We can't blame the economy forever. Yes, purse strings are tight. And yes, raw materials are growing increasingly expensive. But your hands aren't completely tied. Many manufacturers are finding that modifying their pricing structure is helping them ring up near-record revenues and profits in spite of economic and market challenges.
Their approach? Strategic, or value-based, pricing: the practice of pricing products based on their perceived and relative value rather than applying a set margin across product lines. The latter, referred to as the cost-plus approach, is the pricing method still in use by the majority of manufacturers. Those who are breaking away from this traditional approach are looking to tap into the full potential of their product value. It's paying off for them in revenues, profits and company value.
How Strategic Pricing Beats Cost-Plus Models
In a world where cost-plus pricing has been the norm for decades if not centuries, strategic pricing represents a true paradigm shift -- one that is being accelerated by global economic challenges. Faced with cutting overhead and expenses to the bone, manufacturers have begun to look for new ideas to bolster profits. These corporations believe that strategic pricing is an idea whose day has come.
"We have seen companies improve their profit margins by as much as 21% by selectively adjusting their prices," says Ralph Zuponcic, managing partner of PricePoint Partners. "And we're not talking about making huge price increases. Typically, a 1% price improvement can yield an 11% gain in profit margin for a company with an 8% EBIT. Pricing is a powerful tool."
Dr. Larry Robinson, who has taught pricing strategy courses for MBA and EMBA students at Rice, Tulane and The Ohio State Universities, concurs. "As companies begin to implement a strategic pricing strategy, it is quite typical to find 'low-hanging fruit,' which provides immediate increases in profitability. Eliminating price leaks and adjusting prices for customer segments with varying sensitivity to value and price are the first steps to maximizing profits," says Robinson, who recently joined the PricePoint Partners team as director of training and development.
Manufacturers using the cost-plus approach price products simply by adding a set percentage -- say 35% -- to the cost to produce. At this point, one of three things can happen:
- The price is right: Customers buy the product, and the manufacturer makes a healthy margin.
- The price is too low: The manufacturer leaves money on the table because customers would have paid more.
- The price is too high: The manufacturer loses sales.
Strategic pricing is designed to set all of your pricing at the ideal (#1) level -- where the customer is pleased with the value and you are pleased with the margin.
The Science Behind Strategic Pricing
Strategic pricing involves applying analytics to the current pricing structure to identify areas of pricing opportunity. These analytics take three fundamental value drivers into consideration:
- Product price sensitivity
- Market price sensitivity
- Customer price sensitivity
Gauging product price sensitivity involves evaluating each product to determine whether it is a commodity, a high-value (exclusive) product or something in between. Commodities are assigned lower margins so they can compete on price, while high-value items can be priced at much higher margins. A manufacturer might have five margin tiers, ranging from 15% to 65%, for example, once the analytics have been run.
Evaluating products in terms of market price sensitivity simply means that you take into account the level of specialization of the industry purchasing the product. For example, an aerospace widget is more specialized than an automotive widget: It can command a higher price.
Finally, customer price sensitivity is determined as you look at the size of your customers. Large customers expect volume discounts; smaller customers don't. So if your small customers are paying the same price as your large customers, your prices might require realignment.
In addition, strategic pricing takes into account pricing leaks, which may occur in rebate or discounting practices, freight and handling policies, payment policies and product returns.
Who Is Making Strategic Pricing Work?
Manufacturers, distributors and business-to-business service companies are all looking at strategic pricing as an alternative for driving profits and company value. Here is an example of a manufacturing company that has made strategic pricing part of its culture:
Spurred by the rising costs of raw materials, this manufacturer of industrial rubber parts sought to identify areas for potential pricing optimization. Company management hadn't felt confident about passing costs along to customers and hoped that an analysis of their historical pricing data would indicate areas of opportunity.
They were not disappointed. The analysis revealed wide (50%) price variance, with identical products being sold for as little as $8 to as much as $12 per unit to the same market. Management had to ask the question: If so many customers are willing to pay $12, why wouldn't more customers be willing to pay more?
The analysis also uncovered inconsistencies across the firm's pricing practices that resulted in under-optimization and lower profit margins. By adjusting some prices up and others down, the manufacturer attracted additional sales of commodity items while commanding a stronger margin on high-value items. The net reward? A 21% profit-margin improvement and significantly higher sales close ratios.
The Right Mindset: For You and Your Customers
Making the switch from a cost-plus to a strategic pricing model is as much about perspective as analytics. If you can't imagine strategic pricing working in your operation, think about how it works for airlines. Do you expect to pay the same for a ticket to Florida in January as you do in June? Airlines were among the first to apply strategic pricing, changing their pricing structure as peak travel seasons come and go. Customers understand that they "get what they pay for," and they are often willing to pay more than you might think.
Companies that have made the move to strategic pricing are finding that, while a few may protest, most customers recognize the value of their products and accept the rationale behind their price adjustments.
Zuponcic shares, "Remember that it takes only small adjustments in price to make a significant impact on profits. Early pricing initiatives often focus on getting an average 1% price improvement. Starting with attainable goals goes a long way to setting a new pricing culture that is focused on profitability."
Still, communicating your price adjustments to your customers can be challenging. It's important to educate your sales staff about the philosophy behind strategic pricing and to make sure they are able to verbalize the unique attributes of your products, thus communicating their value. Moving from one pricing model to another represents a real change to your corporate cultural, and gaining buy-in from your sales team is vital to your success.
PricePoint Partners -- pricepointpartners.com -- is a strategic pricing firm specializing in pricing analytics, optimization, execution and training.
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