In established markets with lower entry barriers, competition increases quickly and leads to increased buyer power. As new entrants sacrifice margins and under-cut to rapidly gain market share, it compels others to cut prices and subsequently reduces the average market price. It may not cause problems in a growing market as an optimum balance may be accorded between the individual reduced margin and overall sales volume. But during economic slowdown when the market size shrinks it will result in oversupply, disrupting the supply-demand balance and lead to plummeting prices.
For instance; in the auto part manufacturing industry, the initial set-up cost is as low as EUR 40,000 to set up manufacturing facility for machined components. Using CNC (Computer Numerically Controlled) equipment and involving no proprietary technology; the barrier to entry is fairly low. Also the market has limited buyers – auto companies, which procure bulk quantities and opt for the lowest bidder as the items are standard. Price being the only criteria, new entrants under cut to rapidly gain market share and subsequently leads to increased buyer power.
When the market is bullish, undercutting may seem fine as the volumes are sufficient to meet the breakeven targets. But when the bears arrive, shrinking volumes and falling prices become a catastrophic combo. Usually the harbingers go unnoticed as the losses are incurred through non-cash expenses such as depreciation and capital recovery. Also, as raw material prices drop in a sluggish market resulting in reduced costs, the loses do not usually result in cash deficit although the companies might encounter temporary cash crunch.
For instance; steel is used as raw material by auto part manufacturers, being a commodity, the price goes down in a sluggish market as the overall demand reduces. This results in lower manufacturing costs. Moreover, prices of other commodities such as crude oil go down and the demand for services such as shipping and warehousing go down as lesser goods are being manufactured. This leads to a cumulative cost reduction in the supply chain giving some room to breathe.
But before proceeding further, let us understand a simple equation that can help you apprehend your situation in a market with increasing buyer power and subsequently manoeuvre with preventive or corrective actions accordingly to avoid catastrophe.
Selling Price > COGs + CAPex + OPex + Contingency Margins
COGs – (Total Material + Conversion Cost) / Volume or Batch Size
CAPex = ((Book Value of Assets X Percentage Depreciation)/Volume) X (1 + i%)
OPex = (All fixed Costs)/Volume
If your figures do not satisfy the equation, you can either explore possibilities of collective bargaining agreements or explore alternative markets.
In markets which are restricted geographically due to transport constraints originating from ultra-high volume to weight ratio and lower entry barriers, such as EPS (Expanded Polystyrene) insulation or in an oligopoly market condition where the market is regulated by limited suppliers and actions of one directly affect others; collective bargaining agreements are a viable option. One can form an informal consortium and distribute market share according to capacities and affix minimum prices.
Whereas, in the example of auto component manufacturers, it may not be difficult to form such a consortium or arrive at mutual agreement. In such cases one should explore other markets as the famous adage advices us against putting all your eggs in a single basket. A common risk distribution method widely adopted by investment managers who deliver an optimum mix of blue chip and penny stocks along with bullish mutual funds and paper bullion.
In case of the auto part manufacturers, they may explore possibilities of manufacturing other products within their existing set-up without much alteration, for application in other industry sectors. Since CNC machines have robust capabilities, they can explore possibilities of manufacturing components for aerospace or defence. Moreover, they can also explore other materials and sectors such as machined titanium goods used in mountaineering and performance sports equipment.
Although there are numerous other factors to be considered and measures available at disposal, these are the most common and widely adopted measures.