Price Pressures

Warren Buffet recently testified before the Financial Crisis Committee, stating: “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business". Knowing whether pricing pressures are real and unavoidable – or not – often defines the line between those companies that will survive and thrive – and those that will not. Our research has defined four factors critical to the assessment of price pressures.

1. Capacity.  Simply stated, the more excess capacity that exists in an industry relative to demand, the more real and intense pricing pressures will be. This indicator can change rapidly over time as demand moves with the business cycle. It also can change in a significant step-function way as firms build new plants or shutter older ones. The capacity balance is a very significant indicator; in industries with a massive overhang of unused capacity, the pricing pressures will be incredibly intense, almost overshadowing any favorable implications that might be seen in the other three indicators.
2. Protection. Another important indicator is the degree of “protection” that exists for the business or product line being examined. Protection can be legal in the form of patents or copyrights, but it also can involve the degree of customization, engineering, design, or service embedded into the product. The evidence is strong that such value contributions place implicit barriers to competition and impose significant costs of change on customers that shift suppliers. In a common sense way, this indicator reflects the fact that when a supplier’s offering includes elements that are of high value to customers, that supplier should be able to capture some of that value in their pricing.
3. Markets.   A third indicator relevant to understanding the strength of price pressures focuses on the business environment into which the supplier is selling. In healthy business environments, pricing pressures are less intense and less real. The measures of health involve not only the supplier’s direct customer, but even more so the customers that are further along the customer chain. Pricing pressures travel along the customer chain. If a participant at any stage of the customer chain, from the lowest tier supplier to the final end customers that use the product, is facing a difficult business environment, the implications tend to ripple along the customer chain, another manifestation of the old saying that a chain is only as strong as its weakest link.
4. Relationship. Our fourth indicator of the strength of price pressures focuses on the relationship between the supplier and the customer. There are two basic elements to this indicator. On the positive side, instances in which the parties consider each other a “strategic supplier” or a “strategic customer” are ones in which pricing pressures are likely to be less intense. On the negative side, our research indicates that the suppliers that rank among the customer’s largest, suppliers whose products are expensive, and suppliers whose products represent a significant portion of their customer’s product cost structure sit on the bulls-eye, attracting the attention of both purchasing managers and competitors. If such firms are not delivering value, they can anticipate pricing pressures.