When I began teaching Strategic Management in 2003, Southwest Airlines was just entering the Philadelphia market. This proved to be very disruptive for the dominant incumbent, US Air. Whenever Southwest enters a market, the first impact is that overall fares in that market drop dramatically. It was easy to see why in Philly. US Air responded to Southwest’s presence by launching an ad campaign saying that they would match Southwest’s fares on any route they both served. Like any good professor, I was never one to miss a teachable moment, and I would ask my classes if they thought Southwest was upset by this challenge from US Air. Invariably, most of the class didn’t think so. But when I asked why, their thinking was less clear. That is because the students often confused “cost” with “price.” They were able to identify Southwest’s low cost strategy, but they equated it with charging lower prices than other airlines.
I pointed out to them that any firm could lower their prices. In fact, US Air had announced that they would do just that. Wouldn’t that make them competitive with Southwest? Of course the answer is no, because Southwest made money at the lower fare point, whereas US Air lost money. And that is because Southwest’s costs are lower. The key to a successful low cost strategy is having meaningfully lower costs than the competition throughout the entire value chain. Lower costs means that the firm can charge lower prices and remain profitable. Knee-jerk lowering of prices to meet the competition when your costs are higher than theirs means that you start losing money. It is a panic move that is doomed to failure. Executives who console themselves that it is only temporary will be in for a rude awakening when they find that customers who are accustomed to discounted prices do not react well to sudden price hikes.
Are universities just like airlines? In this respect, yes. Private universities discount their prices so much that the stated tuition has become like the sticker price of a car – a beginning point of negotiations that no one actually pays. They do this because they don’t have an adequate response when a potential student tells them that they could get a much cheaper education at Big State U down the street.
How much do private colleges discount? A lot, it turns out. According to the National Association of College and University Officers, the average freshman got a 45% tuition discount in 2012. All students averaged a 40% discount. These discounts might have been manageable when the supply of students was increasing and enrollments were growing. However, a recent report indicates that the number of students graduating from high school peaked in 2011, and most states will see moderate to sharp declines for the next 20 years.
You don’t have to look very hard to see the negative effects of trying to lure a shrinking pool of traditional college-age students with increasingly discounted tuition. St. Joseph’s University in Philadelphia recently disclosed an $8.7 million budget shortfall. They responded in two very un-strategic ways: across the board budget cuts and a plan to increase freshman admissions to raise revenues. Across the board cuts punish all areas equally, rather than investing in promising areas and cutting less promising ones, which would be the strategic response. And, as the faculty at St. Joe’s pointed out, increasing admissions in a time of decreasing applicants will mean lowering admissions standards. The Provost is stepping down after this term.
Realizing that escalating tuition discounts is a road to ruin, a number of small colleges and universities have lowered their tuition while reducing discounting. It is an interesting experiment, but may be a tough sell now that the notion of discounting is so entrenched. It turns out that people like the idea of getting a bargain, and we expect to negotiate over big-ticket items (houses, cars, etc). College tuition is the ultimate big-ticket item for most families.
There are other tactics that universities use to reduce costs for their students such as tuition freezes and four year tuition certainty, but I believe they mostly miss the point. It is not that affordability is not an important issue in higher ed – it is. But as I noted above, the real work of competing on price is accomplished by lowering costs throughout the value chain. Universities that want to utilize a low cost strategy will have to radically reinvent themselves and their business model. Some already are. My next post will be about strategic positioning and how universities can use it to address the question of costs.