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Weekly UpdatesMore often than not, anecdotes and "gut feel" remain the key drivers for pricing decisions. Consequently, organizations fall short of their potential for revenue and profit maximization (RPMs). In addition, lack of a pricing focus can translate into millions of dollars in hidden margin leakage, as well as an inability to support an effective growth strategy. As described in a previous article, "Is the Price Right?" (CMA Management, May 2007), neglecting pricing practices can leave an organization's RPMs stuck in first gear. But all is not lost. Pricing, too, can become an effective process when it is based on developing a pricing road map using sound data and pricing tools to optimize RPMs. In Sodhi and Sodhf's Harvard Business Review article "Six Sigma Pricing," they note: "Many organizations use disciplines to decrease the cost of manufacturing and service processes. They can use the same tools to increase revenues" (May 2005). CMAs, therefore, can lead the way as change agents, by leveraging the power of pricing and implementing best-in-class practices, an opportunity that translates into both short- and long-term financial gains.
Power of pricing
According to an often-referenced study by Marn and Rosiello (1992), pricing is the most effective lever for increasing profitability--more so than managing cost and volume. In fact, for the average organization, a 1 percent increase in price can result in an 11 per cent increase in profitability. If pricing has such a major impact on net income, why do so many organizations fail to use an effective pricing strategy: "It's like throwing a dart at a dartboard," as one manager said. "How can anyone know what price will work? Just provide a target for the sales teams and leave it to them to hit that target. That's our pricing strategy." But as time passed and margins shrank, organizations needed to dig deeper into their world of pricing. In this particular case, the management team chose to conduct a pricing diagnostic. This assessment revealed a strong need to gain control of the pricing process, to reevaluate the organization's value offering, and ultimately to strive towards optimizing profitability by focusing on pricing disciplines.
Pricing audits
As an increasing number of boards of directors are realizing that a sound pricing process drives improved bottom-line results, there has been a corresponding increase in deployment of price audits to assess areas of improvement and opportunity. As outlined in "Is the Price Right?" an internal pricing process assessment helps determine which level within the five levels of world-class pricing (also called the world-class pricing framework) best describes an organization's current situation. This audit can help answer questions such as.: how effective are the current pricing processes? and what pricing areas need improvement? The framework (Figure 1) establishes a snapshot of where an organization is today, and helps chart a vision of where it needs to navigate.
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Each level within the Framework provides an opportunity to add new tools and processes to the CMA toolbox that sets the stage for improving an organization's bottom line. This article highlights many of these pricing tools (with a strong focus on the Level 2 toolbox) that have proven to be highly effective as organizations progress along the path to pricing improvement.
Improving pricing competency
Level 1: Baseline process is ineffective
Management meetings at Level 1 companies are usually fraught with stress and tension. One manager described this level as "table-banging arguments whenever the topic of pricing comes up." At this stage there is no defined pricing strategy; pricing processes and reports are non-existent; high margin leakage occurs at every turn; and there is a lack of understanding about the price-value relationship. Revenue changes are often explained using anecdotes rather than sound data and analytical details. As well, pricing managers find they spend a large portion of their time extinguishing internal political fires with little or no time spent investigating margin opportunities. If an organization resides within Level 1, it is important to perform a full pricing diagnostic across all departments to identify areas of pricing weaknesses that require process and tool enhancements. It is also important to meet with different levels of employees and map all potential areas for margin leakage. Once these weaknesses have been defined, it is necessary to audit and track improvements using various pricing management tools as described in Level 2.
Note that moving towards Level 2 will require a change agent, as there are internal cultural implications with pricing policy changes, as well as a need to constantly sell the advantages of using world-class pricing management practices--a perfect leadership opportunity for a CMA.
Level 2: Internal processes in place
This level is primarily defined as the "gaining control" stage for pricing. It involves tracking key pricing pitfalls, areas of margin leakage, and poor pricing practices that the company has identified as weaknesses in Level 1. It is important throughout this stage to employ pricing tools that continuously audit pricing activities, track progress, and ultimately strive for improvements. It is also necessary to train and gain buy-ins from important stakeholders to ensure they use the pricing tools. A prime reason why many organizations remain locked within Level 2 is the lack of engagement and communication with such stakeholders. A majority of the price audit tools are focused within Level 2, since their key objectives are to take a snapshot of the current state and provide a target that overcomes a pricing weakness and gains control. Gaining control of pricing practices is a critical stage within any organization, and requires the support and engagement of stakeholders in order to progress towards a higher level within the five-level framework.
Case Study: Using a competitive pricing report (Level 2) to grow margin
A large technology value-added reseller wanted to increase margins within its hardware category (e.g., printers, cables, notebooks, etc.). However, it was having trouble convincing its sales force. Negotiations were excessive, and pricing, to say the least, was out of control (Level 1). A newly formed pricing committee created a competitive price audit report (Level 2 price tool) that was routinely reviewed to assess competitors' online and print catalog pricing against the company's own. To its amazement, the company discovered it had been "giving away" seemingly irrelevant addon accessories, items that ultimately translated into a bottom-line gain of over $1.5 million after the organization had trained sales reps to take advantage of this margin opportunity. The report ultimately helped the company gain control of pricing, and set the stage for moving to the Level 2 roadmap.
Two of the most commonly used Level 2 tools include the price waterfall and price dispersion charts. A successful Price Waterfall chart (Figure 2a) must integrate the CMA's talent for costing analysis, as well as the ability to work closely with all departments to identify areas contributing to margin leakage. Not all revenue is good revenue, and the Price Waterfall helps companies truly understand the net realized price being charged to customers after factoring in these hidden costs. A price dispersion chart is another useful pricing management tool that focuses on gaining control of pricing practices. It provides a snapshot of customer discounts based on their account size (often measured as revenue per year). One CEO experienced a highly uncomfortable situation when the company's largest multi-million-dollar account discovered that a smaller account was receiving better pricing (buyers often move around companies that are within the same industry). This created a crisis internally, but it also caused the company to try to understand the current state of discounts and use the Price Dispersion tool (Figure 2b) to establish future discount boundaries. The choice of which pricing tools to use will depend on an organization's pricing-strategy road maps, defined within its original pricing diagnostic. Some tools will be more relevant than others, depending on your pricing needs, and it is important to use those that drive the greatest improvements in RPMs. Other Level 2 tools include: competitive analysis reports, outlier analysis/reports, deal/bid sheets, pricing process documentation--accountability & guidelines, customer profitability reports, and cost-to-serve analysis.
[FIGURE 2a OMITTED]
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Level 3: Value Processes in Place
Value is a frequently used term within the B2B and B2C environments, but it's also one that is least understood. What does value have to do with price, one might ask? Everything. In fact, pricing and value go hand in hand, and drive the top-of-mind mentality at the higher levels of the world-class pricing framework. Level 3 is often considered a paradigm shift for many CMAs, especially for those who rely heavily on cost-plus pricing practices. Cost, of course, is always an important consideration for ensuring a price point drives profit. But a cost-plus pricing approach is far from an optimization practice. Value-based pricing, on the other hand, seeks to truly optimize revenue and profitability by understanding what customers are willing to pay based on the value of your offering. Historically, value has been more subjective than quantitative. But there are ways to measure how customers perceive value, their willingness to pay, and methods to relate value with pricing.
Value also plays a critical role in market segmentation and growth strategies. Many growth strategies fail, unfortunately, because they focus too much on acquiring market share with price, a tactic that often leads to lower profitability and back-and-forth market-share gains and losses. A best-practice growth strategy, by contrast, takes a more hands-on approach to help companies understand the value perceptions of different market segments. An understanding of how these market segments perceive product attributes, and their willingness to pay, is critical for value-engineering effective products and offerings. The price-value map (PVM) is an excellent Level 3 pricing tool that can help assess how customer segments perceive a company's offering and prices relative to the competition. Other Level 3 tools include: In-market research tests, pricing tests (conjoint analysis), transactional analysis, cost by SKU, cost by customer segment, and price-volume-profit modeling.
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