Pricing is a business’s strongest profit lever. Unfortunately, it is often the most neglected and when poorly managed it erodes margins very quickly. So, how does a finance leader ensure that their company manages pricing as professionally as they manage costs?
In his keynote at this year’s Manufacturing Finance Summit, Dr Peter Colman advised how to ensure that pricing doesn’t cost your business everything.
Pricing is the most powerful profit lever, and professional price management is a vital capability to protect margins in uncertain times. However, in practice, sales teams often fail to execute higher prices, in spite of clear targets and commitments from the top.
Using a typical manufacturer’s profit and loss statement, Colman showed that a 5% improvement in variable cost, fixed cost and volume results in increases in operating income of 13%, 15% and 20%, respectively. However, a 5% improvement in price leads to a 33% increase in operating income.
Many businesses want to raise prices, but most are unsuccessful. According to Simon-Kucher’s latest Global Pricing & Sales Study, companies typically achieve little more than a third (37%) of their price increase target, i.e. what they ‘get’ versus what they ‘set’ – i.e. trying to raise the price of a product by 5% but achieving just 1.9%.
That is the lowest achievement rate Simon-Kucher has recorded. In 2012, companies achieved 50% of their planned price increases, on average.
“Pricing often comes down to guess work. Too few people know how to quantify value, articulate it and determine a price accordingly,” he noted.
There are three reasons why businesses struggle with pricing, said Colman: Goal misalignment, cost-plus mindsets, and bad guidance.
Colman explained that too many firms find themselves in a price war. While 77% blame it on a competitor, it is often the result of their own uncontrolled pricing behaviour.
In New Product Introductions this will often result in over engineering if a willingness to pay isn’t measured because there is no pressure on production and pricing is considered too late in the process.
The other danger of cost-plus pricing is leaving money on the table.
Colman told the story of one manufacturer who created a semi-automated driver assistance system to offer ‘stress-free parking’. The business charged the OEM €100 for each system. The OEM understood the actual customer value of the product and charged €670 – a price the market was happy to pay.
The reality in most cases is that there is little reason for the salesforce to fight for higher prices. More often than not they are incentivised on revenue rather than margin and so deals get closed through discounts in order to move on to the next deal quickly.
As price is every company’s strongest profit lever, this discounting behaviour results in a damaging effect on the firm’s profitability.
Colman explained that the solution is to run a Pricing Excellence programme to change these behaviours and deliver typically 2-4 percentage points of operating margin improvement. The starting point is to a get a clear understanding of the size and nature of the pricing opportunity within the firm through a ‘diagnostic’.
His closing words were that there are three kinds of companies:
- Those who make things happen
- Those who watch things happen
- Those who wonder what happened
Which one accurately describes your business?