Economists rely on gaming theory and statistical models to predict how companies may respond to their competitors’ prices. However, if there isn’t an economist on the payroll, how does one go about setting pricing strategies or responding to competitors’ prices?
To illustrate, assume Pete has built an express exterior with a start-up expense of $4.0 million. Finance was loan-to-value 90 percent, 5.0 percent interest, and a 20-year term.
Performance is 100,000 cars per year and $10 average per car revenue. So, sales revenue is $1.0 million and gross net is 50 percent or $500,000 (EBITDA).
Based on unit variable cost of $2.00 and $535,000 fixed cost, breakeven is 66,875 cars or about 67 percent of sales volumes. Based on current earnings multiples, we might value this wash at between $4.0 million and $5.0 million.
Next is Paul who, after hearing and seeing Pete’s success, decides to build his own express wash one mile away from Pete’s store. Since the washes are virtually identical, Paul knows he has to do something besides offering the same products and matching prices to cause customers to choose his store instead of Pete’s.
So Paul decides to use price promotion to attract a larger market share and to entice new customers to become loyal customers. Here, price promotion takes form as a subscription model. Consumers find subscriptions, such as unlimited use of a service, convenient because it helps them save money.
Paul’s program is successful.
Ten percent of his customer base becomes members (2,500) at an average price of $20.00.
Members visit, on average, three times a month.
Here, performance is 180,000 cars per year, sales revenue is $1.5 million, average per car revenue is $8.33 ($1.5 million/180,000), and gross net is $750,000 less $100,000 to administer the program or $650,000.
Consequently, we might value Paul’s wash at between $5.0 million and $6.5 million or more. The reason for “more” is less risk associated with the continued operation of the business because a substantial portion of Paul’s income is recurring.
Next, Mary decides to jump into the fray and builds her own express wash nearby. However, unlike Pete or Paul, Mary believes she can get a payoff by competing on the basis of a low-price or cost strategy.
Instead of a $5.00 base price as with Pete (loyalty program) and Paul (subscription), Mary believes she can attract a larger market share with a $3.00 price and cut cost by not offering a loyalty or subscription program.
Mary’s performance is 150,000 cars per year and $8 average per car revenue. So, sales revenue is $1.2 million and 50 percent gross net is $600,000 (EBITDA). Since Mary’s wash is similar to Pete’s and Paul’s in terms of scale and scope, we might value her wash at between $4.8 million and $6.0 million.
This brings us back to Pete. How can he get a payoff in responding to competitors’ prices?
Does he follow Paul’s lead and add a subscription program with similar pricing or does he go toe-to-toe with Mary and the $3.00 low-frills model. Furthermore, what might Paul do based on Pete’s decision.
For example, Pete may find washing cars for $3.00 unacceptable.
So, instead of following Mary or Paul, he decides to differentiate by offering a limited selection of express detail services.
This is sort of what happens in the real world as markets push the companies to arrive at strategies as best responses to each other.