Wednesday, September 14, 2011

Price Curves

Every product will have a product life cycle and a product price curve. From the time the idea for a new product is conceived, companies begin to establish their pricing strategies. If you ever worked in a product development atmosphere you know that there is always a push for bring the product to market as early as possible, but did you ever wonder why? It all comes down to money.

If you are first to market with a product with new features, new functionality, you have effectively created your own market where you may charge a premium price. If you are first to market, a goal may be to get designed into other company’s products. That gives you an advantage on pricing with those companies, as to change from your product to a competitor may require a re-design, or re-qualification. Unless your price is so high as to force the buyer to change, they will continue to pay your higher price. If you are first to market, you will enter the market at the high end of the price curve where you will make the greatest amount of profit.

What is a price curve?

When there is only one company selling the product the price will be high. As competition enters, the pricing is usually driven downward. As the market becomes flooded with competition the price is driven down to usually the lowest it will be. As companies exit that market because of the lack of profitability or to focus on new higher margin products, the price will increase. The slope of the price curve will be affected by supply / demand positions. Excess supply will cause it to decline faster. Excess demand will cause it to remain stable or potentially increase until there is excess supply. Significant excess demand may cause a longer product life cycle.

There are a number of factors that will have an impact on the price curve which are the same as mentioned in the blog about the five forces of competition.
1. Rivalry in the market between existing competitors.
2. New entrants that create new possible sources of supply.
3. Substitute products or services
4. Barriers to switching to a substitute product or service are small.

In addition to those, things like delays in new or substitute product or service availability or companies being late to adopt those new products or services will always have an impact on the demand for the existing product and the price curve.

Most price curves over time will look like a hockey stick or golf club that are placed against a wall at a 45-degree angle. The end of the club or stick where it touches the wall represents the highest price where there is little competition. As you follow the shaft town towards the floor two things happen, it gets farther away from the wall and closer to the floor. Think of the distance from the wall as representing increase in competition from new entrants into the market. Thing of the the distance from that point to the floor as representing the decrease in price that results from that increase in competition. Where the shaft touches the floor represents the lowest price point. This is the point of maximum competition and excess supply versus demand has driven the lowest price. The blade or golf club face going up represents price increases that occur when companies exit the market or move to newer higher profit margin products, leaving less supply for the remaining demand.

Supplier may try to avoid following price curves or may try to extend their product’s life through what has been called “mid-life kickers”. All a mid-life kicker represents is the introduction of new feature or performance to the product. It’s an attempt to price differentiate themselves from the competition. The goal is not just to increase sales, but it’s also to slow the price erosion until the competition comes up with similar performance or features.

In managing against price surprises you need to do two things. Understand the life cycle of the products that you purchase. Don’t make long term commitments when a product is early in its product life cycle as the prices will most likely be driven down by competition. As you near the end of the product’s life cycle make any purchase commitments for future needs before companies start to exit the market. Always monitor the market to see what will affect supply and demand. It can be impacted by a delay in the introduction of a new product or customer’s acceptance of that new product. Be aware of not just what you and your competitors are do, be on the lookout for other products or industries that may potentially use of those products that could put the market into a demand imbalance. Here’s an example that I used in another blog. At one point in time the major customers for tantalum capacitors where computer manufacturers. Then cellphones were introduced. They also used tantalum capacitors. As cell phone purchases grew enormously the total demand for tantalum capacitors created shortages. In a fairly short period the cell phone industry began purchasing more tantalum capacitors than the computer industry. The competition between different industries for the supply created shortages and drove pricing up. If you saw that coming you could have made commitments to lock in pricing in advance.