Businesses tend to look at price discounting to prop up sales volumes especially when demand is showing a declining trend. Have you considered doing the opposite? Can we get to increase price realisation, rather than discounting, when sales are sliding downwards? Does this sound counter-intuitive? I would like to suggest that this is not only possible but perhaps the best option available with the management in the given circumstances. I would further emphasise that pricing strategy is a weapon that is inadequately used by businesses to improve the bottom lines.
There are only three ways of increasing profitability of businesses – (a) increasing sales volumes, (b) reducing costs and (c) increasing price realisation. When the global economic situation is in doldrums with no immediate signs of recovery, the demand for goods and services suffer owing to the continuing uncertainty. On the other hand costs are rising, as in India, with high inflation, the falling currency and increasing fuel prices. Thus we have stagnation in sales and inflation in costs – stagflation as some prefer to call this syndrome. In this situation we have no other option left than to look at pricing as the route to profit improvement.
Let us look at the impact of price on profits vis a vis that of the other elements of revenue and costs. For an average S&P 1500 company in USA, with an average operating profit margin of 12.5%, the impact on profits for a 1% change in the various elements are shown below.
On the other hand, how much time does the top management spend on pricing, given that it has the maximum impact on profits? A Linked-In poll among 550 CEOs revealed that, on average, they spend 55% of their time on cost management, 29% on volume and just 16% on pricing. What could be the rationale behind such anomaly – the most impactful element being the least attended to? Well, there are several reasons for this – the main one being that we do not believe that pricing can be a management tool. We tend to believe that pricing is determined by market forces only and the management has little role to play in this.
This in real life is far from the truth. Pricing strategy is a management tool to be used judiciously for achieving profit objectives. So how do you use the pricing tool to improve profits in this difficult market? Let us look at the three different levels one will need to work at to achieve this objective.
At the top level which is the industry level, pricing strategy begins with a good understanding of the overall supply demand economics of the product or service on offer. We need to look at overall trends in changes in supply side, demand side, costs, competitive behaviour etc. The pricing strategy will be aligned with the overall industry trends, which can sometimes be in a different direction to the overall economic trend. For example, jewellery industry pricing will be linked to gold and silver markets which may be on the rise in an economic downturn scenario. A good understanding of the trends will enable one to take pricing related moves ahead of the market.
The next level is the product and market place level, where pricing will be based on value-differential with competing products, as perceived and believed by the customer. If you carry out an exercise on economic value modelling of your offering in comparison to a similar product in the market place, you might be surprised with the flexibility in pricing that this can reveal to you. You may find that you are not adequately exploiting the better value offering of your product in relation to competition.
At the actual transaction level, there are often gaps in execution of the pricing strategy. Here we need to take small steps, transaction by transaction, and are likely to find several opportunities to increase net price realisation even without taking any formal price increase.
The large drop from the list price to the net realised price in the pocket – what is termed as the pocket price waterfall – is composed of various elements like volume discount, distributor discount, price rebate, merchandising allowance and so on. Some of these rebates are on the invoice itself , e.g., distributor discount, and some are off-invoice, e.g., cash discount for prompt payment, annual rebates etc. The trick here is to define specific objectives for each element of the pricing structure and to review whether the objectives are being met or not. If not, the corresponding price rebate structure will necessitate a revision.
It will not be surprising if a review of the discounting structure reveals that the smaller customers are enjoying large discounts while larger customers are not. You might find that customer specific costs, whether additional freight, urgent delivery costs, customisation of product or packaging are often overlooked to be recovered. You will need detailed data at the transaction level and the IT capability to analyse such data to determine the price point leakages. Once you have plugged these gaps, you may be pleasantly surprised with a windfall 1% increase in price realisation and operating profits up by a smart 8%.0