Chapter 8 - Case Study of Parker Hannifin

Chapter 8

 Markets and Large Companies:  Case Study of Parker Hannifin

THE COMPANY

Parker Hannifin (PH) is something of a mystery. How does economic theory explain the existence of a large capital goods corporation that produces 800,000 different industrial products, many of them commodities that could be produced by specialized small companies? 

Parker Hannifin (PH) is a $12 billion industrial parts manufacturer that produces its 800,000 parts and systems in 100 divisions.  They produce valves, hoses, motors, pumps, tubing systems, metering devices, and many other products that are components in larger industrial products or systems. PH competes with other large, diversified capital goods companies.  

Customers are large companies and wholesale distributors, in virtually all parts of the transportation, aerospace and manufacturing industries.  One example is Ingersoll-Rand, a large producer of industrial equipment, including Bobcat loaders and excavators.  The hydraulic system that opens and closes the doors of the airplane you fly was probably produced with PH components.

Parker Hannifin is a mature company: 

It has low internal growth rates.

Growth rates are cyclical. 

It acquires other companies, often with increases in long-term debt.

Acquisitions are often made to obtain new technology or enter new markets.

It pays a steady dividend and buys back stock shares.

On the other hand, PH is a capital goods company. It spends large funds on research and development, over $400 million a year. It must innovate new products, improve existing products, and customized products for key customers.

PRICING

Until 2001, Parker Hannifin, like many other companies, used a “cost-plus” formula to set the list price. The formula was easy to understand, easy to use and set a target profit margin. This pricing formula was typical of many companies. What it ignored was that each product, or similar product groups, faced its own competitive environment, a mingling of factors usually sorted out in theory into supply and demand.  As new management began a study of its products’ competitive environments, it realized that its simple pricing formula was mispricing some of its products and hurting profits.

The basic problem was this. If Parker raised the price of a component, what would its big customers do?  Which ones would accept the price increases and which ones would fight them?  Which ones had market power to resist the proposed price increases? What would its competitors do – keep their prices the same and probably take away sales, or raise their prices?

Unlike economic models, there was no industry price or even market price for most of its products. A manufacturer generally can not see its rivals’ prices.  Discussing pricing with competitors is illegal, while published list prices from other manufacturers mean little in industrial markets, where most deals are negotiated.

PH went “price searching”; it discovered that its products fell into three broad categories – “core” products that were high volume versions of basic components with at least one large competitor, various degrees of differentiated products, and unique or custom-designed products. Management learned that about one-third of their products were not commodities but faced limited or no competition because PH offered better or unique net value proposition to customers. PH began to raise prices; for custom-designed products, by over 25%.

How competitors and customers reacted told PH about its different markets and the relative value of its products to its customers.  For its “core” products, there were only small price changes, some increases and some decreases. For differentiated products, price changes ranged from 0% to as much as 25% for highly engineered inputs that PH realized noticeably improved customer profitability and productivity.  Presumably, some price increases had to be rescinded because of customer protests or the loss of market share.

An interesting example was one market where PH decreased prices. One type of replacement filters used on a wide range of industrial machines saw a 15% price decrease when Parker realized that owners of the machines usually preferred to buy new filters from the makers of the machines, rather than an outside supplier like Parker.

This told Parker something about this group of customers. It indicated that the brand names or goodwill of the machine manufacturers were probably worth about 15% of the price of the machines. This was an important piece of information that the original equipment manufacturers probably did not know.

Some companies accepted the price increases and some protested. One major customer reacted by informing PH that it was going to put 50 of PH’s products “up for bid to see if some other supplier can provide them for less.” Parker stood firm and in the end the customer switched to new suppliers for only three of the 50 parts. An interesting price experiment carried out by a customer that told PH its inputs to this customer represented a competitive value proposition, even at higher prices.

By learning more about the competitive environment of its products, PH was able to adjust prices, usually upward. By 2007, price adjustments alone added $200 million to operating profit. PH also learned a great deal about its different customers’ perception of the competitive position of its products in different markets. PH used this information when setting prices of new or modified products.

Parker Hannifin is not a monopoly in any of its market niches. It is constrained from charging monopoly prices because of actual or potential competitors. No buyer wants to be at the mercy of one supplier.

CONCLUSIONS FROM THIS EXAMPLE

PH’s price search helped the company to sort out its individual products into a continuum of different types of markets. New information about customers and competitors in different markets helped Parker to improve its marketing and new product development strategies.

There was an evolution in PH’s thinking about pricing, from “cost-plus” to price searching based on its new knowledge of each product’s market. PH learned about the shape of the demand curve (elastic vs. inelastic) for individual products and product groups.

In “commodity” markets with standardized products, Parker Hannifin often faced a small number of competitors with similar products (close substitutes) and customers bought mostly on the basis of price. The experience suggested that in some markets with large producers and large customers the resulting prices might be near the “perfect competition” equilibrium price.  A hint of this is that attempts by Parker Hannifin to raise prices failed.

In other markets, Parker Hannifin negotiated prices and product specifications with large corporate customers. These markets were examples of bilateral oligopoly.

Large companies have varying degrees of pricing power.  Price is a strategic weapon, not a passively received economic concept.  Pricing strategies like price discrimination and dynamic pricing are common strategies that increase revenue and profit.

There are some similarities to the Baldwin Locomotive example in Economics Tutorial 9. Parker Hannifin is a capital goods company. It competes by selling inputs that increase its customers’ profits. PH works with its corporate customers to design and produce customized inputs. It must continuously innovate.