We’re in the middle of a recession and suddenly all of the smaller companies I’m talking to are concerned about whether or not they should be dropping their prices.  The thinking is that in times of tighter budgets, the lowest cost provider has a market advantage.  Is that really true?  And if it is, are there longer-term risks to such a strategy?

I don’t usually go all marketing scholar on this blog but this is one that deserves a look at some first principle marketing thinking.
The Godfather of competitive strategy is Harvard professor Michael Porter.  Most of what is taught about competitive strategy is based on the foundations that he laid in a book called “Competitive Strategy: Techniques for Analyzing Industries and Competitors”. This book is now in it’s 60th printing (yeah, you read that right, that’s six zero) which gives you an indication of how often it is used in marketing classes.
PortersGenericStrategies
Diagram from Wikipedia
Porter argues that one of the major factors that determine the success of a company (after the attractiveness of the industry the company is in) is how the company positioned itself within that industry.  He argues that there were only three major types of strategies with respect to positioning.
Differentiation – this is where the company goes after the entire market but positions itself as clearly differentiated from other players in the market.  This is usually pursued by companies that are doing highly innovative things and whose products are generally high quality.  Customers will pay a premium for these types of products because of their perceived greater value.
Cost Leadership – like it sounds, this is where the main differentiator is the lower price for the product.  These companies have figured out a way to produce and/or sell their products for lower costs and can then sell them for less with the same profit as competitors or for a lower margin to simply gain market share.
Segmentation (sometimes called Focus) – a segmentation strategy is where the company focuses on a target segment and then adopts either a Differentiation strategy or a Cost Leadership strategy within that particular segment.
Where things get really ugly, according to Porter, is where companies try to mix these strategies together.  He refers to this problem as “Stuck in the Middle”.  Now, you and I have both seen Resevoir Dogs and we know when we hear “Stuck in the Middle”, bad things happen.  Porter stressed that he saw too many companies that were essentially getting beat by their competition both in terms of Differentiation as well as Cost.
So let’s go back to the original problem.  Now that we are in a recession, should you drop your prices to be the lowest cost option in your market?  Really the question is bigger and more complicated than that, unfortunately.  The question is actually – Should you change your strategy to compete on price rather than differentiation?  This mean you have to go back to your original Value Chain Analysis and figure out where you are going to cut some costs.  Can you stop selling direct?  By how much can you reduce your staff?  Can you significantly reduce your cost of service?  If you catch yourself saying “Yeah, but we will still do all the cool stuff we are doing today, we’ll just reduce the price!”, you just might be kidding yourself.
Now, I’m not saying that there isn’t going to be price pressure on software vendors over the next 12 months.  There sure as heck will be.  Smaller companies in particular will be forced to be more flexible on price than they have ever been before.  Short-term dealmaking does not represent a shift in strategy however, and any company that decides that they will now compete primarily on price should take a long hard look at what that means for their overall business.