Industry Price Outlook
Capsule: Depending on the value added in the industry, the Company will develop either a detailed or rough forecast of the direction of prices and margins over the next three to five years. In either type of forecast, the key driver of future margins is the growth of capacity compared to the growth of demand.
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For helpful context on this step:
Videos:
- Video #72: Overview of Pricing Part 1: How to Look
- Video #73: Overview of Pricing Part 2: What to Expect
- Video #74: Overview of Pricing Part 3: What to Do
The industry price outlook projects either prices or the direction of prices and margins over the next three to five years. It adopts a medium to long-term view of the future to allow the Company ample time to plan its capacity changes and pricing tactics.
As a working definition, we can define the Price of a product or service as the equivalent of the cash costs of the next higher cost increment of capacity, the availability of product, that could be added to the market. If the price were lower than that point, no new capacity would come on the market and the industry could not grow. If the price were higher than that level, there would be a good chance that the industry would see more capacity come into the market than the current demand required. Price would fall as competitors began price discounting to put the excess capacity to work.
The amount of time a Company would spend in diagnosing the pricing in the market place depends on its outlook for prices in the coming few years. If prices will be high or rising, the industry would generally follow simple pricing rules and use few components of price. On the other hand, where prices are likely to fall and industry margin conditions to deteriorate, careful analysis of pricing will pay for itself many times over.
The approach the Company uses to develop its basic price outlook for the industry depends on the type of industry in which the Company competes. In an industry with low marketing and sales expenses, the Company would develop careful forecasts of demand and capacity in order to project future prices. In normal to high marketing and sales industries, on the other hand, these detailed analyses are a waste of time. These industries commonly have more production capacity than the industry has demand. Here, prices are less directly variable with the balance between production capacity and customer demand. Rather than developing specific price forecasts, these types of industries would develop an expectation for the direction of prices and for margin pressures that the Company might face during the next few years.
To develop a detailed industry price outlook, you forecast the future for growth in customer demand and changes in the industry’s capacity to produce the product. The balance between these two forces yields your price forecast or margin direction. A less detailed analysis of your future prices concentrates on the likelihood of competitive expansions in the industry and the pressures these expansions might exert on current prices and margins. You may be able to predict these expansions from current industry returns and recent price changes relative to inflation.
If you decide to develop a detailed industry price outlook you should run some simple sensitivity analyses to see whether the Company’s pricing environment would change substantially if the “best guess” assumptions are in error.
This section of StrategyStreet covers these issues in the following topics:
Type of Industry and Its Profitability
Capsule: If future demand exceeds capacity, prices should rise. Prices should fall if future capacity exceeds demand. This rule holds most readily in industries with low marketing and sales expenses as a percentage of sales. If you are in a low marketing and sales expense industry, one with commodity-like characteristics, spend the time to develop detailed forecasts of demand and supply. Otherwise, don’t bother. In high marketing and sales industries, expect prices to come under pressure if industry returns are high or if the industry has had several years of price increases at a rate greater than inflation.
Capsule: As in politics, all demand growth is local. You start by forecasting local demand growth and extend beyond the local service area only where necessary.
Future Capacity from Current Competition
Capsule: The current industry has many different forms of capacity that it can make available or withdraw from the market. Each of these forms has a separate cost that affects market prices. The various forms of capacity enter, or withdraw from, the market depending on the price.
Capsule: The economic effect of every price is the discouragement of a competitor from operating some or all of its capacity. In low marketing and sales expense industries, the price falls just short of the cash costs of the next increment of capacity that the industry could supply the market. In other industries, prices and margins tend to rise until they attract low-priced competition.
Capsule: The best guess pricing scenario may be okay. But, check out the best and the worst case scenarios just in case.
This process begins with an evaluation of the type of industry which the Company competes.
Basic Strategy Guide Users Return to: Step 19
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| Summary Points | Next: Type of Industry |