Buying Loyalty – Does Drop In Defection Make Up For Lost Profit From Price Cuts?

In my previous post on MetroPCS $10 price drop I overlooked a key aspect – increase in profits from customers staying longer because of the price cut.  Thanks to Gerardo Dada for pointing out the scenario of increased customer retention. In my previous model I accounted only for new subscribers and said they needed an additional 1.65 million subscribers (to their current 6.6 million sbscribers). The correct model for break even profit should look like

Lost profit per month =  Incremental % customers retained * 6.6 * $40 +

Incremental new customers * $40

units are $ million, and $40 is revenue per customer and marginal cost is $0.

The two extremes are

(1) No change in churn rate (currently 1.77%), which means MetroPCS must add 1.65 million new subscribers (add 25%)

(2)No new subscribers added, which means they must retain an additional 25% of customers. Since their current churn is 1.77% per month, this case is impossible.

The best churn rate in the industry is 1.1% (AT&T). That is for its subscribers under 2 year contract and driven by iPhone. Even if MetroPCS can reach this level, that is a savings ofonly $1.77 million, it still needs 1.6 million new subscribers to make up for the lost profit.

The net is, while price cuts  help stop customer defection they resulting increased profits are not enough to make up for total profit lost. Brands need to find considerably large number of new customers to make up for lost profit from price cuts.

I stand by my previous claim, price wars lead to value destruction!

Regarding 23% drop in Wii Sales

Nintendo on Thursday  scaled back its estimate for Wii sales by 23% to 20 million units. That means a loss of 5.96 million units.

A few months back, when Nintendo decided to cut the price of its Wii unit by $50, to match Sony and Microsoft, I wrote

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.

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).

Coincidence? Or good data modeling?

What does $10 price cut per TV mean

US TV market is about 36 million per year. Suppose the manufacturers and retailers get into a price war for the coming Holiday season and cut their prices on the average by $10 per unit sold. The market is not going to grow because of the price cut, the market share numbers are not going to change significantly since every one will match the price cut others. That is a loss in value of $360 million with no upside. Price cuts are effective in increasing your profits only if you have the cost advantage, your competitors cannot match your price cut or you can bring in new customers and capture a large share of them. If not why  do it?

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!