By James Brown, April 25, 2016 What do you do well? Many companies are great at building value, creating excellent products, and excellent services. Where they fall down is actually getting the money they deserve and the prices they should be able to charge.
Have you experienced increasing price pressure in the market? Can you raise prices on a regular basis? Can you get the price right first time on new products? Two thirds of companies fail to get price increases to stick, while only 28% of new products meet their profit targets.
Profit lever
Pricing is the strongest profit lever you have, particularly in the short term. Here’s Pricing 101 with a simplified P&L. If sales are 100, variable costs 40 and fixed cost 45 this gives an operating income of 15.
If you improve variable costs by 5% and everything else remains equal, you get a 13% improvement in operating income. If you improve fixed costs by 5%, you get a 15% more operating income. Improve volume by 5% and it’s a 20% increase in operating income.
But if you improve price by 5%, everything else remaining equal, you end up with a 33% improvement in operating income. The leverage of price is often overlooked. There is a flip side though. If you decrease your price by 5% it destroys margins.
Warren Buffet said in 2011 that “the single most important decision in evaluating a business is pricing power. If you have a prayer session before raising your prices you’re a terrible business” – in my view that’s not because you can’t raise prices, but because you haven’t got the systems and processes in place to understand what’s going to happen when you raise prices.
A problem identified…
So who owns the pricing strategy? Sales people will typically know what the competitors charge and want lower prices. Finance departments will know what the costs are, so have target margins, a “cost plus” approach. Product managers want a brand premium. Marketing departments say they know what the customer says, which means a value pricing approach. There’s often no clear leadership and no one person or function with overall responsibility for price.
Pricing is complex, and results of changes often deemed unpredictable – so changes to the way you price and the level at which you price get moved into the “too difficult” or “too risky” buckets – which means a great source of profitability and enterprise value boosting is left unaddressed.
… is a problem solved
Most businesses are familiar with a cost cutting programme. But what does a pricing programme look like, and where do you start. Traditionally the first step is price strategy and agreeing direction. Next you address price setting - levels and models (how do you charge) before moving into execution.
With price strategy, you focus on key questions - What are we trading off? Are we willing to trade revenue for margin? Do we want to go for market share, or are we going to focus on increasing profitability? Where do we want to be positioned in the market?
Price setting is about getting to the right price level, and the right price model. It’s also about the process – not just a one off exercise to set the “perfect” price points. This will usually be a blend of value based-pricing (looking to understand the value your products and services offer your customers), competitive benchmarking (looking at the market you’re operating in), and a consideration of cost.
Execution is about making this happen. You can have the best list prices in the world, but that doesn’t drive profitability if the sales team discount everything or you over promote to hit volume targets. In many B2B businesses execution is about steering the sales force.
There’s no rule that says you have to start with price strategy though. If you know or suspect a problem in one area, start there for quick wins to ensure rapid payback. Maybe you think you need to get discounting or promotions under control – then look here first for cash payback. Alternatively your new product pricing may be off the mark, leaving volume or profit on the table – this would mean looking to address price setting.
Whether you are starting your business, growing your business or selling your business – there’s rarely a bad time to start a pricing programme. Taking a critical look at the way you price and systematically addressing opportunities can lead to big and rapid gains in profitability and enterprise value.
If you would like to talk about how any of these issues relate to your business then please get in touch – James.Brown@simon-kucher.com or nicol.fraser@dunedin.com