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GM May Be Learning Price Discipline
Growing Margins While Lowering Prices by Tilting the Price Waterfall Vector

December 2006 Pricing

When a marketer wants to signify that they are selling a high quality item, they can raise the price. This tactic of raising prices to signal higher quality leverages the learned consumer behavior of “you get what you pay for”.

Likewise, when a marketer wants to encourage purchases, they can provide buyer discounts. This second tactic of stimulating behavior through financial incentives leverages a second learned consumer behavior, to “hunt for sales and better deals.”(1)

Combined, these two tactics lead to a classic pricing ploy: Set the standard price high and provide deep discounts to communicate value yet stimulate demand.

Left unchecked, this classic pricing ploy can get out of whack leading to the old pricing joke of “We offer a premium product at $1000, on which we currently provide a $999 rebate to qualified buyers.” Outside of raising a chuckle, such an approach also trains consumers to ignore list prices and wait for deep financial incentives.(2)

To counter this spiral, pricing strategists should examine their Price Waterfalls to determine the true Pocket Price.(3)

Recently, GM announced a change in their pricing strategy that forms a simple example of tilting the Price Waterfall Vector in their favor in order to drive an increase in their pocket price. We will use this case study to illustrate these principles.

Price Waterfalls and Pocket Prices

A price waterfall graphically shows the difference between the reference, or list, price and the pocket price for an item. The pocket price, so named because it is the money left in your pocket after all is said and done, is the actual price paid less customer discounts, incentives, and other costs related to customer transactions. The invoice price will lie between the reference price and the pocket price.

Within the price waterfall, each source of discount, incentive, or customer management cost is identified and delineated. Those that appear on the invoice will lie between the list price and the invoice price. Those that do not appear on the invoice will appear between the invoice price and the pocket price. (4)

For GM, the Manufacturers Suggest Retail Price (MSRP) represents the reference price. GM sells their vehicles through dealerships who, in turn, pay GM the invoice price which is determined after a number of standard dealer discounts and dealer incentives. At times, usually in the summer and fall, GM provides extra incentives in the form of cash rebates and promotional discounts to consumers to stimulate demand. These off invoice items do lower the average pocket price GM receives for their product, but also clears unsold inventory. Each of these discounts and price points are represented in the 2005 GM Price Waterfall. See Figure 1.

GM Announced Price Increase

In November, GM announced that they would be increasing prices on 35% of their 2007 models. Alone, this does not signify any strategic change within the GM but, because the price increase arrives on the heals of a larger change in pricing strategy, closer inspection is merited.(5)

What is interesting is that, early in 2006, GM changed their pricing strategy from high list prices accompanied with deep discounts through rebates and incentives to lower list prices and removing incentives. This combination is reported to have left some models with a slightly higher average pocket price. We can illustrate this though a price waterfall study.(6, 7)

Change in Pricing Strategy

Figure 2 represents a potential resulting GM Price Waterfall for 2007. It shows that the size of the standard dealer discount has remained the same, but the cash rebates and promotional incentives have decreased compared to that drawn for 2005.

Considered alone, the 2007 GM price waterfall does not make it obvious that GM lowered the MSRP. Moreover, it is difficult to see how the strategic change affected the overall pocket price.

To reveal these changes, Figure 3 overlays the 2005 and 2007 price waterfalls. It clearly shows that it is possible for GM to lower the MSRP while simultaneously increasing the pocket price simply by reducing the size of cash rebates and promotional incentives.

The overall effect of lowering the MSRP while simultaneously lowering off invoice discounts is a rotation of the price waterfall vector.

The price waterfall vector is the line between the list price and the pocket price. In general, any counter clockwise rotations of the price waterfall vector, where the axis of the rotation lies between the initial list price and the initial pocket price, will lead to a higher final pocket price.

Figure 4 shows the rotation of the price waterfall vector for GM which results in an overall improvement in the pocket price.

Tilt the Price Waterfall Vector in Your Favor

GM has long been the brunt of the joke of “what not to do” when it comes to business strategy. However, it might be time to take a second look at their strategic prowess. The company that created the concept of a brand pyramid may now be leading the way in implementing price discipline.

Clearly, GM has tilted the Price Waterfall Vector in their favor, thus improving their pocket price while simultaneously maintaining demand for their products. Someone should be congratulated.

Will GM’s new pricing discipline stick? That remains to be seen. Managerial discipline is subject to reverting to the mean, which in this case would be to move towards volume at any cost, not margins. One year of poor model reception might drive managerial actions to revert toward higher discounts and incentives, countering all gains made through rotating the Price Waterfall Vector in their favor. Vigilance please.

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Notes

  1. Consumers often irrationally sacrifice their time to gain small discounts in price, even when the opportunity cost of their time outweighs the savings gained by hunting for lower prices.
  2. An application of consumer risk aversion theory will lead to the conclusion that sellers usually loose in this gambit, yet that discussion will be left for another article.
  3. Usually, when a consultant uses the word “waterfalls”, you know that there is significant potential that flowing from the waterfall will be a quagmire of uninformed rhetoric that makes the speaker sound intelligent in order to quash debate at the expense of your sanity. Unfortunately, price waterfalls and pocket price are the terms of art for this subject, so I use them also. Please forgive the guru speak.
  4. Michael Marn, Eric Roegner, and Craig Zawada, 2004. The Price Advantage., Hoboken NJ.: John Wiley & Sons, Inc.
  5. N.E. Boudette, GM Is Increasing Prices on About 35% of its 2007 Models, The Wall Street Journal, November 9, 2006, p. D5.
  6. The stated reason for the price increase is relatively uninteresting. GM cited increased costs of steel, plastic, and other raw materials. This may be a red herring or it may be the truth, but consumers rarely care about producer cost problems. Truth be told, the stated reason for any price increase is mostly irrelevant for managerial decision making. Neither governments nor consumers want to hear that a company has boosted their profits by raising prices. Identifying increased costs as the culprit for increased prices is a convincing and socially acceptable reason, even when it may be a terminological inexactitude.
  7. This price increase on 35% of GM models may be positive news for GM and their investors. GM and the other auto industry competitors routinely adjust prices at this time of year. These adjustments are influenced by differences between the initial expectation of demand and the measured demand during the period after new models are rolled out and before the beginning of the actual model calendar year. For 2007 models, this would be the last quarter of 2006. The price increase for a minority of models implies that demand for some GM models is higher than initial expectations therefore prices should be adjusted appropriately. For GM and their investors, this may signify the good news that consumers like the new models and find the current MSRP low to acceptable. Perhaps GM will not have to provide heavy discounts and other price incentives this summer to clear inventory.


About the author

Tim J. Smith, PhD is the Managing Principal of Wiglaf Pricing, and an Adjunct Professor at DePaul University of Marketing and Economics. His most recent book is Pricing Strategy: Setting Price Levels, Managing Price Discounts, & Establishing Price Structures.

Tim J. Smith, PhD
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