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July 03, 2006

Price – Toppling an Incumbent

The bigger they are, the harder they fall.  The proverb applies to incumbents with huge market share (aka former monopolies) as well as to trees and schoolyard bullies.  An enormous customer base paying comfortable margins makes it nearly impossible for an incumbent to fight a disruptor in the marketplace.

Disruptive technologies which provide new and better ways of doing things are all the rage.  As an entrepreneur, I loved seeing the opportunities created by the PC, the graphical user interface, and the Internet – particularly the World Wide Web.  But a necessary condition for all of these breakthroughs was a sharp drop in price.  The PC revolution needed cheap MIPs (computer processing power); GUI needed even cheaper MIPs to do all the graphic processing; and the popular Internet needed the PCs, the GUI, AND cheaper communication at broader bandwidths.

This post is about price – not features.  It is about how price alone can be used to bring down an incumbent and why the incumbent won’t fight back IN THE MARKETPLACE until it’s too late.  You can safely assume I learned everything I know about disruptive pricing tactics in the communications business.

Let’s assume some mega company has a near monopoly in a certain service for which it charges $50 month.  The assumed direct incremental cost of providing this service to an additional customer is $20/month not counting any marketing or corporate overhead of any kind.  And let’s assume that MegaCorp has 10,000,000 customers using this service.

Enter disruptor.net.  Let’s assume that disruptor.net has found a way that it can offer the same service as MegaCorp, the exact same service, at an incremental cost of $20/month even with a relatively small subscriber base.  This is not unrealistic if, for example, disruptor.net uses the Internet rather than some costly and obsolete special purpose communication network.  In the real world disruptor.net may actually have a way to provide service at an even lower cost than MegaCorp but we want to give MegaCorp a fighting chance so we won’t assume that.

We’ll also assume that, in the first year of service by disruptor.com, not more than 10% of MegaCorp’s customers can be lured away by a lower price under any circumstance.  In fact, for a small price difference, almost no customers will be lured away.  Disruptor.net needs to offer at least a 25% price difference to have any impact.

The chart below shows the assumed curve of customer conversions which result from various discounts to MegaCorp’s price offered by disruptor.net.  You can be pretty sure in any industry that the chart is an S Curve – more formally known as a cumulative distribution function (hint: use the Excel NORMDIST function).  The correct parameters of the curve are the kind of arbitrary guess that anyone who has ever made a business plan is used to.

Disruptor_2

The spreadsheet I used for all the calculations below is available for you to play with here.

If disruptor.net prices the service at $37.50, a 25% discount, this set of assumptions shows them converting only 6209 of MegaCorp’s customers.  Hardly worth the trouble especially considering that the competitive service will have to be advertised to be successful.  Certainly this threat wouldn’t cause MegaCorp to respond by matching the lowered price.  A 25% reduction across its enormous customer base would cost MegaCorp 25% of its revenue and $125,000,000/month of margin!  The loss to disruptor.net of this handful of customers costs MegaCorp only $109,000/month of margin.  Lost in the rounding.

But, if disruptor.net prices the service at $25, things look different.  Now MegaCorp loses 500,000 customers.  That costs almost $5,000,000/month in margin.  MegaCorp still isn’t going to match this price; that alternative would cost $250,000,000/month in margin.  Doubtful that MegaCorp would be able to keep the corporate jets flying at today’s fuel prices.  Better to trim a little R&D or even have a reduction in force than to take the ruinous step of reducing prices like this.

Even if the managers at MegaCorp know that they are about to be picked apart by price, they believe Wall Street “won’t let them” react by cutting prices competitively. Imagine what happens to their stock price if margin is cut by 80% or $750,000,000/quarter.  Much better to sweep the $15,000,000/quarter decline from attrition under the rug with some cost cutting or whatever creative accounting Sarbanes-Oxley still allows.  Moreover, Wall Street will be happy that gross margins are still high.

Lucky disruptor.net.  Charging just $25/month it now has 500,000 customers, monthly revenue of $12,500,000, and monthly gross margin of  $2,500,000.  Sure, it’s still not profitable and it burned through a lot of VC money getting the service started and marketing but no matter: these numbers justify at least a followup round of VC funding on favorable terms or even going public.  Someone might even buy it – not MegaCorp, though; they only lost 5% of their customers.

Predictably, MegaCorp will try to respond in ways that don’t endanger its fat margins: more advertising – especially featuring celebrities, eventually a winback desk which is allowed to offer discounts only to those who are trying to cancel service, even more eventually with special proactive pricing plans (special means confusing), and much later with across the board price cuts of its own.  By this time a larger percentage of customers realize that MegaCorp is over-charging them and, even if they don’t care about the money, they feel ill-used.  More of the customer base is vulnerable.  Moreover, when MegaCorp eventually does cut prices, it not only loses margin from all customers; it also acknowledges that price is the name of the game.

Of course, by now both MegaCorp and disruptor.net have competitors.  And consumers have a choice.  Price has gone down so usage will go up (I’ve ignored elasticity in this analysis).  Innovation in features as well as price will happen.  New services can be built using the now lower-priced service as a component.

Call this the incumbents’ dilemma.

Unfortunately, though, the story doesn’t end here like in a fairy tale.  MegaCorp doesn’t go quietly into the night.  It isn’t reborn as a low-cost provider; it has too much debt service, perk cost, executive cost, and unamortized infrastructure investment to allow that to happen.  Instead, MegaCorp fires up its lobbyists to throttle disruptor.net and its imitators.

Remember, I only said that installed base stopped MegaCorp from competing in THE MARKETPLACE.

The first post in this series on price is about the cost of complexity.

The second post is about FON, the WiFi sharing scheme, as a great experiment in pricing.

The third post is about “freeloaders”.

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Listed below are links to weblogs that reference Price – Toppling an Incumbent:

» Price – Toppling an Incumbent from Startup Fever
Tom Evslin explains how to use price to topple an incumbent: The bigger they are, the harder they fall. The proverb applies to incumbents with huge market share (aka former monopolies) as well as to trees and schoolyard bullies. An enormous customer ... [Read More]

» Disruptive Pricing from Architect Partners LLC
Tom Evslin reminded us of a potent theme today, disruptive pricing. Within the telecommunications industry it's a core strategy for many vendors. In our world, software, pricing certainly plays a strategic role but perhaps more is to come. Disruptive p... [Read More]

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