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Some ponderings over Marketing world, some comments, and yes... the pyaas for the gyan !
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Understanding Undercutting of prices
Monday, February 25, 2008

Undercutting is defined as offering to sell at lower prices than or to work for lower wages than (a competitor) or as required officially. Undercutting, hence, is done at the cost of one's profit.

In short, and as used mostly by field salesmen, undercutting means to sell cheaper than one's competition.

The word would be easily recognized by anyone who has ever gone to dealers and tried raising their sales targets. The moment you do so they will start crying that some dealer is undercutting in the market and that the 'evil guy' is actually selling at almost nil margins, giving discount more than that you give to the dealer himself.

Now lets understand the reason for undercutting; while we admire how well kept the products are in retail stores are we never realize the efforts and pains taken by the salesman there to get them up. And similarly we may see some ad of a new product and we would run to the nearest shop next day to buy it; but takes a lot of persuasion, arm twisting, margins game and target adjustment to get those new and 'unreputed' products on shelf. But every month the targets rise for these dealers, salesmen and zone offices; and then comes the most novel uses of undercutting. A dealer dumps in neighboring place or across border and completes one's targets. Or you may see the large wholesale dealers dealing in volume indulging in undercutting to earn bread and butter. So a big stockist in Delhi can dump stock in Faridabad, or a Rajasthan stockist take benefit of VAT induced difference to dump in Ferozpur (Punjab) etc.

Lets talk maths now, generally FMCG products have about 10% of retailer margin and about 5% of stockist/wholesaler margin (direct supply from company). Now there will be some schemes from time to time which increase this margin by some points, generally 1-2%, lets take 1.5% here. Now there are targets set for these stockists and wholesalers, if they perform full quarter, they will get more percentage as reward. Say this target completion margin is 0.75%. So the final margin of stockist is :






Wholesaler Scheme1.50%
Extra Margin if target completed0.75%
Wholesaler/stockist margin5.00%

--------

7.25%

--------
Hence instead of having 7.25% and giving other stockist's retailer his 10% margin, the stockist gives 12.25%; and keeps only 5%. Due to this the retailers take supply from him and the stockist of that area suffers.

But if you understood the concept well, you should have got that its not workable for a long time. And if you think a bit further, you will realize it will actually work as a cyclic process. It brings us to an important price cycle called as Edgeworth price cycle. It's an asymmetric price variation that has the following characteristics:
  1. The good/service is a homogeneous commodity and customers are extremely price-sensitive. If one vendor undercuts another, they will capture all or a very large portion of the market (where "very large" means "as much as they can handle").
  2. Beginning from an equilibrium, one competitor will initiate a round of undercutting by pricing below the equilibrium. Because of (1), competitors will respond immediately, the same day if possible, with a match or a slight undercut.
  3. Undercutting will continue until they bid the price down to the wholesale cost.
  4. One competitor will then restore prices. Everyone will follow as quickly as possible, and the cycle repeats.

Because of (1), smaller competitors have a greater incentive to initiate cutting. Larger competitors will generally be the initiator of restorations. The cycle is asymmetric because restorations happen nearly simultaneously, but undercutting is generally slower. Competitive gasoline markets with a high degree of independent or small retailers typically demonstrate Edgeworth cycling, while markets dominated by majors (vertically integrated firms) will tend toward sticky pricing.

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posted by Jas @ 9:00 PM,

1 Comments:

At February 28, 2008 10:23 PM, Blogger launchpad said...

this is more prominent in the bordering areas of distributors and dealers where they indulge in undercutting.
however in some cases, this rate cutting goes on without the knowledge of the supplier,e.g. a salesman or a dealer in order to meet his targets sells at a lower price, but bills it at the market price and shows the difference in some other expense!
very difficult to catch this unless the greedy customer spills the beans to some other dealer/distributor or an astute auditor nails the salesman!

 

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