Is Being the Low Cost Provider a Viable Start-up Strategy?

Why Entering the Market at a Low Cost Doesn’t Work

December 21, 2011

It’s a common pricing strategy for new businesses. Break into the market by offering your product or service at the lowest price. The long term intention is to build a customer base, audience, and experience, and eventually raise prices. It makes sense, but why doesn’t it work?

There are famous examples of the low cost provider technique working. Often the reason it doesn’t work is because the start-up isn’t implementing it in the same manner or they are missing the nuances. Like many ideas, the general concept is sound, but the devil is in the details.

Let’s take a look at my neighborhood. It was built about 100 years ago. As such, there are both many home remodeling projects and homes being torn down only to be rebuilt. When a construction company is working on a home, the company places a big monument sign out by the curb to announce their company to the neighborhood. Every year there are two construction companies that seem to have most of the projects, and every year the names of those two companies change. Why?

Someone decides to start a home construction company. They figure they will be the lowest bidder on every project. Since homeowners have no real experience on which to judge the quality of proposals, the primary consideration with choosing a contractor is cost. So that season, they win most of the proposals. The next year, they raise their prices because they learn that being the lowest cost provider is a marginal business. They need better margins in order to be a viable business. They don’t get as many projects the following year because there is always some new entrants looking to buy their way into the market, just like they did the year before!

In the second year, the upstart was trying to offer the same product or service, but just charge more for it. They didn’t realize that there were no barriers for new players and there would always be someone trying to break into the business.

Toyota is one of the famous examples of getting this strategy to work. When Toyota first entered the US market, they made the most basic car possible and offered it at a low price. It was the smallest car offered – the mini of minis – and it was cheap. When Toyota raised their prices, they didn’t just take this same car and slap a new price tag on it. That little car got a reputation for being more reliable than any other car. The people driving those bigger cars wanted a more reliable car as well, but they didn’t want to go small or give up the luxury perks of their big cars. So Toyota made a bigger car with features beyond the basics, and offered it at a higher price. And then they offered an even bigger car with all the luxury bells and whistles, at an even higher price. Toyota made a bigger and better product and charged more for it. Also, it’s expensive to start a new car maker or even a new car line, capital is the barrier to entry. There just couldn’t be a new set of players ever year.

Another car example is General Motors. Long ago, when cars were the latest high tech product, large scale manufacturing gave them the ability to significantly reduce prices as volumes and demand increased. But they didn’t do that. Instead they keep their prices high by adding more features to the car.

This is a common mistake many new businesses make. They enter a market as the low cost provider. To increases sales, the strategy should be one of increasing volumes to capture greater margins from the economies of scale, not to simply offer the same product at a higher price. If a higher price is desired, the company has to offer a better product.