Does Wii Stand To Gain Or Lose With its $50 Price Cut

A few weeks back both Sony and Microsoft did a $100 price cut on their respective  game consoles. Sony was the first to do the price cut and was immediately followed by Microsoft. At that time I wrote that Sony’s decision to cut prices by $100 means it needs to generate 23% incremental sales, above and beyond what it would it have achieved without the price cut. The 23% number was based on gross margin and customer margin assumptions I made. Now the third game console maker and the market leader in the next generation game consoles, Nintendo announced a $50 price cut on its Wii. Is  this the right move? For Nintendo? For the market profit?

Let us use gross margin and customer margin numbers of $100 and $200 for each Wii. Customer margin here is the net present value of profits from sales of games, complements and other accessories that a console owner buys over the period they own the console.

According to Bloomberg News Service, Nintendo has sold 52 million Wii, Sony 24 million PS3 and Microsoft 30 million. So their units market share numbers are 49%, 22.7% and 28.3%. Nintendo says the addressable market in US is 50 million units. If Sony and Microsoft had not cut their prices, we can assume their share of the addressable market would remain the same. Let us assume Nintendo’s models show Sony selling 23% more units than they would have normally sold due to $100 price cut. Let us also assume Microsoft gains the same – both PS3 and XBox gaining at the expense of Wii. This means  Wii stands to lose 5.86 million units sales (email me for numbers).

The drop in total profit to Nintendo, based on $200 customer margin per console is $1.17 billion.

With the $50 price cut, its customer margin falls to $150. If this price cut negates the effects of PS3 and XBox price cut, Nintendo can manage to keep its market share of 49% in the addressable market of 50 million. That is 24.5 million units. The lost profit here is the $50 price cut which comes to $1.226 billion.

In other words their lost profit from price cut even if it helped them retain market share is more (by about $50 million) than the lost profit from loss in market share. But only barely. Since we used assumptions about margins, it is possible that Nintendo’s models showed the price cut would deliver them incremental profit over letting Sony and Microsoft gain market share.

This in the end is a good move for Nintendo. But as a whole, on the 50 million US market identified by Nintendo, because of Sony’s price cut the total market profit  shrank by $4 BILLION. That is value destruction!

Backpedaling on my Cheer Volume Comment

Regarding P&G’s plan to go after market share with a price cut on Cheer brand fabric cleaners, I claimed how they need 36% jump in sales revenue and how difficult it would be for them to achieve that given their historical growth. I am not looking at the same numbers their brand managers are looking at. I also based my calculation on the gross margin of 50%. Cheer brand managers may be looking at customer margin and lifetime value of a customer retained over next 5 to 10 years. In such a case it is quite possible that the planned 13% price cut could deliver higher profit than status quo.

Customer Loyalty and Customer Margin

loyalty_margin_matrix

Procter and Gamble Chasing Market Share

All last year, the common theme among the CPG companies was higher profit despite decreasing sales because they had better price realization. CPGs delivered higher profits by increasing prices, reducing promotions and with creative packaging. But that trend is coming to an end for at least one of the companies – P&G. In the recent investor conference call they announced plan to cut prices, add promotions – all in efforts to regain market share. P&G was losing sales for the past two quarters and they are now determined to turn this around, especially in the  fabric care sector. As  some of its customers turned to cheaper store brands, P&G tried to hold on to them with multi-version pricing. They not only introduced Tide Basic to appeal to price sensitive customers but also introduced high margin super-premium Tide Total Care to keep the customers within the brand family.

The tide has turned now, as they so no cheer in continuing drop in market share, especially in fabric care segment. P&G announced a 13% price cut on its Cheer brand detergent. Is that a move that will  help with market share? Probably. But in the key and the only relevant metric of profit they may be giving away too much with a 13% price cut.

P&G’s 10-K states their average gross margin is 50%. With a 13% price cut their margins will drop and the sales have to increase 36% to make up for the lost margin. That is an extremely tall order in the highly competitive and saturated fabric care market. As a comparison, their historical sales growth was in the region of 3% to 8% per year.

Unless they are looking at the total customer margin and not just gross margin on one product. Customer margin is the total margin from many different P&G brands a customer buys. This will reduce the required increase in sales but not near the 8% number (you can do the math on required customer margin for that). There is one more risk with lowering prices, lowering customer reference price and thereby reducing chances of future price increases.

The net is P&G, the inventor of marketing research and customer driven product strategy, is going to trade profits for market share. I  will be watching next quarter sales numbers with great interest.

PS3 Price Drop Not A Game Changer

Sony was used to being the market leader in gaming consoles prior to PS3. Their previous model, PS2 sold 138 millions units worldwide, far ahead of Microsoft’s XBox and Nintendo’s Gamecube. That all changed in the next generation of gaming consoles. Now Nintendo, with its Wii and its  innovative wireless controller is the leader with 50 million units sold in the three years since its introduction. Sony managed to sell only 24 million units so far.

In an effort to drive up its market share, Sony cut the price of PS3 by $100. Technically it is on a different model they introduced called PS3 Slim.  Is this a good profit maximizing move?Is low market share a concern that requires such drastic price cuts?

I have written before the need to focus on profit share over market-share. In the case of gaming consoles, it is a platform market. The sale does not end with the console rather starts with it. There are many revenue opportunities from sale of games and accessories over the lifetime of the console. Now there is also a new opportunity for subscription revenue from online gaming. It is not enough to just look at gross margin on the hardware, we should include margins from all the complements. In other words, the customer margin.

Larger the market share, larger is the number of games available for it as more developers will commit to developing games for that platform. With marker leadership comes exclusivity. A console maker can convince the game developers to  make certain popular games available only for their platform, at least for a limited time. But this has not been the case lately as Financial Times reports

With many third-party game developers no longer willing to make games exclusive to PlayStation, Sony has also suffered from a lack of hits by its in-house games division compared to Microsoft’s success with its Halo franchise, Mr Baker said.

Suppose we assume the gross margin on the new PS3 is $120 per console. Assume that at current market share and growth rate the incremental margin from sale of games and accessories over the lifetime of the console is $150.  So the total customer margin today is $270. With the price cut of $100  and the expected increase in market share from it, let us assume that the incremental margin per unit goes from $150 to $200. There is however  no reason or data to believe this, given the point made by Mr.Baker in  the FT.com story.  So the total customer margin in the new case is ($120-100+$200) $220.

Sony will be  losing $50 in customer lifetime value per unit sold with its price cut. To make up for it, its sales have to increase (over its current sales rate) by  50/220 = 23%.

The price cut would have given them competitive sales advantage only if Microsoft and Nintendo could not do the same. But it is not the case. Microsoft cut its prices by $100 and Nintendo might do the same (although doubtful).

Microsoft acted to consolidate its lead over Sony in the current generation of games consoles as it cut the price of its top-end Xbox 360 on Thursday to counter a similar move last week by its Japanese rival.

It is now questionable whether Sony can deliver a sales increase of 23% from its price cut. Note that this number will be much higher if the customer margin numbers we used are lower.

The net is, price cut is not going to be a game changer for PS3 sales.

Lowering Prices To Generate Sales?

Here is another CEO who clearly believes lowering prices does not automatically guarantee  sales increase: Macy’s Terry J. Lundgren.  In his inteview with The Wall Street Journal, Mr. Lundgren  said,

WSJ: Do you think about lowering your average selling price or changing your product blend, as some of your competitors have done?

Mr. Lundgren: Here’s the challenge. We have [a men’s pants brand], and they typically go out the door between $29.50 and $32.50, with all the coupons and everything.

What Mr.Lundgren refers to as “out the door price” is the “pocket price“, the net price after all discounts. The net effect of the discounts and coupons is price leakage that erodes profit, clearly Mr. Lundgren is driving Macy’s to focus on its price waterfall.

Mr.Lundgren’s management serve as the best case study so for on the three components of effective price management:

Knowing the value add to segments:

Our purchasers are women. She’s spending the same amounts but just shopping with a great deal of discretion. Value is the word, even if it’s at regular price. The intrinsic value of what she’s buying is very important.

Incremental analysis: How much should sales rise to compensate for loss in profit from price cuts? (Lundgren is on the direction but he is comparing top-line while he should be doing incremental math on lost profit. There is also numbers error as pointed out by the commenter.)

So we were getting tremendous sell-through at low price points and no margins. And I am not making my pants sales for last year, because my average sale dropped by 30%. It’s really hard to make the math work. I have to have 30% more transactions on this product to break even.

Customer Margin: Understanding that loss leaders are effective only if they help generate incremental profit from customers who are attracted to the stores by low prices of loss leaders.

We and the manufacturer together agreed to mark them (pants) down to $21.99 or something like that. Selling like hotcakes. Every other pants around them stopped selling.

Does your business practice effective price management?