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How to Transform Profitability through Pricing in a Flat Economy

A properly aligned pricing strategy can yield an additional 1 to 3 percent improvement in net price performance.

However we choose to characterize the current world economy, nobody is arguing that we are in a period of economic growth. Aside from discussions of potential deflation and its effects, one fact is clear to business leaders: It’s going to be very difficult to raise prices anytime soon. Communicating rate increases is never easy, but customers typically do expect some level of annual price inflation. These price hikes can often protect a business’s financial health from routine expense increases. How you approach managing your pricing structure makes all the difference.

Whatever the current pricing climate in your industry, there are still opportunities for optimizing your selling prices and finding significant profitability improvements from the processes you implement. Even in commodity markets, it’s possible to recover margins by imposing greater discipline on the methods for setting prices and discounts for customers. In theory, companies typically offer special deals to their higher-volume customers. In practice, however, those special deals are often a great value to the customer, without reflecting that customer’s great value to the company.

To understand what I mean about optimizing pricing, consider the case of a large commodity wholesaler. Figure 1 is a plot of that company’s net prices relative to customer volume. Experience would lead us to expect to see alignment between the aggregate volume curve and the price points. Surprise—the net prices are all over the place, without showing any correlation to volume. You can see there are just as many large customers as small customers in the $12+ range, and an equal number of small customers and big customers in the $2-6 range. This situation is unacceptable. If we stop giving small customers the same deals we offer big customers, the result is an appreciable boost in average selling prices. And more important, a concurrent boost in profits.

Fig. 1 – Net selling prices compared to volume per customer.

For businesses that work from standardized price lists, better pricing profitability comes from more carefully managing discounting practices. Discounts should only be used as incentives to elicit better customer behavior, e.g., more volume, greater share of wallet or faster payment. Unfortunately, customers don’t always buy all the products they promised your sales force they’d buy during the last contract talks, but they still get the same discounts from the deal they originally negotiated. If you look at the scatter diagram (Fig. 2), you can see how companies can find their discounts and volumes misaligned.

Fig 2. – Discounts contrasted with customer volume.

Plotting pricing and discounts against customer volume is the best way to determine if your company has an opportunity to optimize prices. The quality of the representations you can create depends, of course, on how well your company is mining and analyzing the Enterprise Resource Planning (ERP) data it has on hand. Ideally, you want to know everything you can about every transaction with every customer. While that task may seem enormous, it is possible manage ERP data so it tells you everything it should.

Analyzing price performance is comparatively easy. Conceiving and implementing adjustments is more challenging, particularly in a slow economy. By following these five general steps, you can bring your company’s pricing back into alignment.

  • First, make sure your front-line account representatives and territory managers have the information they need to make accurate pricing and discount decisions. At a minimum, give them average volumes, prices and discounts by customer, as well as imperatives on maximum allowable discounts by volume. Require territory managers to address accounts that are out of alignment.
  • Ensure that discount percentages are set based on actual purchases, rather than planned purchases. Require customers to earn higher discount levels through demonstrated increased volumes or share of wallet. And don’t be afraid to recalibrate the discount if volume falls.
  • Next, verify that your pricing and discount structure is encouraging sales of the right products. Eliminate discounts on low-margin, scarce or highly differentiated products. Then train your sales force to direct customers to higher-margin products if they want to keep their discounts. Reward only the customer behaviors you want to see.
  • Recognize that pricing is as much about psychology as it is about economics. The key here is to evaluate which pricing variables will trigger the fewest negative responses. By focusing on improving factors that are least transparent to the market, you can make your changes private between you the individual customer. For example, if the market focuses on list price, you make changes to your discount practices. If your buyers take pride in negotiating high discount rates, let them have the discounts but raise the list prices. And if both prices and discounts are significant points of competition, try to recover lost margins through service fees. Those can always be waived for your most valued customers.
  • Finally, tune your communication strategy to the value of each customer. To reduce the risk of customer defection, begin by communicating the changes to select groups of small customers. As you gain confidence in your new policies and programs, roll them out to successively larger customers. For your largest accounts, focus on improving each account’s profitability by reducing costly associated activities. That may take the form of eliminating discounts or adding service charges for small-volume orders, or for orders shipped to remote locations.

In spite of the current condition of the world economy, and even in highly competitive commodity markets, properly aligning pricing and discounts to customer value can yield a one percent to three percent improvement in net price performance. That benefit appears directly on your bottom line. It’s a welcome boost in a tough economy.

Robert Shaw is CEO of Accunomics LLC (www.acunomics.com), a New York and Singapore management consulting firm that specializes in pricing and profitability optimization. The firm serves the energy retail pharmaceutical and financial services sectors.

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