Everything you always wanted to know about pricing but didn't know to ask

Business executives have an excellent opportunity to use pricing discipline to increase top-line and bottom-line growth. Unfortunately, most companies suffer from pricing approaches that are oversimplified and chaotic, leading to decisions that actually lower revenue and margins. As some companies have discovered, better price management can stop revenue and margin leaks and lead to material improvements.

Unfortunately, our field experience reveals that one or more of five common pricing myths are blocking pricing progress at many companies.

The Importance of Price Management

Current pricing processes often resemble a multi-headed monster with inaccurate data, conflicting governance models, multiple execution systems and contradictory pricing information presented to customers. This leads to inconsistency, revenue leakage and profit loss. For example:

? At a global specialty chemicals company, every customer and distributor receives the same discount structure, regardless of profitability. Customer segmentation is performed based on revenue rather than profitability. As a result, 21 percent of customers are unprofitable and are treated the same as profitable ones.

? In a leading retail bank's consumer lending division, sales commissions are based entirely on revenue. This creates a culture that rewards volume over profit. Salespeople have the incentive to sell a $100,000 loan with no spread vs. a $50,000 loan with a five-point spread. As a result, 38 percent of transactions are not profitable, while salespeople are paid full commissions.

? At a Fortune 50 consumer products company, target prices are created for each product, but are ignored by salespeople. This results in 70 percent of deals moving through special pricing workflow. When pricing exceptions are denied, salespeople make up the difference by using extra trade promotion dollars. As a result, trade promotion dollars are used by sales to work around price increases, resulting in a 6 percent reduction in year-over-year account net profit.

? At a Fortune 500 high-tech company, four different systems are used for initial pricing, pricing exceptions, order entry and sales order configuration. This requires every quote and order to be entered four times. The data is duplicated across each system, making data analysis next to impossible. As a result, salespeople spend 12 hours per week on administrative pricing tasks instead of generating business.

The negative impact of the lack of insight and discipline described above is staggering. Results from 60 price management improvement projects show that companies add 3 percent to 5 percent additional revenue to the bottom line through price management improvement, according to Deloitte Consulting LLP's Transactional Pricing Assessment approach.

Looking only at the bottom quartile of the Fortune 500 ranked by profitability, adding 3 to 5 percent of revenue to the bottom line equates to $45 billion to $76 billion in additional earnings for these companies.

The Five Myths That Paralyze Pricing Improvements

Myth 1: The market sets prices.
This myth is a cornerstone of Microeconomics 101 classes. Microeconomic theory suggests that the market finds the natural equilibrium point between supply and demand. Sales forces that believe raising prices will make their jobs more difficult often embrace this myth.

Myth 2: Cost-plus pricing works.
We believe this myth emerged because covering costs is a relatively easy way to calculate prices. Cost-plus pricing, i.e., basing the price on a percentage above the cost of producing a product or service, is the most common method of pricing across industries today.

Myth 3: Gross margin is an excellent measure of performance.
This myth started because gross margin can be much easier to calculate than net margin. This is due to the complicated cost structures that companies have in place. Therefore, many companies use gross margin as a leading indicator of performance.

Myth 4: Rewarding volume delivers long-term growth.
This myth started because measuring volume is typically the first and most basic proxy for company growth. Most variable compensation plans for salespeople, product managers and business unit leadership reward volume rather than margin. This leads to the belief that "all volume is good volume," regardless of profitability, thereby creating a culture in which volume is the master and profitable growth is, at best, only a secondary goal.

Myth 5: Data is too complex to find and use to capitalize on trends.
This myth started because data usually resides in multiple systems and spreadsheets, and it is difficult to synthesize for meaningful analysis. The outdated technology and manually intensive processes that many companies use today exacerbate this condition.


Many Companies That Have Overcome the Five Myths Have Seen Dramatic Benefits

Many companies have debunked these myths and have generated higher than expected increases in revenue and improved margins. Here is a look at the five myths and ways to overcome them.

Myth 1: The market sets prices.

We believe: The market sets the average price, but companies set the transaction price.

It is true that the market often sets the price at a macro level. However, the majority of margin and revenue leakage actually occurs at the micro level, where individual transaction prices are set. Our project analysis shows that up to 70 percent of transactions at any given company are actually priced below the market price. Alternatively, prices can be increased on a transaction-by-transaction basis using price band analysis to pinpoint poor pricing decisions. A price band analysis compares the price attained for a particular product or service across all salespeople and transactions. There can be multiple price band views, but a basic view often reveals actions that can be taken immediately to improve financial performance. Transaction prices that fall below the overall weighted average price?the market price?should be raised.

Case Study
An industrial manufacturing company performed price band analysis and found up to a 50 percent variance in the invoice price for the same product, in the same region, with the same competitors. After providing new price guidelines to its salespeople, the company raised the median price by 12 percent. This improvement resulted in more than $19 million in benefits while driving a 1 percent increase in year-over-year volume.
Getting Started

? In the short term, perform a price band analysis for one product or service across all salespeople and transactions. This can be done effectively using basic tools such as spreadsheets or simple databases. The results will most likely create the foundation for a deeper pricing study.

? In the long term, create price guidelines for salespeople that contain a target price, price floor and price ceiling, and then only approve deals that fall within the range.

Myth 2: Cost-plus pricing works.

We believe: Cost-plus pricing is dangerous because it undercuts the value of the product or service being delivered.

We have found that cost information is often inaccurate, especially when several cost allocations are used. Even when cost information is accurate, cost-plus pricing ignores overall customer or portfolio profitability. When companies analyze the value of their products and services, facts emerge that may challenge conventional wisdom. "Voice of the customer" research, where customers are surveyed regarding buying preferences, is becoming an effective way to unearth customer buying criteria. Many companies find that allowing customers to choose the channel through which they interact with the company, such as a contact center or Web site, can be a differentiator for which customers are willing to pay. Other companies have learned that customers are willing to pay more for a product if they are given an accurate delivery date. These value indicators must be added to the service or product price to help move from cost-plus pricing to strategic pricing.

Case Study
A specialty chemical company that focuses on medicinal gases sold its products based on cost and volume, rather than value. One of its products was used to stimulate lung development in premature babies, as well as to treat adult emphysema. When sold on a cost-plus/volume basis, the treatment for an adult with emphysema cost more than a treatment for a premature baby, even though the value of the treatment was much higher for the newborn. The actual value of the product was dramatically under-represented when the cost-plus pricing method was employed. Changing the pricing strategy to a treatment-based approach in which the higher-value newborn treatment was priced at a premium led to a top-line year-over-year revenue increase of 42 percent for the product.

Getting Started

? In the short term, for b-to-b companies, send out a short survey to the 10 to 20 customers that generate 50 percent to 80 percent of revenue. For b-to-c companies, sample 1 percent of customers. In both cases, ask customers why they choose to do business with the company. Use these results to start to align pricing decisions with buying behavior.

? In the long term, perform detailed customer segmentation analysis to better understand the profitability, revenue and buying behavior of all customers. Determine prices and discounts by customer segment to increase the likelihood that value drivers are aligned with pricing drivers.

Myth 3: Gross margin is an excellent measure of performance.

We believe: Gross margin masks true performance.

Gross margin ignores many of the cost components that drive the difference between the invoice price?what the customer was charged?and the pocket price?what the company "puts in its pocket," or net margin. While cost cannot be the primary determinant of price, it is important to understand true costs in order to make better pricing decisions. Gross margin calculates the obvious costs of a product or service, while net margin reveals the actual costs. When combined with the price index?the price that a customer actually paid divided by the price that a company wanted to achieve?true price performance emerges. Based on our experience, companies that have not improved price management have a price index of roughly 55 to 65 percent, while leading companies achieve a price index of 95 to 100 percent.

Case Study
A consumer packaged goods company used gross margin to determine its most profitable products. Products produced for mass channel retailers appeared to be the most profitable products from a gross margin perspective. Additional special products for these customers were created to drive more volume, and prices were increased. Then, a new CFO joined the company and began measuring net margin. Initial reports showed that the special products were losing money, even though gross margin numbers still looked good. Further analysis revealed that two important costs had been left out of the gross margin calculation. First, the special products required distinct, expensive packaging, the cost of which was captured in supply chain expenses. Second, account representatives increased trade dollars to offset the price increases, a cost that was allocated to the marketing department's trade promotion budget. When net margin became the primary metric used to determine the performance of these special products, trade-dollar loopholes were closed and the full promotion-to-retirement cost structure was calculated. As a result, the company was able to increase net margin of the special products by 4 percent without a negative impact on volume.

Getting Started

? In the short term, document how gross margin for each product and service is calculated. Understand the cost allocation assumptions that form the basis of the calculation.

? In the long term, move toward using net margin as the fundamental calculation, and redefine how cost allocations are performed. Separate the variable-cost elements from the fixed-cost elements and focus on more specific allocation of variable costs on a transactional basis.

Myth 4: Rewarding volume delivers long-term growth.

We believe: Rewarding margin delivers long-term growth.

Focusing on volume at the expense of margin creates a sales force that would rather sell a large-volume deal with no profit than a smaller volume, more profitable deal. When the corporate pricing team makes strategic pricing decisions, it is very difficult to enforce them when salespeople are given incentives based on volume. Salespeople often become customer advocates because it is easier to sell products and services at the lowest possible price. While companies that are most effective at improving pricing have made major changes to their incentive structures, even those companies that implement small or incremental changes have also achieved benefits. For example, some companies have introduced a "controllable" margin component that equates to 25 percent of the overall commission. Controllable margin comprises the cost elements over which the salesperson has control, for example, service, freight, expediting charges, and payment terms. Net margin, on the other hand, includes elements out of the salesperson's control, such as manufacturing costs, overhead and labor.

Case Study
The 900 salespeople at a $5 billion distribution company told the price management team that there was no way to raise prices because customers would not accept the higher price. After their commissions were realigned with net margin, those same salespeople delivered a 50 percent increase in net margin and achieved increased prices on 15 percent of deals, adding $45 million to the company bottom line in nine months.

Getting Started
? In the short term, highlight and publish a list of the salespeople who are selling the most-profitable and least-profitable deals. Peer pressure begins the process of change management.

? In the long term, develop a sales incentive program that aligns pay with desired?i.e., profitable?performance.

Myth 5: Data is too complex to find and use to capitalize on trends.

We believe: Complex, high-volume data can be managed effectively when the right tools are used.

The data does not lie. Finding, synthesizing, analyzing and applying data to pricing decisions is one of the most effective ways to achieve improvements. The first time a company pulls the data together, it is typically a painful, manual process. Technology is then added to automate the most complex analyses. Price management tools complement the price list management and configuration capabilities provided by enterprise resource planning and customer relationship management tools. These tools augment business process improvements by providing additional analytical capabilities, algorithms that improve price setting, flexible price/discount targets by customer segment, and workflow to help manage price and discount approvals, and thereby create sustainable benefits. Price management software vendors are relatively small, with most under $30 million in revenue in 2005. However, any vendor viability concerns should be weighed against the benefits that these tools provide when implemented in combination with process improvements.

Case Study
A high-tech company performed two years of process improvement in one business unit to remove price leakage. Using spreadsheets and a simple database tool, the company added $4 million to the bottom line. To help make these benefits sustainable, the company purchased software to drive process improvements in other business units. Each rollout became successively easier. What took two years to accomplish in the first business unit took only three months to achieve in other business units because the technology was used to synthesize data and apply it to transactional pricing decisions. After two years of additional business unit rollouts, the company achieved pricing benefits of $84 million, and improvement continues.

Getting Started

? In the short term, pursue process improvement before or in parallel with technology. Once ready to add technology, start with software that supports the communication and enforcement of pricing decisions, also referred to as price execution. Starting with price setting, also called price optimization, does not deliver value if improved prices are not well communicated, managed, and adhered to by end-users.

? In the long term, select a vendor that also provides price setting functionality, including customer segmentation, algorithmically supported price optimization, and analytics to measure price performance. Implement this after price execution has been tackled.


The Time for Price Management Is Now

Companies typically struggle with all five pricing myths. Each of the five must be dealt with at the strategic level before tactical pricing improvement can occur.

Start by collecting and analyzing existing transaction data, and use the price band analysis described in this article. The graphic results of that analysis depict the reality of pricing; that salespeople create the transaction price and their incentives must be realigned to change behavior. Once the "market price" and "volume is master" myths are addressed, the remaining three myths become easier to tackle.

Executives cannot afford to pass up this compelling opportunity to increase revenue and earnings. Those who accept the challenge to overcome conventional pricing wisdom can be rewarded with career-making corporate results.



Laura Preslan is a manager with Deloitte Consulting LLP; Ranjit Singh is a senior manager with the company.