Undercut CompetitorsAnalyzing Firms
A firm can undercut competitors into non-existence or retain market share high simply by being cheaper than them to purchase products/services. Undercutting, frequent sales or fire selling results in customers being more willing to shop at another competitor. If the firm frequently offers better prices, a customer may begin to believe they have the best pricing and shop there normally.
(Racing to Zero to) Undercut Competitors
There are problems with this strategy. Industries which compete on price slashing strategies will often “race to the bottom”. This results in a game to see who is the most willing to lower their profit margins. The firm with the lowest expenses will have an advantage since they can maintain a profit margin longer. You should remain aware that they are reducing return even if they can maintain a profit margin. That is why you should avoid industries where this strategy is the only way to gain an advantage. If anyone can slice prices, when one firm reduces their prices, the competitors will be forced to slice prices as well. This means one firm will reduce returns for all shareholders of firms engaged in competition. The competing firms will be less affected if they can reduce expenses while retaining product quality, or increase efficiency in other business sectors outside of the price competition.
How do you determine if a firm you are investing in can even survive in this environment? You determine if the firm can afford to slice prices cheaper than competitors. To start, if they are forced to sell products below production costs, they can’t afford price cutting competitions. If the firm is forced to reduce product quality, they are damaging their reputation. If they reduce return below your desired rate of return they should not receive your investment.
Handling Being Undercut
There are three basic ways a firm can deal with this strategy. They split into cheaper supply costs, cheaper manufacturing process costs, or better distribution patterns. All of these can result in an ability to sell a product cheaper than another competitor, but cheaper supply costs and cheaper manufacturing processes can result in long-term business problems. A cheaper supply cost should be achieved by negotiating a purchase of quality supplies at lower prices. They produce the same product quality at lower costs. The company reduces prices without hurting margin and keeps product quality reputation.
Undercutting Their Own Reputation
The problems begin if the firm is saving money by purchasing low-quality supplies for cheap and reducing prices. Low-quality product may undermine the brand’s reputation or prevent them from building one. If the quality of the product saves the firm money but undermines future business they may lose customers anyway. This defeats the point of saving money selling products over the long term since the growth is hindered unless the firm uses additional strategies.
The same principle applies to the manufacturing process. If the firm attempts to save cash on manufacturing but ruins the brand’s reputation with defective products, they harm themselves in the long run. Shaving costs in ways that hinder the company’s reputation results in more harm than good. You should ensure that the strategy the firm uses doesn’t harm it in the long term.
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