Pizza Wars: The high price of a low cost model

The high price of low cost leadership

Two of Australia’s largest pizza chains are duelling it out in the market place in an attempt to gain the upper hand and win market share. Their main weapon? Price. But from a strategy point of view, is this smart?

What’s happening?

Pizza Hut and Domino’s Pizza are currently locked in a competitive death spiral by trying to win price-sensitive consumers into their stores (or ordering online) by lowering how much they charge for their products. As reported on the 22nd August, 2014 in the Fairfax owned The Age newspaper, the Franchisor company Yum!, who own the Pizza Hut brand here in Australia, have told their franchisees that the cheapest pizza should be priced at $4.95 and their most expensive pizza for only $8.95. As you might imagine, the franchisees who have had to shoulder high start-up costs and ongoing franchise fees are not happy about this and are claiming that that can’t make any money at these prices. They are threatening to take their franchisor to court. In the meantime, Domino’s, for their part, have entered the battle with similar pricing structures. The argument seems to be that by lowering prices dramatically more people will buy more pizza and it is thought that as more pizza is bought, profits will increase. This rests on the assumption that people will switch from either one brand of pizza to these brands, or that they will be attracted to pizza instead of eating, say, hamburgers.

What does the strategy theory say?

Michael Porter argues that there are three main ‘generic’ strategies that can describe the actions of any competing firm. He advises that when an organisation chooses one of these strategies that they are best to stick to it and execute it well. He argues that firms can either:

  • Differentiate from other firms on the basis of a characteristic valued by its customers and thus charge more for the product or service that they sell or;
  • Attempt to be the overall lowest cost producer in the industry thus generating profits by increasing the gap between what it costs to produce a good or service and what it can be sold for in the market place; and,
  • In either case, the firm can either decide to target a broad range of consumers in the market, or they can choose to focus their attention on a very small, well defined section of the market.

Ultimately this produces the following matrix of generic strategies:

Aspect Broad approach to the market Focused approach to the market
Differentiation Broad differentiation strategy Focus differentiation strategy
Cost Leadership Broad cost-leadership strategy Focus cost-leadership strategy

Which strategy are they following?

In the case of the pizza market we are discussing here, both Pizza Hut and Domino’s are trying to argue that they deliver high quality at a low price. They are trying to make the argument that they are differentiating on ‘quality’ and therefore that should encourage purchasers to shop with them. However, when the switching costs for consumers of pizza are so low (it doesn’t ‘cost’ a consumer much to choose one brand of pizza over the other – i.e., they are not invested in the decision in any material way), each of these companies will need to find a way to differentiate on something other than the nebulous concept of “quality ingredients”. Is it true, for example, that one brand of pre-shredded pork flesh is qualitatively better than another by such a margin that it would persuade someone to drive to one pizza chain store rather than another? Unlikely. There is not a sustainable argument that can be made that either of these companies are differentiating their product in any meaningful way for which customers are likely to pay a premium.

So I think it is safe to make the argument that each of these companies is actually trying to keep their costs as low as they can and then pass those cost-savings on to consumers by the way of cheaper prices that they charge in an effort to get more customers through the door. After all, the more transactions that they can complete (even at a small profit) ultimately means more money in the bank (hopefully). Each are following a low-cost strategy – and that is where the trouble begins.

Focussed or broad based?

So, in this instance, are the competing pizza establishments following a broad based cost-leadership strategy or a focussed cost-leadership strategy? Well, it is a matter of degrees as to how you interpret this question. Since both companies offer a range of pizzas and pizza toppings that can appeal to a wide variety of dietary requirements, the argument could be made that they are using broad based cost leadership strategy. They are not, for example, only catering to a segment of the market that will only eat, say, certified organic vegan pizza. However, if you think of it in terms of the wider fast-food industry, then the very narrow product offering of just pizza indicates that they are a niche player, focussing on a very well defined market segment. There is no one point at which the definition switches from a broad approach to a focussed approach. The key aspect to consider is that since both companies are competing on the basis of nearly identical products to nearly identically defined markets that the issue of scope becomes less important.

Ok, so they are both following a low-cost leadership strategy. What now?

The key thing to understand is that in any industry/sector there can be only one low cost leader. Whoever has the lowest cost structure is the leader and everyone else are the laggards. Why this is important is because the organisation with the lowest cost structure can better withstand any price war that might erupt. The low-cost leader can continue to drop the price of their product until it becomes uneconomic for their competitors to continue to do business – at which point it would be rational for the cost laggards to exit the market.

That’s why the stakes are so high for both of these pizza joints: in a price war such as this, it’s a winner take all game.

The determining factor for victory is likely tho be the relative scale of each operation. A large scale of operations allows cost savings to occur in different parts of the organisation and in different ways. Take, for example, the advantage that can be gained if one of these organisations was to be able to figure out a way to reduce the total time for the making of a pizza by 20%. This would mean that for customers there would be shorter waiting periods (something that they no doubt would value) and it would mean that more pizzas per hour (pph) could be made/sold. There might be two ways in which one of those companies might approach figuring out how to achieve such an advantage:

  • they could undertake dedicated research (maybe hire a university professor?);
  • they could rely on their staff developing new routines through ‘learning by doing’ and re-enfolding that experience back into the organisational routines.

If we take the first example, the cost for both Pizza Hut and Domino’s to invent this new routine would be roughly the same. However, if one organisation has a much larger scale of operations (i.e., they sell more pizza more often) then the cost associated with the research effort of those highly paid(?) professors can be spread out across many units of production – a tiny addition to the overall price per pizza.

If we take the second example, the organisation with the most employees who are making pizza at any one time increases the chance that the efficiency breakthrough will be discovered. Each of those people may be experimenting and learning in only small ways, but each improvement in efficiency delivers real cost savings back to the organisation.

In both situations*, scale matters.

What’s the likely outcome?

The key element here is that Domino’s has the largest footprint in terms of stores in Australia and also the highest total network sales in this segment. They have more places to buy pizza and they sell more pizzas. Their ability to spread costs associated with finding ways to be more efficient across a higher number of pizzas and stores means that they are in a strong position.

However, as long as each company is able to continue to bring more and more customers through their respective doors – enough at least to cover costs – then it will come down to a matter of which of these companies can stand the heat of competition the most. It seems from the legal action being threatened by the franchisees of Pizza Hut against their parent company Yum!, that their appetite for the fight is not very great. Domino’s should probably take heart from this news and continue to apply the pressure by maintaining low prices and continue to find ways to lower their costs of doing business. It will take a laser-like focus on costs to maintain this position, but if they can force some of the competition to exit the market in geographies that they both share, the gains for Domino’s could be high as the previous Pizza Hut customers move over to Domino’s.

Dare I say it? For the winner the spoils will be a larger slice of the… market.

*There are other way in which an organisation can attack their cost structure, but these are probably for a post at another time. Let me know in the comments if you would like me to write about them.