Practical pricing translating pricing theory into sustainable profit improvement

Figures 3.1 Sample Price Waterfall Analysis 3.2 Sales Volume Trend Analysis 3.3 List Price versus Net Selling Price Trend 3.4 Net Selling Price versus Cost Trend 3.5 Net Selling Price ve

PRACTICAL PRICING

* PRACTICAL PRICING

Copyright © Michael Calogridis, 2010

Softcover reprint of the hardcover 1st edition 2010 978-0-230-61460-4 All rights reserved

First published in 2010 by

PALGRAVE MACMILLAN®

in the United States-a division of St Martin's Press LLC,

175 Fifth Avenue, New York, NY 10010

Where this book is distributed in the UK, Europe and the rest of the world, this is by Palgrave Macmillan, a division of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills,

A catalogue record of the book is available from the British Library

Design by Newgen Imaging Systems {P} Ltd., Chennai, India

First edition: January 2010

10 9 8 7 6 5 4 3 2 1

List of Figures VIi

Figures

3.1 Sample Price Waterfall Analysis

3.2 Sales Volume Trend Analysis

3.3 List Price versus Net Selling Price Trend

3.4 Net Selling Price versus Cost Trend

3.5 Net Selling Price versus Gross Margin ($)

Trend

3.6 Net Revenue Trend History

3.7 Percentages from Price Increase

3.1 Margin Impact of a 5 Percent Price Increase

8.1 Revenue, Volume, Price, Margin, and

8.2 Region Revenue, Volume, Price, Margin, and

8.3 Product-specific Revenue, Price, Volume, Cost,

8.4 Contract-level Revenue, Price, Volume, Cost,

10.1 Various Price Increase Scenarios to Enable

Chapter 1 Introduction

The overall objective of this book is to discuss how companies price their products and set pricing in any type of contract they may sign with a customer It's become quite noticeable through financial profit and loss results in many companies that average sale price (the overall price paid by customers for a company's products) is not increasing very much year over year Companies are judged by their financial results, and each quarter the overall revenue and profitability increase Given the basic formula for calculating revenue of volume x price = revenue, you can see why price is so important in obtaining positive financial results In order to maximize price opportunity, many companies have turned to developing formalized pricing strategies When a pric-ing strategy is implemented successfully, it can result in consis-tent, sustainable profit improvement Consider a minimum annual 1 percent-3 percent margin point improvement each year

as your benchmark goal This book will provide an outline (called aprice plan) for developing and implementing aglobai pricing strategy with a focus on taking theory and making it more adapt-able to everyday business This methodology is called Practical Pricing

In this book, I provide, in detail, all the steps and inputs required to build your pricing strategy and function I also discuss what factors derail most pricing programs and pricing leaders and how to correct those issues Finally, I discuss pricing as a career and the recent development of pricing roIes in the past 10 years I also discuss my own tenure in this field of work

The writing style I've chosen to use is the one I'm most fortabIe with and the one I think is most effective from a reader's perspective; concentration on basic business without overpowering

com-the book with equations Where needed, basic analyses required for pricing are included

Introduction to Pricing

Generally, everyone is usually on board with all the changes needed

to make pricing work in a company, right up until something has to actually change This statement, while it provides a somewhat

caustic viewpoint, needs to be carefully considered in the ment of any price plan Remember, pricing excellence is a new

develop-"phenomenon." This phenomenon will require change, big change Unfortunately, many people in mid-Ievel positions in com-panies don't react well to change Especially, when it spotlights past poor decision-making in regards to price

Any functioning pricing strategy must have three basic elements working simultaneously to be successful:

1 Data or "analytics" that support your pricing decisions

2 Changes in behavior ("the individual") around price

3 Changes in the company culture ("the company environment") around price

Driving change in company culture is where the CEO can be a huge positive impact All three areas must be up and functioning effectively to see the margin improvement from price initiatives The changes required can be great and changing behavior and culture doesn't happen overnight Pricing is more than numbers;

it has failed in companies for some very specific reasons However, when set up strategically, pricing can be a much needed "critical" revenue growth engine While many companies have jumped on the bandwagon and hired pricing leaders or created pricing teams, for the most part these roles are delivering much less than the desired dollar impact

Recent Focus on the Pricing

Phenomenon

In the last 10 years, some pretty amazing changes have occurred

when you consider the development of the pricing function Go back and examine how many specific industries had formalized pricing strategies and functions-top consumer brands, pharma-ceuticals, and airlines were, for the most part, the only companies

INTRODUCTION 3

actively engaged in creating a pricing strategy Much of this had to

do with the extreme price sensitivity of their products in a sumer environment (that is, increase the price of a can of diet coke without careful price analysis and you may get a very unpleasant shock from your consumers) Most companies did not have for-malized pricing functions Most likely, the marketing product manager would manage the price on an ad hoc analysis and the finance team would do some very quick margin analysis But no individual person or team responsible for pricing analysis and ensuring price opportunity was being maximized Many industries had no pricing function, but they survived and even thrived for decades without dedicated pricing resources So, why make the

con-change now?

There is constant, constant pressure on CEOs to improve the bottomline and obviously price plays a large role in that improve-ment But to be honest, that's not the reason for all the sudden interest in pricing Pricing simply became "in vogue." Several top companies (GE, RCA, etc.) and prominent CEOs wanted to bet-ter "wrap their arms" around price It was really only after the

"fad" introduced pricing into the company that they started to understand how badly they had been mismanaging this critical area At this stage, majority of large companies now understand the pressing need to have a value-based pricing strategy It's not only companies that jumped on the pricing bandwagon Consultants saw an ocean of billable hours and were more than willing to knock on every CEO's door and tell hirn/her how rnany millions of dollars they could have in profit improvement if they only instituted "pricing excellence."

But an important fact (and conclusion) is that the pricing tion, for a large majority of companies, is new Pricing leader and team roles are still evolving and likely will be for a few more years But go to any of these companies and you'll see the pricing team set up a bit differently These are critical points in trying to under-stand the positive impact that the pricing leader is able to make on the company This function/role has been established to deal with

func-a criticfunc-al func-arefunc-a-pricing excellence, thfunc-at is, gfunc-aining the mfunc-aximum net sales price for a particular product or portfolio of products, but

it may not be empowered to drive the degree of change required

to bring about a value-added pricing strategy The underlying issues affecting price management evolution are critical in under-standing what it will take to ensure the pricing function succeeds Simply having an interest in pricing is not quite the same as

actually having a workable and functioning pricing strategy The two can be miles apart

Why Pricing Fails in so many Companies

It's not that pricing fails per se, but more that it fails to live up to expectations The expectations, however, are neither weIl thought out, nor practical to the business, nor resourced correctly Let's say a CEO sees eroding margins and is hearing from consultants

or competitors how better pricing practices can improve those margins If the company has no current pricing function, most likely the business excellence group-six sigma team-will be first utilized It's also important to understand that there can be sev-eral reasons why price erosion is impacting the company

1 Lack of process and procedure has resulted in a majority

of products being underpriced (versus competitors) or overdiscounted

2 The company is involved in a price war with top competitors

3 The company has enacted a market share gain strategy, which usually results in price erosion

4 Service quality is so poor that sales folks are relying heavily on price

5 The lack of a new product pipeline has forced the sales force to rely on heavier than anticipated discounting on existing prod-uct portfolios to gain and maintain customers

The company will understand the primary reasons for price sion (which can be calculated) It is how they stop it or slow it down that usually doesn't go very well Some important terms will need to be clarified as they will turn up again and again First, list price, can be defined as the price of a product to the public with-out any discount (or price concession) removed from the list price List price is occasionally defined as not being a valued number because everyone gets some type of discount thrown in with their purchase While this may be true, list price is still important from

ero-a pricing ero-architecture perspective ero-as for eero-ach product you would want to establish one list price for that product and discount off that list price as needed to be competitive in the marketplace If you do not have the structure of a list price present, you would then need to change every single customer's net price to do a price increase or some other type of price management initiative So list

INTRODUCTION 5

price is important from a structural standpoint in terms of putting the product prices in some sort of order management software sys-tem for buying purposes

The term net price is the selling price to a customer after all types of discount or other incentive is removed from the list price Discount percent is the price concession made to a customer, usu-ally for making a volume purehase To follow on that, a discount grid is just a set of discounting percentages that are aligned with some level of revenue "spend" by a customer, usually on an annu-alized basis The grid would be fairly organized with the goal of treating all similar sized revenue customers in somewhat the same manner

Let's say for argument sake, that lack of process and procedure

is causing overdiscounting by the sales force However, the sales force say they have to discount at a higher percentage off list because the list pricing isn't at market level once you subtract the discount Were process and procedure in place, the pricing depart-ment would be working with marketing to review the list pricing each quarter to ensure that list minus discount percent equals a market level rate versus top competitors

The point is that upper management most probably hasn't clearly thought out or just doesn't understand why lack of price management occurs The conclusion most will come to is that the marketing and finance folks are not putting in enough analysis and thought to do better at price analysis and strategy Additionally,

it would be fairly easy to come to a common agreement that sent internal resources do not possess the level of pricing knowl-edge to drive either the implementation phase or manage pricing from an overall value perspective Hence, the CEO feels a strong desire to turn to internal "help" resources and and/or consultants It's generally a feeling of "we need to be better at pricing so let's get people who are pricing experts or experts in general around process."

pre-The CEO wants action and gets it, weIl not really Six sigma folks usually have no pricing background at all Consultants can

be pricing experts but they make their money by selling services

So companies have begun to create a position called the pricing leader Many times this will be the first time the company has established this sort of role and it would take a while to establish a basic pricing competency

To date there have been some rather consistent issues with these so-called pricing leader positions Some of the critical errors in

organizational placement and management in regards to pricing positions are:

1 Defining the position too broadly and then not providing quate resources to support the leader Stand-alone pricing lead-ers rarely, if ever, succeed They become quickly overwhelmed and are pulled in many directions alm ost from the start

ade-2 Not structuring the pricing leader position into a reporting channel of authority Burying the position below mid-level sycophants, who don't embrace change or the ideas around change because of some inherent fear of being "spotlighted," dims the candles, so to speak, on all the ideas and change man-agement that would be needed to push the agenda forward

3 Not hiring the right candidate The ideal mix of skills to enable

a successful pricing leader is asolid finance foundation (pricing

is inherently numbers), but balanced with a marketing view of the world, that is, someone who does not look at price based on margin alone

4 Lack of executive commitment The executive level has to embrace the idea of pricing excellence in the company and demand the same attention from everyone else

The Basics of an Effective Pricing Strategy

In this introduction chapter I review the basic inputs required for

an effective strategy Each area will require, though, additional detail in subsequent chapters First, let's define effective pricing It

is the process by which the selling entity obtains customer-defined full-dollar product value consistently across a wide array of differ-ent type of contract transactions in a precise and defined manner (that is, you must have an effective discounting strategy, it shouldn't

be left up to each sales person to define maximum product price value) That full dollar value is continuously updated for changing market dynamics and your pricing strategy should be congru-ently aligned with your market share goals, both short and longer term

Along with data, pricing behavior and pricing culture, a cessful pricing strategy will have the following sub-set attributes

suc-1 CEO mandate for pricing excellence (can't be stated enough times)

2 Market research-conjoint analysis

INTRODUCTION 7

3 Data analytics around price

4 Effective discounting

5 Aligning sales incentive compensation around price goals

6 Implementing consistent sales force behavior around price increases

7 Managing an effective exceptions process and pricing committee

An executive mandate for pricing excellence is the absolute, ber one item required to drive an effective strategy Pricing is a function that cuts across multiple departments (sales, marketing, finance, legal, etc.) and companies rarely, if ever, bring in pricing experts when pricing is operating effectively The executive sup-port should be what 1'11 call a mandate It has to be a passion of the CEO that he/she will instill on the company culture from CEO level on down The CEO has to have pricing as one of the top five items that the company needs to "master" and finally, the CEO must facilitate the funding of pricing resources

num-Market research (or conjoint analysis) can be most easily defined

as the measure by which a company gathers consistent, planned feedback about high-impact/expensive products both for the product's attributes as well as where price fits in the buying deci-sion Commoditized products typically are priced through more

of a cost-plus methodology, which 1 discuss in a later chapter Data analytics around price should be seen (and correctly so) as the foundation upon which every decision or conversation about price originates Data is the cornerstone of an effective conversa-tion with both your internal customers as well as your external customers An individual's (that is, the pricing leader) opinion will never be as effective as data Even so, data tends to drive a lot of rather divergent conversation, but safe to say, relevant data will "ground" your audience in the reality of their world That's the power of data

An effective discount strategy is a core requirement in "netting"

a market level price Product marketing ("upstream") controls this activity as much as they control the actual setting of list price However, since a discount strategy revolves around all products, it's not really one product person who is going to drive this initia-tive Most times what you'll find is that "way back when," someone

somewhere in the company came up with a discount grid Typically not a lot of analysis went into the creation of the grid but never-theless you'll usually find something in place historically The crit-ical point is that a discounting strategy somehow has to net a correct or market level price when applied against the list price The discount structure (if not carefully planned out) will some-times leave the sales organization with a bunch of leeway in increasing the discount

Rule 1, if you give your sales force a range of discount to use, assume they will go to the top discount almost 100 percent of the time If the formula of list x discount = net somehow isn't work-ing, that is, the list is too high or the discount percentage remains high even if you tweak the list, then you'll have what I call inertia, meaning stopped or stalled progress Your product marketing folks will not touch the list price because of fear that the discount percent will not come down in the sales force You'd be surprised how often this takes place Having an effective discount strategy will require (and should require) a standalone chapter to provide the appropriate level of detail Suffice it to say that discounting is usually a fairly disjointed activity in most companies and is at its core, a critical area where the pricing leader must take full charge

Aligning sales compensation with prlcmg: Most folks I've worked with in companies don't find this a difficult issue to agree

on, if you want your sales force to be "aligned" on pricing lence, you'll need to insert something on pricing or margin into their sales compensation I say "something" because it can be a bit different based on the specifics on how the company prices or discounts For example, you could insert an average discount per-cent that you would want your sales folks to be under or you could have an average margin You don't want to turn your sales force into mini-CPAs but you do want them focused on profitable sales

excel-Implementing consistent sales force behavior around price increases: Many times the sales force views price increases as either optional or will request an exception for a key customer because that customer will balk at the price increase The only way to develop an effective pricing strategy is to provide consistent lead-ership to the sales force that says "you need to learn how to sell through price increase issues." No customer ever "likes" a price

INTRODUCTION 9 increase, but reality says, most customers won't leave a vendor just because the vendor raised their priees Role play training for the sales teams on implementing is a help here

Exception pricing: Every customer wants a deal and as much as you might try to design a grid for the vast majority of the cus-tomer account population, your largest customers are most assuredly going to want some special level of discount The trick really becomes how do you do these type of deals for your largest customers, where some margin percentage trade-off is okay in return for more sales and margin dollars, and not have your sales force requesting deals for a large proportion of the customer pop-ulation The rule usually should be 80/20 where exceptions should never climb above 20 percent of your customer population

What Role{s) should Consultants Play

in Pricing?

The prime benefits of a consultant are the ability to have a "highly respected" third party assess and make recommendations !t's important to keep in mind that consultants don't know your com-pany and the people and issues in it and quite frankly, they don't have a long-term interest Their interest is in devising recommen-dations for improvement, not actually implementing and execut-ing the changes Most consultants will give you a holistic recommendation based on a set structure that, most likely, they use time and again Additionally, and not to be forgotten, they get paid on a project and hourly basis The longer they are at an engagement, the better for them Also, as I've stated before, don't look for a magie potion, consultants are not going to come in and instantly solve all the problems that you haven't been able to solve

up until now

Finally, consultants are hired by and make their pitch to the executive staff level in the company The recommendations of the consultant then become the project of the executive sponsor So what does that sponsor do, especially when pricing is not his

"thing," he/she turns to someone they trust who may have been exposed to some type of pricing experience at some point in their background Or, and sometimes in combination with, they turn

to the business excellence folks (that is, six sigma) who have even less pricing experience But at the end of the day, are consultants worth the price? !t's important to view their work as a first step in

understanding the issues and problems required to develop a ing strategy They will either validate or tell you (the collective company "you") things about how you price that even you don't realize

pric-Companies and Industries with Long-standing

Historical Pricing Functions

Certain industries have long had formalized pricing functions and teams and it's important to understand why other industries didn't follow suit If you look at other parts of a company, you would find finance, marketing, sales, and the like Why did pricing as a job speciaIty develop only in selected companies? To some extent having a pricing group or function may have been viewed by top management as a nice to have but not a must have After all, "aren't

I paying all those marketing product managers to manage price?" Yes, they were doing so, and finance was paid to manage the profit And it's equally true that pricing can at times be called the invisi-ble benefit because many other factors drive price other than price increases For example, why did Coca Cola have a pricing function and many other similar sized companies did not? To a large degree,

it was the corporate culture Hire top school grads and put them through training courses and you'll have exemplary employees as

YOUf skill base These companies historically had pricing functions because it was their direct knowledge that small and even minimal price changes had enormous effect on products And since these were direct-to-consumer products, the effect was immediate Who would realistically want to price incorrectly a can of diet coke? The financial effects, even from a miscue of a few cents, would be disastrous

This is the fundamental reason why many industries long aga developed pricing functions and others did not, until recently If your product price decisions are relatively feIt at the consumer level and, again, using the example of the price of a can of diet coke, that change in product price would be felt almost immedi-ately Consumers purchase diet coke every day, if the price jumped, you'd know quickly if sales volumes have changed Consider the airline industry Pricing to consumers (with a heavy

ac cent on fixed assets) made pricing excellence a key component early on So if the change in product price did not directly and immediately have an impact, pricing never got that much of a spotlight

INTRODUCTION 11

The Bottomline-Profit

At the end of the day all roads lead to profit Failing to equate each initiative in pricing to profit is a critical failure If your strat-egy or your pricing leader is overly connected to process without tying the improved process to dollar increases, then, from the 10,000 feet level, the project will not be deemed successful Make

no mistake ab out it, companies are embracing pricing excellence

to improve performance However, presently there is a large gap between the concept of "let's establish a pricing leader role" and actually having that leader role financially impact the company The are improvements that pricing can make on the bottom line, but the improvement will more come from bettering the pric-ing excellence on individual transactions and contract renewals than from some idea that "low hanging fruit" opportunities will abound forever What do I me an by all this? The 1 percent to

3 percent sustainable (repeatable each year) profit improvement from price will be to a very large extent driven by having a core discipline in place that allows pricing excellence to function con-tinuously at a very high impact rate Hence, being "good" at pric-ing and all that is attached to price (discount, contracts, etc.) needs

to be part of the company and individual culture and behavior

Practical Pricing Defined

The practice of pricing a product or series of products would not seem to be all that difficult You have a product with certain attri-butes If you've used market research in your determination of value, you've got some idea of whether your potential customers would view the product as a commodity or highly differentiated

or somewhere in between If the product has direct competitor products, then through various types of competitive intelligence techniques, the marketing manager could get some fairly reason-able idea of what competitors are charging, and then charge along the same lines Also, in terms of profitability analysis, finance could provide the marketing manager with cost data so we could understand how much profit on aper unit basis the product would generate

On and on this goes toward a conclusion that pricing a product

is not inherently difficult If you don't "hit" the perfect price, you'd certainly get something fairly reasonable Right? Wrong? While pricing one product can theoretically be "easy," in fact, what complicates matters are all the different folks that touch price

in the company across the marketing, sales, and finance teams Without a defined pricing strategy, it's unlikely that all these dif-ferent groups are going to get pricing right each time However,

in response to the demand for better techniques and methods for managing price, there's been a plethora of books that define pric-ing theory as well as the creation of headcount specifically created

to drive profit driven price strategies The basic premise and the basic audience for this book are managers in any company who are either directly or indirectly involved in pricing decisions

Pricing doesn't need to be a theory-Iaden book of multiple equations At its essence, price can be relatively simple (it's the customers who are more complicated) with the right techniques applied This pricing book aims to take pricing theory and trans-late that theory into everyday business practices that can not only correct long-standing pricing issues but a create a pricing strategy that adds sustainable profit margin impact each year (2 percent would be considered a minimum annualized benchmark) Pricing

is usually divided amongst different parts of a company Every department from marketing to sales to finance has some unique interest in pricing but not one of those departments looks at price holistically Yet, there is no one to tie all the pieces together into one cohesive "story" and carry the message forward

The best example is the theoretical price increase Ifyou increase your prices by 3 percent per year, then you will see x percent on the bottom line But talk to any CEO and he/she will tell you how difficult the practicality is of executing aprice increase The pric-ing leader is the person who ties all the disparate pricing pieces together and translates them into workable solutions that can function in an everyday business environment Pricing theory is fine to discuss, but it won't apply very well to any business without significant tweaks

General Business Goals

The overall global pricing strategy must tie to the business' defined business goals Business goals are usually defined in terms of rev-enue and profit and/or market share growth Revenue growth needs to be at a market growth level, that is, if your company grows 8 percent but the overall market grew 15 percent, then you're growing but losing market share Pricing decisions will be somewhat affected by your business goals Price may be "sacri-ficed" in order to grow share If that is the case, it's important to

INTRODUCTION 13

align pricing with the overall goals but strategically "using price" shouldn't be a signal to open the gates and arbitrarily erode price further than necessary

Building the Price Plan

To create the basic structure of the pricing strategy, in terms of core elements and outcomes, a formalized price plan should be completed, tracked, and continuously updated Aglobai pricing strategy has many elements, so it's strongly recommended that whoever is the leader of the pricing strategy initiative create the detailed structure guide to not only keep the strategy on track but also be able to communicate the overall goals as part of the com-pany-wide alignment process The pricing initiative leader has to understand and it must be clearly spelled out by executive man-agement, that hurt feelings aside, this project will instill a pricing discipline in the company It's not meant to pinpoint (per se) peo-pIe issues within the overall poor price practices, but may validate some long thought ideas about pricing competence The pricing initiative leader needs to have the courage of conviction to be able

to see the bigger picture and not worry about potential highlights

of mid-Ievel folks involved in an inadequate pricing system

Initial Price Assessment

Pricing Assessment

The first step in assembling a price plan is to conduct a pricing assessment A pricing assessment is a list of questions asking each individual involved in a company's pricing process what their spe-cific analytical processes are in developing recommendations for their area of price involvement This assessment provides visibil-ity to the degree of value add process and analysis that currently exists in a company's procedures for setting a price For example,

in estimating a product's maximum-value net price (the desired price the company would like the customer to pay), the company would need to understand what a competitor's similar products are priced at in the marketplace If the company has a competi-tive intelligence team, understanding competitive dynamics would fall to this team Potential questions for the competitive intelligence team might be: Where do you obtain competitive pricing information? What process do you utilize to compare key features of the company's products versus competitive offerings, and so on

The competitive intelligence team might then, for example, assess similar products through Internet web searches on the com-petitor, do some random surveys of particular sales folks or cus-tomers, and so on Last, the competitive intelligence team would provide a written record to the product manager of a desired price range for the product and an audit trail to give the manager some indication of the rationale behind the decision Pricing is not a science with 100 percent accuracy but a reasonable understanding

of how the recommendation was arrived at This is what you're seeking here The assessment seeks to monitor the degree of

16 PRACTICAL PRICING

process and procedure consistently utilized in arriving at price recommendations

If the company currently has pricing processes that are more

"informal" (not documented), then feedback to the assessment questions will clearly show that fact to the executive audience sup-porting the implementation of improved pricing practices To some degree, there won't be a lot of surprise from managers if the feedback to the questions doesn't show reasonable effective pro-cess However, there is sizeable difference in having the summary results of a company-wide pricing assessment completed and com-municated versus having the leader(s) of the pricing initiative merely state that he/she doesn't observe solid processes In a very real way, the leaders of the initiative (who don't own the pricing process) show managers who do own the pricing process as to how well the owners manage price That's the value of the assessment

as a first step in constructing the price plan It provides reasonable factual data on the current pricing processes employed by all of the owners of price

Amention should be made at this point about how pricing is managed in the majority (but not all) companies that have some type of pricing leader function For the most part, the leader func-tion has been established to provide better pricing practices for the marketing team, who have historically owned the execution of product pricing The pricing leader function does not technically own the execution of the pricing analysis The pricing leader func-tion is instituted to define and execute better overall process, pro-vide analytics on price performance, and ensure any defined processes are similar over the entire organization A pricing leader's job is especially difficult when he/she recommends improvements

to a process owned by another team That's why the whole tive needs to be supported by the CEO and his/her direct team and the pricing leader needs to develop strong working alignments with product marketing, as a prime example

initia-Who Conducts the Pricing Assessment?

Normally it would be the company's pricing leader but it also could easily be outside consultants or various personnel in product marketing or finance who would conduct the pricing assessment Whoever is doing the pricing assessment, however, needs to under-stand that it is very much a team effort in developing the appropri-ate questions to ask each person or group involved in pricing The

team would include representatives from marketing, sales, finance, and to a lesser extent legal All of these departments have input into pricing decisions on an everyday basis Obviously, those par-ticipating in helping develop the questions to be used in the assess-ment need to understand that the overall goal is to define strength

of process, not simply to criticize the current owners of pricing The assessment would be distributed to the various teams, for the most part, everyone from analyst level up to vice president It's desirable to have a wide number of people at various levels so that you can capture many different opinions and formulate sum-maries of the results Each respondent's answers should be com-pleted privately, and ideally it would be best to protect the identity

of each respondent when reasonably possible The quality of results from the pricing assessment will vary; some companies have fairly defined procedures for setting price, many more do not The very fact that a recently developed pricing leader func-tion is doing this assessment as part of the overall strategy improvement would strongly suggest that current pricing pro-cesses are not robust

Effective Pricing 15 Important

Think of it this way: in a publicly owned company, the owners, that is, the shareholders have a right to expect reasonable answers

to reasonable questions about how product level pricing is set Companies are judged on how weH they meet or exceed revenue and margin targets Given the price x volume = revenue formula, it's not hard to see how so important a process as pricing cannot

be left to nondocumented guesses and estimates with no audit trail as to how the decision was formulated The people involved

in setting prices have a responsibility to the company owners in working within a value-add defined process The pricing leader is the "insurance" to make sure the value-add process is put in place and remains functioning

The results from the pricing assessment will serve as a tic for the company on the health of the current pricing strategy and provide answers to the following questions:

diagnos-1 What is the company's current procedure for setting a product level price?

2 What is the process for pricing a contract or tender? What are the specific price initiatives that will drive annual price and

18 PRACTICAL PRICING

margin improvement? Again, an annual 2 percent point improvement in gross margin should be considered the bench-mark minimum

Determining the Company's Current Procedure for

For this first question you're looking for procedures and analyses techniques to be solidly in place that would detail all the steps and procedures that anyone in the organization would have to com-plete to set or change a product's price or get the changes approved Any analytic spreadsheets to be utilized would be included in the policy and procedure document It's simply the directions to fol-low in setting a product price Is there a standard set of instruc-tions currently distributed to everyone in the company who has responsibility for executing price analysis? You're seeking consis-tency in approach to analysis Without some formalized process to follow, the odds of all of them doing the analysis and getting the proposed pricing reviewed in the same manner are virtually nonexistent

For example, as part of policy and procedure, marketing would

be required to know who are the top two or three major tors for this product offering and in what price range are their products found The marketing or competitive intelligence team would provide the audit trail to the recommendation Is there a standard price analysis template embedded within the policy and procedure document? Some of the questions that might typically

competi-be found in the analysis template could competi-be the following:

1 Why is the product price being set or reset? Is this a new uct introduction or an upgraded replacement?

prod-2 What is the current market share (if existing) of the product or product family?

3 Has market research been conducted for this product? If so, what were the price recommendations?

4 Do you have product level historical price data? Competitive data? Have you assembled the data histories into some type of trend analysis? (Remember, price is best looked at in a trended format over a reasonable period of time-say, two years-quarter over quarter will suffice)

5 For any changes in price, has a volume (units) forecast been completed?

6 Ras the upside from the mini-business case been included in the operating plan's latest estimate?

7 Ras the prieing committee reviewed and approved the price changes?

8 Will a post-audit be conducted to determine the actual volume uptake for any price concessions?

While the goal of a standardized template is to provide for a "set" analysis using the same types of criteria every time a product analy-sis is completed, it's not meant to be a lO-page document In a value add pricing strategy you're seeking some balance between adding fact-driven process with the reality that many folks in this process are not "numbers" folks and pricing is not a science A pric-ing analysis template has the best chance of success when the tem-plate is brief (not over one or two pages), is online, requires minimum keypunching, and so on If you make the price template too overwhelming, marketing might complain that it delays prod-uct launches by "forcing" them to supply too much information The culture, whereby marketing gets used to documenting their pricing decisions versus making decisions informally without pro-cess, will take some for them to get used to A good route to take with a pricing template is to test it out on a few preselected market-ing folks and ask them for their opinions on what they like and don't like

In terms of making it user friendly, the most effective design is

to have one space for every answer that you would like For ple, if you want to understand the competitive landscape for a partieular product, add one space for competitive company and one space for each estimated competitive net price for that com-petitor, and so on If you want a question or piece of information

exam-in your template, just ensure there is aspace or a lexam-ine for it Additionally, it will be most helpful for the pricing leader to have some sort of training for marketing on using the template The pricing initiative leader would be encouraged to do some type of standardized training of the marketing teams While the detailed instructions on how to set a price or complete a contract (the pol-iey and procedure doeument) would be developed and would aecompany the template, the training would ensure that everyone knows how to use the tools and has some opportunity to praetiee

on these new tools The training allows nonfinaneial folks to ask basie questions and ensures that everyone understands how the model works Overall, if no written poliey and procedure

20 PRACTICAL PRICING

document with a standardized analysis template exists, then value add, consistent pricing process for setting product levels prices probably does not exist

Along with having a formalized policy and procedure for setting a product price, you want to understand if the company has formal procedure in place for executing contractual agreements Formal contract or tender agreements are signed, legal documents that define all of the product pricing and terms and conditions that bind both the customer and the vendor Price defines the product pricing and discounts, terms and conditions would define any other revenue related areas such as payment terms, annual mini-mum revenue commitment, and the like Contracts tend to be found more in the United States while tender agreements are found more in Europe and other global markets

For the most part, these agreements are usually part of long negotiations for very large amounts of money that the purchaser may spend with a vendor Purchasers are driven in part by the qual-ity of the products they purchase from a particular company; how-ever, they also seek to control the costs incurred to better manage their overall profitability In the business-to-business sector, for-malized procurement (purchasing agents) positions exist to specif-ically deal with negotiating the best deal possible with vendors Much of their variable compensation (annual bonus) may depend

on containing costs (that is, obtaining lower prices) with vendors However, contracts don't just exist for large business-to-business customers They also exist for consumers Consider, for example, the contract you sign when you rent a car or purchase a mobile phone or any host of transactions The key difference between business-to-business and consumer agreements is that a majority

of a person's salary is not spent in renting a car or buying a mobile phone Consumer purchase volumes, of one or two, are much less risky, for both dient and vendor, versus business-to-business agree-ments where a sizable majority of revenue may come from that one large agreement The agreement could be multiyear in length I've worked with dients where 5 to 10 large business contracts were

75 percent or more of the company's total annual revenue In this type of scenario, executing the "right" pricing on a contract or tender is vital

It is imperative that value-based processes exist for executing agreements Whoever is executing the contracts should be able to detail reasonable process in how pricing and terms and conditions are developed for specific agreements However, since contracts effectively are an agreement to buy products and if value-based processes don't seem to currently exist in executing product level prices, it's highly unlikely that contract pricing is based on any-thing of substance Depending on the specific industry, a majority

of the total business of the company may be medium and large contracts The sales force will be under great pressure to dose deals Usually a contracts team will be set up as part of the sales operations team (Contracts would/should be moved under the pricing leader if the pricing position has been established.)

A key point to make here is that pricing excellence in terms of executing a contract is not something that will occur during the time that a contract is being actually negotiated or bid The pro-ces ses around contract price need to be developed and in place long before the actual contract is up for renegotiation Some key items to look for in doing an initial evaluation of the contracting/ tender process are the following:

1 Does a calendar of contract/tender expiration dates exist and does the contracts department proactively start their analysis 90,

120, or 160 days before the expiration date? It takes time to review all of the prices for products within a contract, review terms and conditions, and so on So this is an activity that needs to start well

in advance ofthe expiration date In this case, the contracts ager should be distributing to everyone who would be involved in the contract process the start dates on the contract analysis to ensure it's done with reasonable accuracy and procedure Is this happening currently?

man-2 Are there quarterly business reviews to understand current formance of the account (if preexisting) versus the original expir-ing contract/tender terms? If a company has a finite number of agreements that make up the bulk of revenue, then it's advisable to

per-do a quarterly review of the actual performance of the business that the customer is providing versus what was agreed to in the master contract

For example, you would want to know how much revenue the customer is generating each quarter to see if they will meet their revenue commitment The amount of revenue the customer

of understanding does the company presently have for financial performance of large contracts or tenders

3 Is there a pre-call with all the involved participants once the renewaljbid process kicks off? This relates back to the calendar of contract expiration dates and beginning the analysis process some time period prior to expiration For example, if it's decided to begin contract analyses 90 days prior to expiration, then at this 90 day "pre" date, the contracts manager should get together a meet-ing with each person in the contract process, that is, the sales rep, the sales manager, the pricing leader, marketing, finance, and the like Everyone would be apprised of the most recent information regarding the financial performance of the customer as weH as all the roles and responsibilities everyone would have in the renegoti-ation Basically when you're operating with a "team" of folks in executing a contract, the contracts manager would want everyone

on board in terms of deliverables, due dates, and so on

Does the contracts team have a fuH understanding of code by code level competitive pricing to identify the level of current com-petitiveness? Some companies have only a few product offerings that may seIl for hundreds of thousands of dollars (that is, capital equipment-Iow volume/high dollar) and other companies may have thousands and thousands ofproducts (called SKU-short for stock keeping unit) Some level of competitive intelligence should exist on each major product to understand how competitive the company is in the marketplace 1t's also important to note that while some companies may have potentially thousands and thou-sands of SKUs, a relatively few products usually account for the majority of revenue in any company SKU is the code assigned to

a specific product part for identification and inventory tracking purposes

1t's not realistic to presume a contractual pricing offer could be prepared and offered without having some idea of where the

competitors are at But if solid product pricing capabilities don't currently exist, it's unlikely the contracts manager would have much more insightful knowledge

4 Does the contracts team prepare a profit and loss statement with the proposed pricing for particular contracts? Is that profit and loss statement done for three years outlooking? Someone (either pricing or finance) should be generating a full profit and loss statement on each major customer both at the time of renewal and ongoing to monitor performance Additionally, when looking

at contracts, it's important that someone is responsible for ing the annual improvement of the profit and loss statement for those very large contracts Simply generating the profit and loss statement with no action plan for price improvement isn't a value add pricing program

manag-It's also important to understand any additional price incentives that may be provided to large customers Many times customers are provided rebates or additional promotions on a once-a-year time frame Rebates are some portion of the product price given back (rebated) to the customer for some predetermined level of annual revenue performance These rebates are usually provided at the end of the calendar or fiscal year The key point is you wouldn't see this rebate impact, for example, in the monthly per product sales, but you would factor in the rebates when creating the annual profit and loss statement

Last, many times contracts/tenders are multiyear agreements (two to ten years in some cases), so you'd want to see some evi-dence of an outlooking profit and loss for at least the next three years

5 Does the pncmg committee review and approve the deals? When the contract/tender offer is complete, who reviews and approves the deal? Is it one functional area (e.g., finance) that approves or are approvals sought over many departments? The pricing committee would be the ideal multifunction council to review contracts For the reviewers, you would also want to under-stand if there are some minimum price and profit benchmarks that they are looking for

6 What are the annual or one-time price initiatives that will drive average selling price (ASP) improvement of at least 2 percent?

A company's average selling price is a compilation of all customers' net paid price (price after all discounts, rebates,

24 PRACTICAL PRICING

costs, etc.) across all products An effective pricing program should monitor, on a monthly basis, specific price initiatives with a goal that overall company average price should grow at least 2 percent points per year as aminimum Two percent to three percent is becoming a more or less standard minimum criteria on margin improvement through price, as pricing strategies/functions are established in more companies

For example, you would want to understand if the company does a list price increase List price is price before any type dis-count, rebate, promotion, and so on Most customers who buy in volume receive a discount offlist price Raising prices is never pop-ular with customers but all companies should look to do aprice increase at least every other year at aminimum Once per year is preferred Prices charged for specific products are based on per-ceptions of customer value, if customers value the products they will be willing to pay any reasonable price So products that are unique in the marketplace (no competitors) could absorb sizeable price increases (6 percent to 10 percent as a range) while products that are more of a commodity (many competitors, little differenti-ation between competitors) will face more price pressure but increases of 1 percent to 3 percent every other year are possible

7 Is there a review of all accounts and products to look at parts of the portfolio that are underperforming from a margin perspec-tive? Low margin accounts and/or products are big drainers on overall company profitability In some cases I've seen underper-forming parts of a portfolio decrease overall company profitability

by 25 percent Is anyone currently monitoring this activity in the company? And ifit is being monitored, are there follow-up actions

to take either price increase actions or get out ofunprofitable tracts? As part of this initial monitoring of the company's pricing practices, the pricing initiative leader needs to understand what the pricing initiatives are annually

con-Analyzing and Presenting the Pricing

will be able to provide a very solid analysis on where a specific company's pricing works weH and doesn't work well The basic outcome from the pricing assessment should ideaHy be to get everyone involved in the pricing efforts (marketing, finance, exec-utive, etc.) on the same page as to the effectiveness of current price practices Once everyone is on the same page as to the issues facing the company in pricing, then solutions and action plans can be drafted and implemented

Keep in mind two thoughts when presenting and discussing the summary results from the pricing assessment First, even though it's likely the procedures for setting prices were not docu-mented with enough detail, it doesn't necessarily me an that the final price recommendations presented by certain folks in market-ing were necessarily wrong They most probably were built more

on a certain individual(s) knowledge of the industry rather than consistent tools and analysis that could be easily replicated by oth-ers in the organization Second, the very folks who have just been

"scrutinized" through the assessment as not demonstrating enough process around executing price recommendations are now the very same people who will work with the pricing initiative leader/team to drive a value add pricing strategy through the organization

At the conclusion of the pricing assessment the next step in assessing price performance would be to look at recent price data history to assess how much growth pricing adds to revenue each year

Chapter 3 Price Leakage

Price leakage is the overall term for the analysis that will document any product level average selling price variances (product level leakage) versus major competitors, as well as the selling price con-cession trends over a defined time period (aka the price waterfall) Simply put, you want to demonstrate, through data, that the prices charged for products were reasonable compared to compet-itor's similar products and also, in direct alignment with maxi-mizing value, and that the company hasn't given away unnecessary price concessions (increased discounting, rebates, promotions, etc.) to sign customers to contracts Products that do not attract

a selling price that meets a minimum margin threshold (usually established by finance) will also be analyzed and reviewed here Again, this is an initial review to gain some understanding of the severity of the issues at hand Price leakages will play a major part

of later analysis in the overall price plan Price waterfall is a term that describes the "takeaways" from a product's list price toward the actual price paid by customer The net (or actual) price would

be list price minus all discounts, rebates, promotions, costs of producing the product, and the like What you want to then understand is that net selling price truly represents the maximum value that customers would/should be paying for a particular product versus any reasonable competitors

Contract leakage is essentially product leakage rolled up to the

aggregate of products a customer may purchase What you want

to understand for contracts is very much the same items you need

to understand for products: Is a customer's average selling price going up, remaining flat, or declining over the course

of the contract term? Is the customer meeting his/her revenue

commitments that were made in the contract and is this er's margin at a minimum benchmark level for the company to see a positive return?

custom-Product levelleakage: Review the top 10 or 20 products (by

rev-enue contribution) Ideally you'd like to capture 70 percent to

80 percent of the company's overall annual revenue total It's important to review the competitive data you are able to collect from the product marketing teams and by surveying randomly chosen sales folks At this early stage, don't be overly concerned with having every possible piece of competitive information You're simply trying to gain a benchmark understanding of leakage Realistically all product teams have some sense of the competitive-ness of their products If not, get on the phone and individually chat with some sales representatives in the field Ask them whether certain product pricing is high or low compared to the competi-tion Doing the calls separately allows you to compare the results

of individual opinions to understand whether some trend is dent rather than have one group consensus answer

evi-Once assembled, the pricing initiative leader/team can see the trends in the answers and gain some insight into the pricing practices/issues of the company Companies don't get to where they presently are by accident If, for example, systems are lacking, that would explain some of the issues around lack of analytics and hence the quality of price decisions Once you've assembled your historical data, you can begin the process of understanding price leakage There are several age-old methods of dissecting price data

to understand the level of leakage

Again, let's reiterate what we mean by price leakage If you sell your product for $5.00/unit and all your competitors are getting

$6.00/unit for exactly the same product and it's not your strategy

to undercut (price wise) your competition, then you have price leakage It is essentially accidental price erosion; no one planned

on the erosion but it's happening in one form or another anyway

Measuring and Managing Price Leakage

How does price leakage occur? Don't you have to fix the sources of price leakage to stop it? Yes, resoundingly to both questions, but at this introduction phase, you simply want to start with what the current situation is, measure the unplanned price erosion (versus competitors and internal price waterfall), and begin to show the executive level the value of a pricing initiative Effectively, in not so

PRICE LEAKAGE 29

many words, you're trying to show the executive level just how bad price is being executed now and how much additional revenue they could/should be seeing if they had some better processes around price You're trying to gain some leverage that this pricing initiative

is indeed worth everyone's time and efforts and expense

Also, showing the company's level of price erosion is very much

a value add exercise But here's a cautionary note: whoever is doing the analysis on price leakage needs to be very careful about show-ing "real" versus "theoretical" price erosion Here's a great exam-ple In reviewing low margin products, one could simply say that you have the potential to generate an additional $50M in revenue just by raising prices on those codes What has been failed to take into account is that perhaps many (if not most) of the customer base is under signed contracts where the pricing is essentially locked for some defined period of time So in these cases consul-tants usually say that within two to four years, the company could see $50M in additional revenues simply by taking up price on low margin codes

If your company has seriously mispriced the marketplace either

on all products or several product lines, the opportunity to fix the current pricing structure is not going to come about in one swift action It may take several years to make up any identifiable price gap versus top competitors Because, if you mispriced the market place, your customer is not going to care, it's not their problem, it's yours This topic of correcting "mispricing" will be dealt with

in more detail in the chapter on price increases Additionally, from

a perception or positioning standpoint, if your company's uets are on par or superior to your direct competitor's produets, underpricing creates a perception with your customer base that you're the "eheaper" provider Cheaper is almost never associated with quality

prod-In general, when you talk of price leakage, talk reality, resist the temptation to throw out big numbers Your audience is going to know that the big, big numbers you're throwing out aren't real and you alm ost immediately fall into the trap of talking "theory" versus real, exeeutable priee improvement

Calculations/Analyses to Determine

Price Leakage

Prieing, should be a very simple proeess but gets complieated by many people defining priee: "the more you buy the better your

deal should get to some minimum value line" If a customer chases $lOM of goods throughout the year, it would and should

pur-be an expectation that the overall discount percentage they receive and apply to each individual product transaction would net them

a lower price versus a customer who perhaps purchased only $2M annually It is a very easy concept but I've seen so many companies that have offered very high discounts to relatively small customers Usually, it's due to a lack of oversight on price exceptions and a lack of price analytics regularly provided to management to moni-tor price performance Additionally, there is always a great "push"

to sign additional customers to meet quarterly or annual revenue targets Hence, sometimes value-based pricing gets lost in the sales and marketing desire to meet targets

The calculations for reviewing and systematically estimating price leakage will involve the following calculations: Compare the size of discount percentage off list price for each segmented size of customer You can segment your customer base on revenue size, market segment, contract segment, and so on What you want to understand is the level of discount a smaller customer may receive relative to a larger customer Again, resist the temptation to talk theory, keep it real For example, some groups of customers may

be banded together under common contracts that provide a tain level of discount regardless of size of the individual account You'll need to understand these dynamics to hold your audience Showing a grid that teIls the level of discount for individual cus-tomer size is one strong indicator of whether or not price leakage

cer-is rampant Additionally, review individual product codes that may

be "under water" from a gross margin perspective It's important

to understand how many of these codes exist, how much volume they account for, and so forth To do this exercise you'll need to understand from finance what is the minimum threshold on both gross and fully costed margins The third and most important measure of price leakage requires some competitive price metrics

different prices (and yours is much lower) for the same products, that's huge price leakage

Presenting Initial Findings on

Price Leakage

Price cuts across the entire company from marketing to sales and finance to executive All of these different groups have a stake in

PRICE LEAKAGE 31

price and why it's working or not working and their expectations around how it will operate in the future For the most part, ele-ments of your audience will be aware of (or have a hunch) that price leakage exists This will generally come as a shock to no one Top executives get adequate amounts of customer contact Don't ever assume a CEO does NOT get customers complaining about pnce

Completing the Price Leakage

Calculation

You'll need historical data down to the product level as mentioned previously This is usually available in most company systems for processing orders that later tie to the accounting systems for mea-suring profit and loss Price is best looked at in trends over time,

so you'll need the information month over month say for aperiod

of two years This is enough time to see any trend come to ition You'll most likely require the following historical data items: list price, net price, discount percentage, promotions, rebates, and manufacturing and overhead cost information All of these items that are subtracted from list price to obtain net price should be considered What do you do if the company doesn't have historical information readily available? It does happen in many companies Systems seem always to be in a "development" state for various reasons The core foundation of any effective prieing strategy is based on data (historieal, competitive, etc.) Failing to get to the historical data because of availability issues is not okay and will seriously undermine the integrity of your prieing plan If a com-pany has an accounting and order tracking/fulfillment system (all companies do), then the data is tagged as individual orders and therefore you can get to the data You will need to get Information Systems (IS) assist you in accessing the data and finance to help you understand the various fields This author has had many months taken up in prieing roles at the initial stages by the efforts

fru-to get data It was never done before, was not a high priority for anyone, but when accessed, the data was readily digested by each audience

Most likely you're not going to have competitive data This should not be a cause for concern though Some very basic exer-eises in data mining the historical data will clearly show any internal price issues (aka leakage) When doing data analysis keep

in mind the following, too much data is not good, conversely

too little data is not good You need to be able to streamline your results to that you can convey clearly to an executive, mar-keting, finance, and sales audience base your core findings, so that your analysis will be judged properly Also, showing just the problems without offering solutions is not the way to approach analysis

Reading the Results

As was remarked earlier, once you've got all this data assembled you're going to need some period of time to analyze the many thousands of lines of data This, most likely, is not an exercise for one individual but will require several folks in various pricing capacities You'll want to show the entire "life" of an average trans-action in the company This graphically represented exercise will show the total scope of discount, rebates, promotions, and the like, that factor "off" list to generate the net average selling price The price waterfall is perhaps the most powerful price analytical tool to understand what occurs in an actual transaction (from list price to net price) The question then be comes one ofunderstand-ing how much value must be given to obtain the customer In the following example (see fig 3.1), the company has given total value

to the customer of $31 ($25 for a volume discount, $2 in rebates, and $4 in promotions)

For example, review the graphs provided below on a fictitious company Review the key components that make up revenue

Figure 3.1 Sampie Price Waterfall Analysis

Source: Author's Illustration

PRICE LEAKAGE 33

(volume and price) and what graphing the historical trends show

or confirm about the revenue performance Figure 3.2 clearly shows that while units sold (volume) has had some ups and downs, the overall volume trend is increasing-we're selling more units

Figure 3.2 shows that list price has not been increased over a period of time, yet its clear that net selling price is eroding

In figure 3.4, the erosion in net seUing price cannot be blamed

Figure 3.2 Sales Volume Trend Analysis

Souree: Author's Illustration

!tl

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co

9 'S

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Figure 3.3 List Price versus Net setting Price Trend

Souree: Author's Illustration

_ Number of Units Sold

- List Price

- - Net Selling Price

Figure 3.5 Net Selling Price versus Grass Margin ($) Trend

In summary, figure 3.6 confirms that the revenue increase has been mainly "fueled" by selling more units, not selling those units

at a higher price

So what would the revenue gain look like if this company could have gotten 1 percent more in net selling price? Easy, without off-setting additional costs, the entire 1 percent in additional net sell-ing price would have all been profit This is the power of pricing,

Figure 3.6 Net Revenue Trend History

C! Oll 0 oJ oJ '" 0 M M '" 0 '" 0 <ci <ci '" 0 <6 <6 '"

I_ $'s from Priee Inerease 1

Figure 3.7 Pereentages from Priee Illerease

which is indeed dramatic In figure 3.7, assuming an average

$5000/product net price and 1000 units sold, a 5 percent price increase nets $250K in additional revenue

Note in table 3.1 howa 5 percent price increase drives a gross margin impact 2.5 times the original price increase Exactly the opposite is true with a 5 percent price decrease The point's been made, price is a very powerfullever, and relatively small moves can produce large profit increases

Creating price performance graphs to visually show pricing trends over time and also versus competitors' pricing is the bench-mark of effective analysis on price and contract leakage At this early, discovery stage, you want to gain an idea of how bad the leakage issues are and carry that data into the broader solutions diagnostic presented later in the price plan