Company factors such as cost structures, capabilities, and strategic positioning should also be examined carefully. Cost structures may be affected by changes in technology or business practices, which in turn may tempt a company to cut prices in a manner that will trigger a price war. For example, consider the implications of outsourcing. It’s probably true that it is cheaper to buy rather than make something in-house, because the invisible hand of the marketplace will lower the acquisition price of a product. But the cost of manufacturing something in-house is largely sunk and fixed. When that product is purchased on the market, its acquisition cost is a variable one. In other words, integration can lead to a cost structure with a higher fixed-cost component and a lower variable-cost component. Consequently, the company with the lower variable costs may be tempted to reduce prices and start a price war.
But even though the lower variable costs give the company an advantage, it should carefully consider whether a price war is consistent with its strategic posture. The company’s lower variable costs should be used to start a price war only when it will result in the neutralization or the exit of an undesirable rival. Consider, too, the coherence of your pricing strategy and your ability to execute it. The actions of one participant engaged in a fierce price war in the utility industry is telling: The company’s senior management group asked its top manager to increase market share by 20%, return prices to profitable levels, and stabilize them. Confronted with apparently conflicting goals, the manager chose the easiest goal—build market share—which he achieved by lowering prices, thus exacerbating the price war. The directive to the manager was confusing, his resulting actions baffled competitors, and that led to considerable uncertainty and increased price turbulence in the market.
When the soft costs (managerial time and attention) of changing prices through a complex supply chain were factored in, the cost of the increased market share was very dear. The essential insight that should emerge from this exercise is whether a simple price cut is the best option given one’s cost structure, capacity levels, and organizational competence.
