There are many reasons why companies fail to set and manage the prices they charge for their goods and services effectively. Even among companies that recognize the power of the pricing lever, efforts to elevate the pricing discipline frequently underdeliver.
This is often because companies fail to develop the appropriate pricing infrastructure to support and enable sustained excellence in pricing decision-making. For companies to fully realize the payoff of pricing done well, they must not only rethink how they price, but also create the right pricing decision processes, capable pricing organizations, proper gauges and incentives, and effective systems and tools to make pricing a sustained core capability.
In "The Price Advantage," which first appeared in 2004 and has now been substantially revised and updated, we show how a fact-based, comprehensive approach to pricing can have incredible bottom-line impact. In an analysis of the 1,200 largest public companies around the globe, we calculate that a 1% increase in price levels would net, on average, an 8.7% improvement in profit. This rate of return dwarfs that of any other basic performance lever. For example, a 1% reduction in variable costs (the next most powerful lever) produces a 5.9% profit improvement and a 1% reduction in fixed costs yields only a 1.8% gain on average.
What's more, the opportunities for gaining a pricing advantage are relatively wide-open and untapped. Many organizations have already made great strides in reducing fixed and variable costs; few have invested in pricing.
Too often, pricing has not been treated as a core strategic capability or a performance differentiator. Instead, pricing has been perceived as largely unmanageable -- seemingly driven by external forces (the market) or misguided assumptions. For example, a common belief is that a price cut will deliver volume and market share improvements that more than pay for themselves. Not necessarily. Based on the economics of the largest 1,200 global companies (see exhibit), it turns out that just to break even, a 5% price reduction must drive an 18.5% volume increase. That implies price elasticity of 3.7% (18.5/5), which is highly unlikely. In our experience, price elasticity (the volume improvement per 1% reduction in price) is usually in the range of 1.7-1.8%, occasionally reaches 2.5%, and virtually never reaches the 3.7% required for break-even.
In the current environment, taking a strategic and comprehensive view of pricing is exceedingly important, especially for industrial companies. The pricing lever works both ways -- a 1% reduction in price drives on average an 8.7% drop in margin. With global competition, open-book costing and consolidated distribution channels, makers of industrial goods have faced unrelenting price pressure. Our premise is that only companies that create the price advantage for themselves (by putting in place all of the elements of a high-performing pricing infrastructure) will be able to withstand these downward pressures. Companies that don't will see a continuous margin decline as additional points of price erode away.
How can you create the price advantage? It is not simply charging what the market will bear or indiscriminately raising price. It requires a pricing infrastructure that creates and delivers the knowledge that allows you to make intelligent pricing decisions. One of the key forms of knowledge is understanding the true costs of serving each customer. Too often, prices are set based on an averages or estimates and do not reflect variables (special requirements, shipping, promptness of payments, order frequency) that can dramatically affect individual actual profitability. What really counts is the "pocket margin" -- what's left when the true costs of completing the transaction are factored in.
To understand how this works, let's look at the example of Alen Glass Co., which makes tempered glass for use in heavy-duty trucks, construction and agricultural equipment. No two customers have exactly the same requirements and all items must be custom designed. In addition, no two customers require the same volume and service levels. Some customers, like the biggest truck builders, demand special packaging and shipping to fit into their logistics and production systems.
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