Does your organization create appropriate value with Pricing Policy? Normally organization doesn’t give as importance to pricing as to Volume growth & Cost optimization however reality is that Price optimization creates more value than Volume growth & cost optimization.
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Irony is that price optimization is overlooked as key business driver though for many businesses price optimization plays major driver of growth than volume or cost optimization.
Now the question arises why haven’t more organizations use price optimization for value creation. Following are the challenges for not adopting price optimization-
- Belief that price is driven by external forces: Many businesses mistakenly believe that they must passively accept prices across all products, markets and channels
- Sales force resistance: This is particularly the case when people are rewarded on the basis of sales volume
- Information collection: Difficulty obtaining the necessary information from existing systems is a reason why companies may ignore potential value from price optimization
- Perceived complexity: It generally requires thoughtful manipulation, often at the level of individual transaction
Management’s challenge is to achieve optimum price in the existing market. Normally following approaches are dominated the pricing strategy-
Cost Plus: It has an advantage of simplicity in implementation & administration however there is a high risk of leaving value on the table if some customers are prepared to pay higher price
Customer Value: Pricing according to the customer value approach involves setting prices to capture the full value customers place on a product or service. The advantage of this approach versus cost plus pricing is higher profit margins can be achieved through the capture of the customer surplus. However the main drawbacks are complexities involved in implementation – how to determine customer utility for each product line and how to account for difference in the price a customer is ready to pay
Penetration Pricing: Pricing low to gain market share in anticipation of scale or experienced economies however with product lifecycles becoming shorter and shorter, the risk inherent in penetration pricing is that the product may not endure long enough to deliver the expected savings
Skimming: A skimming strategy is essentially the opposite of penetration pricing — pricing high to maximize margin from customers ready to pay the most however success of skimming strategy depends on the ease of entry by competition, since high margins are an open invitation to new entrants
Company’s pricing strategy depends upon market position, stage of product life cycle & customer demand however pricing choice should be driven my marketing strategy & to maximize shareholders value
Supply & Demand
How will current and future supply, demand, and cost dynamics affect the overall industry price levels in the foreseeable future? Although managers are often well versed in monitoring demand drivers and attuned to responding to the threat of new entrants, market and customer strategies are typically less effectively managed. Therefore for many companies these last two hold the greatest potential for where additional value can be captured.
Product & Marketing Strategy
The key issue in product and market strategy is determining the “list price,” the seller’s published price for a service, product line or SKU. The Stock Keeping Unit (SKU) is the level at which price optimization is most powerful, since customer price sensitivity can frequently be found to vary according to the colors, dimension or other variations in the characteristics of a product.
The psychology of list prices is an important factor, since the price acts as a reference point for customers and conveys a range of signals about the product. The list price must be set at a point that preserves a product’s price / benefit advantage in the eyes of customers while maximizing profitability.
The list price is generally the base against which discounts and allowances are taken. Therefore, it needs to be high enough to offset the expected discounts, freight recoveries and so on. A higher list price allows managers a greater degree of freedom in terms of offering a range of customer discounts. However, a list price too high may push the product into an inappropriately elevated price bracket in the eyes of customers.
Optimizing list price is easily grasped in principle, but in practice it is often ignored or not successfully implemented. Managers can identify the potential opportunities for value creation when they develop an improved understanding of the forces influencing achievable list prices. This requires investigation of factors such as:
• Margin bands
• Regional variations in margin
• Freight rates
• Pricing conventions in the industry (early payment discounts)
• Distribution channels
Analysis of price sensitivity often reveals that the optimal list price can vary among geographic markets, products bundles or product lines within a category. Each of these areas represents an opportunity to enhance margins.
Figure: A
Figure A reveals that client was able to identify margin bands based on customer purchase volumes of a fast moving consumer product and to implement a new list price structure with the potential to add significantly to the value of the company.
The principal outcomes and benefits companies obtain through product and market price optimization strategies are:
• A restructured list price program that reflects the varying competitive intensity that enables the seller to capture more of the customer surplus
• Identification of opportunities to increase value through price differentiation between segments.
Figure: B
Figure B shows the magnitude of margin increases available on low volume items in one market for fabricated products. Higher list prices were possible in this case due to a combination of lower customer price sensitivity on slow moving items purchased only infrequently and less intense competition in the supply of many low volume products. Previously, this manufacturer had maintained a standard margin as its pricing policy across all SKUs for each type of product. Analysis of price sensitivity revealed that while intense competition on high volume SKUs (D & E) required company to “meet the market” on price margins could be dramatically improved on low volume lines. This was because competition on low volume SKUs was typically less intense and infrequent purchases by customers made them less sensitive to the price. Higher margins on low volume SKUs produced a significantly higher contribution and helped ensure that the company could remain competitive on high volume products.
This example illustrates how a better understanding of relative price sensitivity of customers enables a more sophisticated approach to list prices, and can result in significant potential for value creation.
Customer Strategy
The key to customer pricing is maintaining loyalty while achieving the highest prices possible that are appropriate to the volumes sold to the customer. It’s a delicate balance and is based largely on the psychology of discounting.
In many companies, senior management’s understanding of price variation at the customer level is poor with the actual price ultimately determined by the sales force. Management needs to carefully monitor and evaluate customer pricing. Without an appropriate pricing framework, specific discount schedules and aligned performance incentives, sales staff with too much autonomy can quickly erode company profits and even provoke competitive responses that destroy value through out the market.
The key issue is identifying and managing the factors that have the potential to erode list price. These include:
• Discount schedules
• Rebates
• Volume bonuses
• Promotional bonuses
• Cooperative advertising/marketing
• Allowances
• Payment terms
• Buybacks
Performing a transaction level analysis can be a powerful tool for value creation, enabling managers to tighten the relationship between volume and price. In particular, it helps companies increase the contribution from low volume customers that may have obtained discounts or favorable terms that are otherwise reserved for high volume purchaser. Transaction level analysis also allows managers to directly assess:
• The value of customer segments and accounts, therefore determining the appropriate allocation of sales effort
• The net effect on profit of discounts, bonuses and other incentives given to particular sales channels
One indirect benefit is the increased price discipline in the overall market that results form a rational and consistent approach by key players, thus reducing the risk of irrational competition destroying margins for all. Another application of a rational pricing strategy is to examine price differential between small and large companies. Often, small customer accounts can occupy a disproportional amount of sales force time and provide relatively small returns for effort.
Pricing Frameworks to Improve Shareholders Value
Managers are under increasing pressure to lift returns and to focus on improving shareholder value. Institutional investors are becoming increasingly vocal in demanding cost reductions and rationalization programs however they should devote extra attention to the revenue side and the potential for price optimization. A robust pricing framework has the potential to improve shareholders value through:
• Establishing and maintaining list prices that effectively balance profit maximization with product positioning
• Preventing erosion of prices at the customer level through a careful customer pricing and discount strategy.
Senior managers therefore need to regularly assess pricing policy and administration. Key questions to consider:
• Does the company pricing policy recognize differences in regional market dynamics?
• Is pricing segmented to recognize the variations in perceived value among different customer groups?
• Is there a transparent discount policy based on customer relationship value?
• Who has discretion to modify prices? What criteria are required?
If an organization can acknowledge the importance of price as a driver of shareholders value, part of the battle is won. Once managers and sales people incorporate this awareness price into their everyday monitoring of performance, the company will start to create long-term value for its shareholders.
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