Not at any price

Cheap thrills: Bargain basement behaviour is widespread

It is hard to remember such an orgy of discounting at shops around the country – from low-rent malls to the best boutiques – as that over the past few months. Opening sales, closing sales, birthday sales, “take 25 per cent more off” tickets – it’s deflation before your very eyes. Retailers know they have to do something to capture flagging interest. But the reality is they are resetting consumer expectations to new lows and will pay the price later.

Getting prices right is a fundamental skill in any business. Yet some of the world’s most capital-intensive and advanced industries – from global transport to computer hardware – have been guilty of the same bargain- basement behaviour as that in the local shopping strip.

Management thinker Michael Porter in his 1985 classic Competitive Advantage wrote that companies were quite capable of trashing the value of whole industry sectors through ill-aimed competition and reckless discounting. Who you cut prices against can be a risky business.

All companies, he says, have to compete on either differentiation (a flashier product) or on cost (cheap and cheerful). There are varying combinations but by definition there can be only one cost leader – and lowest price setter – in each industry. If all the others try to do the same, Porter says, there can only be one result: “The consequences for profitability (and long-run industry structure) can be disastrous, as has been the case in a number of petrochemical industries.”

Consider a business as vital as ocean container shipping. Without the massive increase in global transport productivity since containerisation came to shipping in the 1970s, globalisation and the industrialisation of Asia could never have happened.

Yet the industry has made little return for itself from this achievement, mainly because of the enthusiasm of carriers for chasing cheaper players to the bottom on price.

Mark Page, a director of Drewry Shipping Consultants in London, has followed container shipping profitability for 20 years. He says that even in the height of the China export boom in 2006, the industry globally managed only a 3.3 per cent operating margin. In a capital-intensive industry, where a dollar of assets is needed to earn a dollar of revenue, this miserable result is also close to the total long-term return on investment.

Why? Partly because of bouts of over-optimistic ship ordering (bankers love big mortgageable ship assets as much as shipowners do) and long remorseful hangovers of over-capacity. The result is fratricidal discounting in which winning market share and the volume that comes with it beats discipline. Ships have very high fixed costs and need to operate at near-full capacity. As a result, there is an ingrained habit of “Friday afternoon pricing” in which carrier sales reps try to fill the last cargo space before the ship sails. With too many shipping lines – more than 20 global carriers service Australia – it is not long before those last few containers are driving the pricing for the whole ship.

Containerisation created massive economies of scale but it also commoditised the job of shipping goods and made it hard to differentiate between service offerings. Expensive attempts in the 1980s to create premium container services, such as sophisticated inland logistics and just-in-time delivery for global manufacturers, were either quickly matched, or given away for market share against bigger but cheaper no-frills competitors.

During the mid-2000s global trade boom, there was further huge investment in bigger and faster ships, with more direct connections between ports than ever – and a huge jump in cargo delivery times for the lines’ multinational company customers. But Page says that again container lines “completely undervalued the product that they have provided” and used it merely as a marketing tool.

The biggest irony is that for more than a century, liner shipping was uniquely allowed to globally collude on pricing. The so-called conference system gave regular carriers widely agreed antitrust immunities in return for not deserting customers if there was a shipping boom elsewhere in the world (one of the bargaining chips of highly mobile assets).

The system began crumbling in the 1980s under the pressure of new Asian independent carriers with business models better suited to containers. The conferences had merely provided what Porter calls “umbrella pricing”, in which the established carriers sheltered the entry of cheaper nemeses that simply shadowed their prices at a few dollars below until the leaders buckled.

The shipping industry has tried many of Porter’s strategies to escape pricing hell but found itself with some of the failings he warned of. Carriers tried bundling together different value-added logistics services – the one-stop shop of warehousing, trains, trucking and cargo tracking – in an effort to sell more in bundles than they could have sold as separate services.

However, these bundles quickly became targets for specialist providers such as rail operators or freight forwarders to attack – or to offer their own versions of the bundle.

There are similar problems with loss leaders, where one service is sold cheaply to draw in business but is supported by a cross-subsidy from more expensive items.

But just like bundled services, says Porter, the seller had better be confident there is a strong connection between the products and a good reason to buy the whole package. Otherwise there is the risk of the more expensive product being cherry-picked so that the seller is left holding only the loss-leader.

Nonetheless, it is possible for businesses addicted to price-slashing to reform and fight back.

Computer hardware is another industry that became rapidly commoditised as the technology spread.

In the 1980s, the world discovered personal computers. Retail margins for these then-exotic products sat at 40 per cent and the industry seemed set for a 20-year boom, says the research director of marketing and channels for IT analyst Gartner, Neil McMurchy, who started his career selling Osborne computers.

The industry was then immature from a marketing point of view, McMurchy says. It was run by geeks who assumed that technical knowledge would keep customers coming back. But they also had a tendency to give away new kit to enthusiasts and prices kept being negotiated down. Each wave of new computer technology would kick off a new round of sales. Yet as the volumes went up, prices went steadily down. It was the familiar story: discounted to death, with large numbers going out of business or left competing only on price.

At the same time, the approach of the computer makers themselves was very confused, he says. Some appointed more resellers than they could sustain, others allowed mass retailers to cut the recommended retail price and some competed directly with their own resellers on the most lucrative contracts.

The result? Aggressive sellers and buyers who got low prices but no service.  Jamie Warner, chief executive of eNerds, decided to play the differentiation game, stepping in with a service-based offering to fill the gaps left by service-shy resellers.

Others were also trying to balance Porter’s cost versus differentiation equation. Joel Shapcott of AV Clarity went into the world of home audio-visual equipment. He noticed it falling into the same pile-em-high, sell-em-cheap practice of IT resellers, despite the usual investment in airy expensive retail space. There were, he figured, plenty of customers who would pay for the service of setting up the kit at home. Shapcott, like Warner, decided to run a service-based business, with the product an afterthought rather than the principal reason for the sale.

However, juggling price and service is still difficult. Karen and Glenn Voyzey set up Connect Multimedia to provide high-end installations of digital home entertainment. They have positioned the company against price-cutting mass retailers and believe they have learned the salient lesson: “If we go down the track of being as cheap as the next guy, we are just going to end up out of business.”

BRW

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