The right price, to the right customer, at the right time
Setting the right price to attract as many customers as possible is tough. Getting actual profit from your price and protecting your margins is tougher. This article covers price setting and price getting, and the difference between the two. We share three tips on minimizing price leakages and finding hidden costs, all to optimize your profit.
Product or service pricing can be divided into two steps:
Price setting → the process and policies used when setting list prices
Price getting → price execution or realization, i.e., how much of the list price that the company keeps when the customer price is set
Price setting (as the name suggests) is about determining the right price level to serve the sales and profitability requirements of a company, business unit and/or individual product. Price setting is often perceived as a particularly sensitive process, as price increases can scare off the more price-sensitive customers. Further, as prices fall, doubts arise as to whether demand will be increased enough to compensate and reach the absolute margin achieved at previous price levels.
“Price getting,” or price realization reflects how well a company manages to turn set prices into revenue. At the heart of this, business and sales processes are found, where concrete examples could be: whether all the work done is invoiced, whether the invoicing includes all the elements agreed with the customer (invoicing surcharges, freight costs, etc.), and whether customers are given more discount than they have earned.
The rule of thumb is that before (radically) changing your own price levels, you should have a thorough understanding of how current price and discount levels are realized into revenue. Only on this basis should changing price levels or pricing elements be considered. I say considered because changing pricing is not an absolute answer to all problems, but it does allow for faster adjustments than, for example, in the features of a product or service.
The rule of thumb is that before (radically) changing your own price levels, you should have a thorough understanding of how current price and discount levels are realized into revenue.
Get a deepened understanding of your revenue with a price/margin waterfall
The price waterfall is a powerful analysis tool for evaluating price leakage, as it brings transparency to your pricing and profits. The waterfall allows further understanding of hidden costs, where potential revenue leaks exist, and where discounts are unjustifiably high. Depending on the industry and the nature of the product being sold, a price waterfall could look like this:
When building and interpreting a waterfall, the following three areas should be considered:
1. Identify the elements that affect profitability
The main function of the waterfall is to illustrate all factors that affect the final pocket price and margin, to grasp how they affect profitability.
In the illustrated waterfall example above, the sales volume at list price is 100. After various discounts (costs for selling company) and invoiced freight (income for selling company), the company invoices 93. After this, freight discounts, the cost of goods sold and various post-credits are deducted, leaving 18 to cover fixed costs.
2. Drill into the individual discount elements in detail
Once you have gathered the elements that affect price and profit, it is advisable to drill down into each element in detail and compare their realization between, for example, business units, product segments or regional sales offices.
In the example above, the final price level between the different customer segments is roughly the same (and possibly even in line with the set turnover and margin levels), but the actual formation of prices and discounts is very different. For example, segment 1 customers receive significantly higher discounts in discount category A, while segment 3 and 4 customers receive higher discounts on post-rebates.
So, what is the right level and ratio? Unfortunately, there is no unambiguous answer, but price and discount levels are largely determined by the company’s business strategy and thus its pricing strategy. If Segment 6 customers generate a lot of extra work for the company, for example, many small orders, it may be justified to modify discount policies from a profitability perspective. If, on the other hand, the company's strategy is to increase market share, for example by increasing sales from existing customers, it is justified to increase discounts and thereby lower prices, assuming a significant increase in turnover at the same time.
Whatever the strategy, a careful analysis of the determination of the final price level will help management focus its development efforts on the right areas.
3. Plan actions to make an impact
Once you have a comprehensive image of the realization of current pricing, you can move on to modify your current structure and processes to fit your goals. When planning changes, the needs and habits of different customer segments and stakeholders must be contemplated. Therefore, it is particularly important to collect qualitative information about customers, the market situation, and the behavior of competitors, as the conclusions drawn from data alone do not necessarily tell the whole truth.
The focus should be on changes that have a high impact but are realistic and practical to implement. Price increases should also not be postponed or avoided for fear of losing customers, as price is only one of the many elements in a customer’s purchase decisions.
Read more in our article: Stopping price leakages – The first step towards better pricing.
Pertti Palosuo works at Capacent Finland as a pricing and working capital expert. Pertti has accumulated extensive experience in his customer projects, e.g. pricing and sales development in the retail, wholesale, mining and software industries.
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