ValuePoint

ValuePoint Musings on Price

Most of the global industrial enterprises have managed to re-engineer their organizations to cope with the current economic downturn.  Businesses from small to large, from commercial to industrial (if they're still around) have figured out ways to do business more efficiently and more effectively in an effort to avoid declining margin and profitability, but most importantly to stay in business as competitors fall by the wayside. Buying smarter, focusing on the value chain and eliminating waste have been the hallmarks of the business reshaping, leaving many to ask the question of where and if additional value can be found in today's market? Bare boned and "lean", industry leaders need only think back to one of the fundamentals of marketing and realize that unlimited growth potential exists through the implementation of pricing strategies that shy away from normal conventions and logic and maximize returns and margin.

An area that has been overlooked in the drive to "lean out" organizations is that of pricing. Strategic pricing, as an initiative to drive market success, has not gotten the visibility one would think it would in today's environment. We've seen aggressive discounts being used to drive traffic and to help improve top line numbers this past holiday season, to the delight of consumers. Setting short term results aside, one has to question the wisdom of some of these tactical pricing decisions and their long term implications.

An enterprise can derive great benefit by thinking more strategically about pricing, in being proactive instead of reactive. The rewards of developing and implementing a proactive strategy can be substantial and the penalties for not considering the ramifications of price reductions can be catastrophic. The graphic to the right demonstrates the power of a 1% increase in price can have on profitability, an 8% increase for most firms. The inverse is also true in that a 1% decrease in price can require an increase of more than 8% in revenues just to break even. That kind of leverage is hard to find in today's market.

 

Some Common Barriers

I believe that there are many reasons for not considering pricing as a viable tool for achieving business strategy; I've been guilty of most of them. My first experience with pricing was early in my career. I asked an executive of my technology firm why spare parts were so much more expensive than the data communications equipment they went into and he told me that it was "standard practice" to price spares at 5X the cost.

I accepted that (he was my boss after all) for about three years until I did a study on spares profitability and discovered that certain spares that were considered to be critical to the operation of the systems had a much higher value to our customer than did the cosmetic parts. By applying the 5X formula we found we were losing an opportunity to gain margin and provide a more rational pricing scheme to our customers.

When I was running a compound semiconductor business where we made both custom and catalog parts we decided to take a deeper look at our pricing. Not too long into the investigation we discovered that the distribution of the pricing for a family of similar parts was very unusual. The pricing distribution was skewed to the right showing that the higher price garnered the higher unit sale volume. Confused by this and digging into the issue a little deeper I discovered that the prices were being approved by two managers and that, even though they shared a common technology platform, they didn't share information about pricing and customer needs and as a result the catalog pricing was actually higher (and more profitable) than the customized parts. We installed a pricing review team that enabled visibility across the business units and that was able to implement effective control.

The last barrier was perhaps the most difficult to overcome. I ran a consumer electronics firm that sold through distribution, sales reps and direct to some large "big boxes." My primary input for pricing was the big box customer and the rep organization. These two sources were often in conflict and whenever I started an initiative to review pricing, both the reps and my internal sales force claimed that sales would plummet if we raised prices…they were perfect as they were. With no ammunition to the contrary I was too afraid that they were right to pursue any change. When I modified the sales compensation plan to focus on multiple elements (Margin, EBIT and alignment with the strategy) I found the opposition to working the pricing formula diminished.

 

Determining the Need

So how do we know if we have an effective pricing strategy? There is a simple diagnostic that a business leader can perform to determine if they are a proactive pricer:

1. Do you use a formula or "rule of thumb" to determine your prices (like 5X cost or delivers 50% GM)?
2. Do you have a nagging suspicion – but no real evidence – that you are regularly bidding too high on contracts?
3. Do your salespeople keep complaining that your prices are several percentage points too high although your share is holding steady?
4. Do your contribution margins for the same or closely similar products vary widely from customer to customer?
5. Do your pricing approval levels seem to be functioning more as a volume discount device than a control mechanism?
6. Would you say you have difficulty in describing your competitor's pricing strategy?
7. Are most of your prices aimed at gaining volume, despite an overall non-volume strategy?
8. Are most of your prices set at minimum approval levels?
9. Are you unsure who the industry price leader is?
10. Do your competitors seem to anticipate your pricing moves?

If you were able to answer no to these questions you have a strong grasp of the market and the pricing drivers. The next series of questions look at your internal process and other aspects of your pricing practices:

1. Do you have a planned method for communicating price changes to your customers and distributors?
2. Do you know how long to wait before you follow a competitor's price change?
3. Are your prices set to take customer specific costs such as administration, warranty, design, carry costs for inventory and set-up?
4. Do you know how long it takes your major competitors to respond to your price moves?
5. Do you understand the economic value of your product to you customer?
6. Do you regularly use pricing analysis to aid in setting prices?
7. Do you understand the value of incremental price changes over single large moves?
8. Can you tie your pricing strategy directly to your business growth strategy?
9. Do you have multiple sources for gathering pricing data?
10. Is price review a standard metric used in evaluating sales performance?

If you can answer yes to these questions then chances are that your pricing processes are in good shape.

Price Bands

One of the tools you can use to help understand your pricing landscape is price banding. When a number of individual orders for a product in a particular market are plotted on a graph against price, something close to a normal frequency distribution is likely to emerge. Because of differences in prevailing practices with respect to list prices, automatic discount points, and so on, the shape of the curve varies from industry to industry, but a spread of ten percentage points on either side of an average industry price level is not uncommon. Understanding the price band is important in understanding where the hidden opportunities lie.

Regardless of its shape, the existence of this price band in virtually every market results from variations or imperfections in both demand and supply factors. On the demand side, customer inertia – the tendency to stick with an established supplier – often contributes to the spread. In some industries the switching costs of a customer may influence the pricing needed to capture a new account. This is coupled with a customer's unique buying practices and value placed on intangible value.

Pricing Strategy and Tactics

We can look at pricing strategy as the attempt to move the curve and the overall industry price level. On the other hand, pricing tactics are focused on moving within a given curve. The chart to the left reflect a framework in which to consider the potential for pricing opportunities.

The degree of strategic pricing freedom that is open to any supplier depends on both the perceived value of the product to the customer and the competitive intensity of the business. The competitive intensity is defined in terms of either product or service uniqueness or the number of competitors bidding on a particular piece of work. At one extreme of the intensity scale is the specialty manufacturer of a patented product (the iPhone may be an example here). The manufacturer has a lot of freedom at where the price is set and, in effect, chooses a position on the demand curve.

At the other end there are those manufacturers in the commodity space where every order has multiple manufacturer's vying for the order. In this arena there is little product differentiation and the value proposition is more than likely manipulated through non product elements such as terms, return policy or quality. An example in this arena can be LCD HDTV.

The combination of these two variables provides a useful framework for thinking about pricing. Understanding where your products or businesses fit in the pricing framework will help you in understanding pricing opportunities. Four questions can help us understand how we can capitalize on these opportunities:

1. Is the price accurately keyed to the value to the customer?
2. Will the price help the purchasing decision makers look good?
3. How will prices change over time?
4. How will the competitors respond?

A Pricing System For Profits

Proactive pricing approaches are more likely to succeed if they are supported by sound pricing systems. Such systems are not always easy to develop, and their effective implementation takes time and perseverance. The elements of a successful pricing system should include the following:

• Extensive data collection on market and customer characteristics, competitive capabilities and past actions.
• Collection and analysis of price data for each product to understand band characteristics, price volume opportunities and to gain insight to customer's perception of value.
• Organizational structure that gathers and maintains this information. Money spent to keep prices focused on profit generally garners substantial return. Insure collaboration and communication of strategic elements and decisions
• Understand the profitability of products and businesses with respect to moves within the pricing framework.
• Development of incentives for accurate data collection as well as appropriate incentive for the selling organization. Making sure that the selling organization is linked directly to the pricing (profit) objectives of the business is crucial.
• Develop and effective control and feedback mechanism. You must have a timely and reliable way of tracking and evaluating the pricing decisions made by each individual pricing authority. This also lets the organization know of the importance of pricing decisions to business success.

The value of strategic pricing system can be measured in hard cash. Most companies don't recognize major pricing opportunities. Some because they aren't aware of the latitude the price bands afford and as a result don't recognize the opportunity costs of passive, purely reactive pricing policy. Taking advantage of proactive pricing opportunities, if done intelligently, entails little risk and in these economic times that represents an opportunity that should be hard to pass up.

ValuePoint Solutions would be happy to meet with you to discuss pricing opportunities within your business and how we can work together to craft an effective and profitable pricing system. You won't be disappointed with the returns.

Charles Stott Managing Director (603) 858-5800 Charlie@valuepointgp.com

Jay Humphlett Managing Director (919) 467-0291 jay@valuepointgp.com