Gross: An Expensive Lesson On Lowering Prices

Crazy Eddie, the electronics retailer who advertised insanely low prices, went out of business nearly 20 year ago. But the company's spirit is thriving in blue-chip American corporations. On Sept. 5, Apple sharply cut the price of the 8GB iPhone from $599 to $399. Last weekend, Hovnanian, the big home-builder, held a highly promotional "Deal of the Century" campaign, slashing prices for 72 hours on new condominiums. In some Hovnanian developments, prices were cut by up to 25 percent. Other builders are now following suit. Welcome to fire-sale nation!

High-profile price-chopping tends to occur whenever companies freak out about the vicious combination of a slowing consumer economy and the prospect of getting stuck with big inventories of unsold goods. The tactic often works in the short term. The hype over insanely low prices functions as a form of free advertising, and the lower prices tend to attract buyers. Apple announced on Sept. 10 that it had sold its 1 millionth iPhone. Hovnanian's preliminary results show that it notched sales of 2,130 units over the weekend. (The company reported inventory of about 3,200 homes on July 31.) For the entire third quarter, Hovnanian delivered about 3,500 homes.

But the gonzo cuts can have negative results after the initial frenzy. First, it makes chumps out of the customers who made the product a hit—and profitable at full price—in the first place. Early adopters who paid through the nose for the new iPhone, were iPissed when they realized that their technologically less-forward neighbors could get the exact same product for one-third less a few weeks later. In response to an avalanche of angry e-mails, Jobs responded that he really cut the price in order to help all those who paid $599 for it. "It benefits both Apple and every iPhone user to get as many new customers as possible in the iPhone 'tent.' We strongly believe the $399 price will help us do just that this holiday season." How would you feel if you bought a condo in a Hovnanian development last month, only to find that your new neighbor paid significantly less for the exact same floor plan?

For products that have active secondary markets—like homes and cars—fire-sale discounting can have broader marketwide impacts. Home-buyers base their decisions about what to pay in part on recent comparable sales. By temporarily slashing prices, Hovnanian has established a new market level not only in its developments—where plenty of customers have already bought homes at higher prices and where Hovnanian still plans to build more homes—but throughout the towns where its developments sit.

As U.S. automakers, which have long resorted to heavy incentives to clear inventory, have learned to their chagrin, consumers are easily conditioned. Fire sales have a way of freezing consumer decisions. Once they know that retailers are likely to slash prices, many tend to delay purchases. Why buy an SUV tomorrow if you know it will be reduced in price at the end of the season? And once you start discounting, it's very hard to stop. Check out this data on the use of incentives by auto manufacturers in August. The Japanese automakers don't offer much (Toyota's average was just $849), while the Big Three U.S. automakers each offered incentives of more than $3,000 per car. Is it any surprise they're having such great difficulty turning profits on their U.S. operations? Given the horrific dynamics of the housing market, it's likely Hovnanian will have a difficult time simply jacking its prices back up to wishful, pre-fire-sale levels. And the next time Apple brings out an expensive new product, it might find that the lines are somewhat shorter.

Finally, while carrying excess inventory can damage profits, so can efforts to get rid of inventory. In its most recent quarter, Hovnanian's margins on homebuilding were already thin. Slashing prices of homes that are completed—i.e., that the company has already paid for—is likely to boost revenues but hurt the bottom line. And margin-shredding behavior tends to spawn more margin-shredding behavior. To make it up to angered iPhone customers, Apple had to offer a $100 credit to early iPhone buyers. To assuage customers angered by large discounts on a single product, in other words, Apple is effectively now discounting all its products. Think different, indeed.

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