The Payoff from Investing in Pricing Capabilities

Sept. 2, 2010
In an analysis of the 1,200 largest public companies around the globe, a 1% increase in price levels would net, on average, an 8.7% improvement in profit.

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.

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.

Like many companies, Alen had developed a view of the "pocket price" -- the price it would receive after deducting routine costs, such as a 10% discount off base target price, a 5% volume bonus, cost of financing receivables, standard freight and emergency freight. Altogether, these add up to 25% for Alen, leaving a pocket price of 75% off base target price.

To get beyond pocket price to an appropriate message of account profitability, Alen examined its order books and created a "pocket margin waterfall," showing the account-specific costs of the major steps involved in fulfilling the order -- all subtracted from pocket price (see exhibit). On average, it discovered direct product costs consumed 30% of the target price; custom tooling costs were 11%; technical support 4%; and special cost to serve (custom packaging, etc.) consumed another 2%. These costs added up to 47%, yielding a pocket margin of 28%.

What Alen did not fully appreciate until it drilled down deeper, was the impact that certain customers had on the pocket margin. Looking behind the 28% average, it found that pocket margin rates ranged from as high as 55% to as low as -15%. Alen calculated that, based on its fixed costs, it needed a 12% pocket margin to achieve operating breakeven. When it looked at is customers again, it saw that one-quarter of orders failed to reach the 12% bar.

By arraying its customers according to pocket margin, it was easy to start drawing conclusions. It became obvious, for example, that certain types of orders fell into the high-profit ranges: medium-volume, flat or single-bend parts that were sold to certain customers (those who paid promptly, stuck to volume projections, didn't require emergency freight, etc.). Equally striking was the pattern of unprofitable transactions. These involved excessive receivables carrying costs, high freight costs driven by erratic ordering and excessive per-unit tooling costs driven by design complexity.

Armed with this information, Alen could take a strategic approach to pricing (and marketing). It stepped up efforts to win business in its sweet spot, where every transaction was inherently more "margin rich" and negotiated aggressively with companies in the unprofitable ranges -- holding firm on pricing, adding explicit penalties for violating receivables rules, erratic ordering, missing volume commitments, etc. The new policies did drive off some customers, but those accounts were unprofitable anyway. Overall, the approach resulted in a 4% increase in the average pocket margin and a 60% increase in operating margin in just one year.

We believe such results are not anomalous and that many manufacturers and b-to-b companies can unlock untapped sources of value via pricing excellence. What's more, we have seen a "nobility" to pricing done well -- a psychological boost that raises the morale and effectiveness of the organization. The message to a company that has achieved a price advantage is that its products and services are worth it. That creates pride in the organization and drives performance at all levels.

Walter L. Baker, Michael V. Marn, and Craig C. Zawada are partners at McKinsey & Company, a global management consulting firm.

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