as Low-End Competitors continued to gain share of the long distance telephone market, AT&T wearied of pursuing low-use customers. It began a monthly minimum charge for every customer and attempted to switch some customers to prepaid calling cards.

At the most extreme, a Standard Leader may pull out entirely. In the mid l980s, Salomon Brothers dominated the market for municipal bonds. Over time, however, the company found that it was under increasing pressure from the lower costs and lower prices offered by commercial banks. Though it had the largest market share in the industry, Salomon Brothers reluctantly concluded that commercial banks had a permanent cost advantage, and withdrew in order to save itself from further investment in a low profit business where its prospects were dim. Another example is Hechinger, which was founded in 1919 and in 1999 operated 117 stores under the Hechinger, Builders Square and Home Quarters brands. Nevertheless, after concluding that it could not alter its cost structure by enough to compete with Transformer rivals such as Home Depot, it withdrew permanently from the market.

Closing Thought

Low-End Competitors are anything but invincible. They are, in fact, few in number, and only occasionally succeed long term. Standard Leaders have so many strengths that they usually do prevail against low-end competition. But history shows that this process often takes the Standard Leader too long and costs it too much. A more rigorous approach to developing an effective response to the Low-End Competitor might shorten the time and reduce the cost of fighting off a challenge from below.

Reprinted from "Turmoil Below: Confronting Low-End Competition" by Donald V. Potter
MIT Sloan Management Review, Summer 2004 Vol. 45 No. 4, pp. 73-78, by permission of publisher.
Copyright © 2004 by Massachusetts Institute of Technology. All rights reserved.

(Note: This Perspective was written in the context of the economy in 2004. While some of the companies may have changed their policies or indeed no longer exist, the patterns they exhibit still hold today.)