Sustaining Profits in a Down Economy

Feb. 19, 2009
Pricing is the most underutilized lever to drive profits

Dramatic energy and commodity price volatility, unprecedented turmoil in the financial markets, and relentless downward pressure on product prices are putting an incredible strain on profits of companies across industries, and manufacturing companies are no exception. Reducing costs -- whether it is reducing workforce, curtailing new investments, or consolidating operations -- is the most tried and tested lever for protecting profit margins, but for many companies today, cost reduction is no longer an option and increasing sales is a slim possibility. Now more than ever, manufacturers must turn to the most influential and yet overlooked driver of profits: active management of price.

An often-cited study by McKinsey & Co. makes clear the power of pricing: a small 1% increase in realized price can deliver up to 10% increase in operating profits. Also consider the example of a leading global manufacturer that invested strategically in pricing. Through a combination of organizational pricing leadership, revamped pricing processes and pricing software to enforce and support those new processes, this manufacturer realized a significant margin gain, even as price points eroded! Companies that elevate pricing from the back office to the boardroom, from a tactical lever to a strategic one, reap tremendous benefits and ultimately emerge stronger and more profitable than their competitors.

One of the most salient benefits of pricing is the "low hanging fruit" -- value that can be realized rapidly after undertaking a pricing initiative. It is not uncommon for companies to realize profit improvement of up to 1% of sales ($10 million in profits for every $1 billion in sales) in 4 to 6 months from these short-term opportunities. In the long-term, effective pricing strategy and execution can build a platform for ongoing pricing improvements and drive profits to give companies a competitive advantage. How can you leverage the power of pricing in your business? Following are five key pricing strategies that will help you weather the economic storm.

Improve Price Responsiveness

One of the biggest culprits of margin erosion is pricing inertia. In today's highly volatile markets, raw material and energy costs are fluctuating wildly, competitor pricing is changing rapidly and the overall buying environment is uncertain. Companies that want to protect profits have to adapt to these conditions rapidly. They need to continuously fine tune pricing across products and services to ensure that it is aligned with prevailing market conditions. Equally important is the need to communicate prices across the network of sales reps, partners, and distributors -- arming them, in a timely manner, with the pricing they need to compete effectively.

Identify and Address Low Margin Business

Most companies analyze the profitability of their businesses at an aggregate level -- for example, it could be at the divisional, regional, product or channel level. However, a transactional-level profitability analysis is more effective because it uncovers missing critical opportunities to identify low margin customers and deals. By accurately identifying low-margin business and associated root cause(s), companies can make informed decisions on whether certain deals make strategic sense despite their low profitability, or whether corrective action needs to be taken.

Tighten Cost-to-serve Recovery

Cost-to-serve items such as freight surcharges for expedited shipping, technical service costs for design, and product support costs, are often viewed by companies as unavoidable costs of doing business. Few companies make a serious attempt to recover many of these costs, and the result is significant, unnecessary margin erosion. In tough economic times, it is critical for companies to tighten the cost-to-serve policies. By classifying customers into categories such as strategic and opportunistic, companies need to ensure appropriate cost-to-serve recovery for opportunistic customers while effectively serving the needs of strategic customers.

Set Granular Pricing

For every company, there are significant differences across the customer base in perception of the value of a company's product and the resulting "willingness to pay." Yet, most companies use an average price approach -- effectively ignoring these differences in perception and forgoing an opportunity to sustain profits. In a downturn, rather than reducing prices across customers, companies should first identify fine-grained segments based on relevant attributes. They should set prices and negotiation guidance for each segment taking into account the segment's Pricing Power (unrealized ability to change prices) and Pricing Risk (measure of what is at stake for the business).

Control "Maverick" Selling

There is good revenue and then there is bad revenue. Bad revenue results from low or negative margin business, and is often an output of "maverick" selling by sales reps and channel partners. This behavior is driven by either non-existent negotiation policies or lack of enforcement of current negotiation policies. As a result, it is not unusual to find dramatic variance in margins across similar deals. Tightening guidelines by establishing target prices, approval levels and floors enable companies to increase the consistency of negotiations while improving margins and price realization. In one particular instance, an industrial manufacturer was able to increase price realization by 9% in less than a year by effectively controlling maverick selling through the use of pricing strategies combined with the right price management and optimization software.

In these difficult times, pricing provides companies an unparalleled opportunity to resist downward pricing pressure and preserve margins. Companies that invest strategically in pricing have the potential to dramatically improve profitability, while distancing themselves from the competition.

Tapan Bhatt is the Director of Marketing for Vendavo. Vendavo is a provider of price management and optimization software for business-to-business companies worldwide

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