Adaptive Price Management

When the downturn started in 2008 and retail sales started dropping, the department stores started dropping prices from fear of being left with inventories. There were big sales, with 50% to 70% drop in prices even in high end retailers like Saks. There was one exception, Abercrombie & Fitch, which steadfastly refused to drop prices.

They knew they were not a product for the mass market and there was a small segment they served. For a long time that segment was not worried about price. They were more concerned about the brand and the long term effects of sales on their brand and future pricing power. They were worried about setting low reference price in the minds of their customers and did not want to train their customers to wait for sales. There was more to lose from price decrease than to gain.

However, things got worse for Abercrombie & Fitch. Their operating margin shrank from 20% to barely 4% in less than a year. Their sales fell 30%. Whatever happened to Effective Price Management  that recommends pricing for profit and protecting  price premium to deliver higher profit.

They  correctly following and religiously implementing two of the three components of Effective price management:

  1. Pricing based on value add to segments
  2. Pricing based on incremental analysis

Unfortunately there are two problems that led to profit erosion.

First  problem is effective price management requires the marketer to manage all three components and selectively choose one or two and implement just those. When a marketer optimizes a subset they end up missing the true optimal solution.They were focused on margins from individual items and not on maximizing total margin from the customer. They ignored the third component of effective price management – Focus on customer margin not product margin.

Second problem is the model is not static – you do not decide  your segment, their value proposition, their demand curve once and forget about it. The segments, their taste, value proposition and willigness to pay all change and change drastically due to external events. The New York Times  reports on a market research that found just this shift:

Aéropostale and Wal-Mart, the discount chain, are among teenagers’ go-to stores this season, while more expensive stores — like Hollister and Abercrombie & Fitch — are not, according to a survey of students ages 12 to 17 by Majestic Research.

“Rather than get one top at a Hollister, they can get two or three at Aéropostale,” said Brian J. Tunick, a retail analyst at J. P. Morgan Securities.

When this shift happens then all the previous models on segmentation, targeting and incremental analysis on sales drop and lost profit must all be reevaluated. When the model does not evolve and remains static, it results in decisions that does not deliver under changed conditions.

Effective price management is not about picking and choosing a subset of the three components but implementing all three with right balance to maximize profits. It cannot be done in a, “set it and forget it mode”,  it is a dynamic model that requires continuous tuning to adapt to changing inputs.  Failure to do so will result in sub-optimal results regardless of how optimized the partial model is or how accurate and complete the initial model is.

GM Sowed Its Own Seeds Of Failure

(draft version, will be edited continuously)

On Wednesday July 2nd 2008 GM shares hit the levels seen only in the 1950s. Almost six decades of value creation wiped out, serving as a counterexample for the buy and hold thesis of investment. GM is losing money on every vehicle it makes and with current high gas prices there are no takers for its gas guzzlng SUVs. It is an easy answer to blame it a on the oil price shock. Oil price shock is not the root cause of the problem, it only hastened GM’s problems.

To look at the root cause we need to go all the way back to start of its growth phase, the 1950s, (the levels to which GM’s stock has now fallen). By then GM had successfully eliminated the cheap substitution to its automobiles, Electric Trolleys, and started selling more autombiles to Americans. Historian Stephen Goddard describes in his book, Getting There: The Epic Struggle Between Road and Rail in American Century, how GM teamed up with Firestone the tire maker and, ironically, the Oil companies (Philips Petroleum and Standard Oil), systematically elimiated trolleys in towns across the USA.

Goddard writes,

Trolleys considered artifacts today pervaded all aspects of american life at the turn of the century.

There were trolley cars for commuting, trolley cars to carry the mail and trolley car to hire for parties.

This posed two kinds of problems to GM, Firestone and the Oil companies. First they acted as the substitution for automobiles, a cheap and comfortable one indeed. Second the trolleys ran on tracks and the tracks in the middle of the road did not serve well for driving automobiles. Goddard describes how the foursome formed a shell company to systematically buy the local trolley franchises, just to shut them down, blaming it on incompetency.

GM’s growth took off. It was a successful strategy, illegal but successful atleast over the next 50 years. But the problem is the strategy was based on the assumption that Oil will remain cheap and ignored the secondary costs like pollution. In any other case, a strategy that delivers 50 years of growth would be considered extremely effective. But the strategy is flawed on two fronts. First, the macroeconomic factors take longer than 50 years, GM’s strategy failed to look ahead that long. Second, and arguably the core reason, GM’s Marketing Myopia.

Ted Levitt wrote in his seminal work, how companies sow their own seeds failure by narrowly defining their strategy. For example, Kodak look at itself in the business of photo films and missed on the digital photography growth. Instead Kodak should have looked at itself in the business of “memory capture”. Then it would not have mattered whether it was selling films or digital cameras.

GM’s Marketing Myopia is obvious in the hinsight. While it executed the strategy that correctly identified trolleys as its “true competition”, it failed to define correctly the business GM is in. GM looked at itself in the business of selling automobiles and not in the transportation business. GM continued to commit to a strategy that made bigger, faster, powerful and luxurious automobiles, forgetting to look at the “purpose these automobiles served”.

People did not want muscle cars, they wanted thrill. People did not want automobiles, they wanted a safe, easy and comfortable way to go to places. People did not want SUVs, they wanted to make a statement and chose big SUVs as the medium.

The other big US car maker, Ford, isn’t doing better than GM. Ford suffers from the same two factors that GM suffers from. When Ford started, it was not suffering from Marketing Myopia. Henry Ford purportedly said, “if I listened to people I would have made faster horses”. Whether those were the exact words or not, it was a proof point that he realized that what people really wanted was a way to travel from Point-A to Point-B.

As we stand now, at the beginning of the third quarter of 2008, facing increasing Oil prices and the effects on the environment, GM is facing what appears to be a certain failure. It is not easy now for GM to lose its myopia. It has committed all its resources towards automobiles and cannot rally recast itself to make the new transportation means. GM is doing more of the same, with its plan to make more mini-cars than SUVs. Again, the strategy is myopic, reactive to Oil price crisis than solving the real needs of people.

If GM survives for another fifty years, it will be because it recast itself to be in “the business of connecting people to their economic, physical and emotional needs” and not because it made smaller fuel-efficient cars.

In fifty years, we may not even travel from point A to point B, but this topic requires its own article.