The Case for Pricing Management
Written By: Predrag Jakovljevic
Published On: April 3 2006
Enterprises have long realized the importance of improving profits by curbing upstream supply chain costs, as evidenced by an increasing strategic approach to sourcing, e-procurement, and contract or spend management over the last several years (see The Hidden Gems of the Enterprise Application Space). However, this broad strategic approach, including education and discipline, has not been applied on the sales side. The kind of thoughtfulness recently seen amongst well-informed and disciplined buyers and purchasing managers has been lacking when it comes to deploying information technology (IT) systems for analyzing pricing processes, pricing optimization, sales force education, and price enforcement in the downstream components of the value chain. Another major deficiency is the dearth of software providers for the management needs of the entire price lifecycle, from price setting, price optimization, and price policy management, to deal execution monitoring, analytics, and reporting.
Justifying the "why" of pricing and profit optimization is fairly easy, since the objective is to increase profits and margins, and hardly anyone could disagree with that objective (see Profit Optimization—Can We Possibly Argue with the Objective?). But the "how" of the optimization is not easy. Although a simple analysis of the profit increase equation may prescribe raising prices, cutting expenses, or simply selling more—and all of these seemingly simple solutions are right in principle—the real problem is far more complex. For example, if one raises prices, will the customers continue to buy, or will they rebel?
On the other hand, if one cuts expenses drastically, will the product quality suffer as a result of resentful, underpaid, overloaded workers, or equally resentful (beaten up) suppliers delivering cheaper but inferior products? Will this drive customers away? Will the consequent warrantee cost increase to the extent that expenses actually rise instead? Moreover, at many companies, there is little cost-cutting maneuver space within operations, given that most enterprises have been watching their procurement costs closely, and evaluating their trading partners. The option of selling more is not simple either, because no one can control customer needs: one cannot know for sure that they will buy more. Some indications show that volumes would have to rise about 19 percent to offset the profit impact of a 5 percent price cut, and such demand sensitivity to price cuts is quite rare. And even if customers do buy more, the question then becomes, can this upsurge in demand even be delivered?
Thus, it appears that raising prices justifiably is the most effective way for enterprises to increase (or maintain) profits in times of both economic boom and slump. While this holds true for most environments, it is particularly true in the razor-thin-margin retail and commodity manufacturing establishments, where prices and availability are the only levers of competitive differentiation. Savvy and dynamically optimized pricing can then mean the difference between survival and failure. The Power of Pricing, the well-known 2003 McKinsey & Co. report, showed that a price rise of 1 percent, at constant volumes of sale and costs, should generate an 8 percent increase in operating profits, which is 50 percent greater than the impact of a decrease of 1 percent in variable costs (materials and direct labor costs), and more than 300 percent greater than the impact of a 1 percent increase in sales volume, even if one ignores the fact that increased production typically increases costs.
It is often not even necessary to raise prices, but rather to make sure that the customer is charged the theoretically right price (or something close to it) at the end of the day. Corporate nominal list price information might be visible in back-office systems, but the trick is to incorporate real-time, transaction specific, on- and off-invoice price adjustments (such as rebates and promotions, consignment costs, cooperative advertising, end-customer discounts, chargebacks, payment terms or cash discounts, online order discounts, performance penalties, receivables carrying costs, slotting allowance, stocking allowance, freight charges, or volume incentives). The real art is in discerning the actual price each customer has been charged per transaction, after accounting for actual deductions, many of which come only after the fact, from the nominal price. Related to this is the notion of the "pocket price waterfall" to display how much actual revenue the enterprises really keep in their pockets from each of their customer transactions, which thereby helps them diagnose and capture pricing opportunities.
This is Part One of a multi-part note.
Looking for the Pricing Rationale
Yet the majority of sales and marketing executives typically still cannot provide short and snappy rationales for where their list and actual product prices come from. Typically, we hear "that is what the market demands." Or else a convoluted business process is described, that at best involves educated pricing analysts who perform detailed financial, or competitive analyses (using variables such as demand, buyer type and preferences, and sales channel characteristics), or any other spreadsheet-based evaluation to conjure up a pricing list, which is then shared with salespeople. This is really when the fun begins, since salespeople will often ignore these lists anyway, and offer products at the price that—according to the salesperson's hunch—customers will pay.
Sales folk only want to sell something after all, given that commissions (sales incentives) are typically not based on profit margins, but rather on volume. In fact, the company may (unwittingly) be losing money on some of these orders. To close a sale, sales personnel typically leverage discounts off the nominal price lists, in order to please their "very important" customers. Thus, often the actual sales prices are a matter of maverick sales practices, horse-trading approaches (meaning shrewd bargaining with reciprocal concessions), or decisions based on the emotion of the moment, all with the handy excuse of appeasing important customers. Typically, it is more productive to the salesperson's personal objectives (higher total commissions) to cut prices than to justify the standard price.
But maybe maverick sales folk are not entirely to blame, given that their superiors themselves let their companies waste millions of dollars in profit and revenue, simply because they cannot really diagnose (or acknowledge) price management problems. Many companies have an unjustifiably optimistic and somewhat imprudent assessment of their price management capabilities, despite their inability to explain their pricing rationale. Also, managers watching over pricing often focus on invoice prices, which are readily available, but revenue leaks (e.g., price waterfalls, such as cash discounts for prompt payments; cooperative advertising allowances; volume-based rebates; promotional programs; freight expenses; and special handling) are spotted with difficulty, as they are unfortunately not detailed on invoices.
Furthermore, these pocket prices are adequate measures of price performance only for the companies that sell commodity products and services with little variation in the cost of selling and delivering them to different customers. However, it is well-known that in order to differentiate themselves, many companies today are offering customized products, often by bundling them with specific personalized services to please the customer. In this case, one has to use the pocket margin to reflect the variable costs of each order, by additionally subtracting from the pocket price any direct product costs, and costs incurred specifically by serving the customer in question. This would help enterprises identify which customers are more profitable (and worth nurturing), and which should conversely be approached more aggressively, even at the risk of losing their (nonprofitable) business. Lately, for instance, in the specialty chemicals segment, tighter markets and rising costs for raw material and energy have given sellers the leverage to raise prices. More producers now say that they are willing to lose those customers with low or negative margins.
Many specialty chemicals producers have been focusing lately on improving selling prices (rather than gaining market share at loss-leader prices). There is also a growing trend towards structuring contracts to include value-adding items, such as incurred research and development (R&D) and technical services for a certain customer.
Any company's price management state of affairs should not be ascertained through mere intuition, but rather through a sound metric system and assessment of current pricing practices and their visibility throughout the trading network. Once the pricing flows are well understood, potential improvements are often easy to spot, since these processes were devised before sophisticated pricing software applications were available to guide and support the pricing process. The trick is to identify a source of profit margin leakage that has long gone undetected, as salespeople typically do not comprehend how the terms of sale can affect profitability (for example, offering a pricey overnight delivery on small orders to appease some customer will likely reduce, if not annul, the margin of the individual order). Thus, as discipline, understanding, and visibility are added to pricing processes, one might want to consider changing sales commission structures from gross (top-line) revenue targets to margin-based (bottom-line) sales incentives.
Inadequacy of Traditional ERP Systems
Financial and cost accounting applications report and analyze history, but neither suggest alternatives nor understand the complex relationships. To deal with complex relationships like overhead, traditional cost accounting makes simplifying assumptions (for example, that overhead is proportional to labor, or that all products get the same dollar amount or percentage of overhead per unit). Furthermore, for their analysis, accounting and costing traditionally use financial periods that are far from the real-time (or close to it) information required for profit optimization calculation.
In other words, accounting takes an accounting view of the world, while profit optimization and pricing management take an operational view. Consequently, the first software category will not help users optimize their win/loss analysis to discern how they should price better so as to close more deals, or let them realize where in the product structure (bill of material [BOM] and routing operations) the margin is leaking from.
However, price management applications certainly require correct cost information as an input, and the more accurate the costing information, the better the resulting pricing decision. Insight into costs allows companies to identify where exactly the line lies between profit and loss, rather than (typically) shooting in the dark. Once this profit point is understood, price can become a weapon for achieving various competitive goals (such as pricing clueless competitors out of the market, or intentionally selling at a loss-leader price to penetrate the market). For example, a dairy knows that school milk programs lead to a preference for their brand in the supermarket. Therefore, pricing school milk programs at a break-even point means not losing money, if the supermarket market share increases. The trick is to know the price point that matches the break-even point, which requires a full understanding of cost, and therefore of price.
Price optimization and demand management should have a bidirectional relationship. On one hand, actual customer demand must be an important input into the pricing process, which should be cognizant of the market success of all brands and products. Leveraging techniques such as advanced demand forecasting and a sales and operations planning (S&OP) process should help companies better understand the actual market demand for their products and services. On the other hand, it is only logical that price be the defining factor in molding demand for any product.
Thus, specialist software applications should take specific market conditions and customer buying behaviors into account, to create optimized prices across the various environments of price list developments, bid development, and promotional discounting. After all, profit optimization applications have long been leveraged by hospitality establishments (airlines and hotels), where the key variables for profit control are the load factor (the occupancy of seats or rooms), and the average revenue per seat or room. These variables are continually monitored, with price being continually modified (certainly more dynamically for airlines than for some hotels) to meet the objective of the maximum profit for a particular time bracket or flight.
As for the other segments, buyers and sales representatives have traditionally bargained, and will continue to do so almost everywhere, while manufacturers will always scrutinize competitors' catalogs and negotiate through distributors for a given deal with a given customer. Pricing proposals often offer discounts for larger bundles of goods and excess inventory and, conversely, charge a premium for items and services in short supply.
However, new analytical software tools have recently emerged to combine and condense this wealth of information. In theory, they give the salesperson a more definitive "yes or no" answer fairly quickly when it comes to offering specific pricing, while also giving management a higher-level view of business efficiency and profit/loss drivers. Thus, in many environments besides airlines and hotels, it might be smarter, quicker, and more useful for the IT system to calculate pricing based on systematic analysis rather than on human emotions (but of course people can be involved occasionally, to override this analysis for strategic reasons).
As for the retail sector, demand-shaping markdowns and promotions have long been in use, even in many corner shops (to say nothing of large retailers), but the time has come for owners to move away from rule-of-thumb or hunch-based discounting, and to use analytics and business rules to automate and report point of sale (POS) decision making.
And yet, there has not been a real boom in the pricing optimization market—despite a salient need—and real deployments are lagging behind market interest (if only in terms of the putative interest of prospective users). The reasons are multiple. First of all, even the companies that have successfully implemented pricing solutions, and reaped tangible benefits, have been secretive about leveraging these, both for competitive reasons and for fear of alienating (or even angering) customers who might feel gouged. And secondly, there are questions about product maturity, data availability, the risk involved, cultural conflicts, and so on.
The fragmentation of the market, with a slew of point solutions targeting only certain industries, is not helping either. Cumbersome ERP price list and discount management functionality has further clouded the space, and has led multiple vendors to focus on different niche areas or industries, with hardly any single vendor delivering an integrated, business process oriented, pricing solution (which would cover all the price lifecycle bases of optimization, execution, and enforcement of prices).
Also not helping is the need for up-front business process improvement, and change management education in this domain. More companies should spend significant time before investing in pricing technologies. This, together with the need for immaculate history data (which has to be tested thoroughly), is only bloating investment price tags, and deterring risk-averse purse string holders, leaving them to work indefinitely from dreadful spreadsheets and silos of data.
This concludes Part One of a multi-part note.
About the Authors
Predrag Jakovljevic is a director of research with Technology Evaluation Centers (TEC), with a focus on the enterprise applications market. He has nearly twenty years of manufacturing industry experience, including several years as a power user of IT/ERP, as well as being a consultant/implementer and market analyst. He holds a bachelor's degree in mechanical engineering from the University of Belgrade (Yugoslavia), and he has also been certified by APICS in production and inventory management (CPIM), and integrated resources management (CIRM).
Olin Thompson is a principal of Process ERP Partners. He has over twenty-five years of experience as an executive in the software industry. Olin has been called the "father of process ERP." He is a frequent author, and an award-winning speaker, on topics such as SCP, gaining value from ERP, e-commerce, and the impact of technology on industry. He can be reached at Olin@ProcessERP.com.