Applying Discipline to Pricing Strategy

Applying Discipline to Pricing Strategy

2016 | By Lidija Polutnik

Estimated reading time: 5.5 minutes

Key Takeaways

  1. The development of pricing and financial-modeling tools, coupled with the increasing availability of data about competitor prices by segment, time, geography, and channel, together provide a better understanding of market demand, what customers value, and their willingness to pay.
  2. Poor pricing optimization is a serious problem for many firms due to the tendency to focus on cost, sales, and growth targets; lack of internal alignment on financial metrics; reliance on traditional “cost plus” pricing models; and a lack of discipline in granting discounts.
  3. Pricing strategy must begin at the top and then be executed in a team-based matrix structure, with all critical stakeholders—finance, marketing, sales, operations, and purchasing—working together.

As competitors such as Amazon change product prices many times daily—and customers compare product attributes and prices on the Internet nearly as often—the lesson for all companies is that they must be able to respond to market changes rapidly, if not in real time. Indeed, a laser focus on customer value and pricing is crucial to long-term strategy focused on profitability, unless a company sells its products in commodity markets where we observe no product differentiation and therefore no power to price. This article will describe how companies can bring new rigor to pricing decisions.

Until recently, very few companies used price-optimization software. However, today’s dynamic and complex pricing environment has spurred the development of pricing and financial-modeling tools from a growing number of software providers, such as Vistaar, Zilliant, and Vendavo. The increasing availability of big data, meantime, allows views of customer and competitor prices by segment, time, geography, channel, and other dimensions. Together, these tools provide a better understanding of market demand, what customers value, and their willingness to pay. Yet, such critical intelligence is often untapped by many senior managers, who have traditionally concentrated on cost, sales, and growth targets. A compounding issue is that a lack of discipline in granting discounts—combined with poor coordination and communication within organizations—contributes to the persistent gaps in efficient pricing execution.

Discipline in Pricing Execution

While it is fairly straightforward to define optimal prices using a variety of modeling tools, the suggested “list” prices are only the starting point in appropriate pricing execution. Differences in customers, their ability to negotiate, power in the channel, and sales incentives are just some of the reasons why ‘pocket’ prices are significantly different from ‘list’ prices.

The Price Waterfall graph popularized by McKinsey & Co. identifies multiple layers of customer discounts resulting in deep price reductions. In the end, the ‘pocket’ price can be, on average, more than 30 percent lower than the starting ‘list’ price. Managing price performance should be one of the core management functions, yet “price waterfall” profit leakage continues to be a serious problem.

In 2009, Unisource Worldwide, one of the leading distributors of paper, packaging, and facility supplies in North America, adopted Zilliant’s Margin Manager software to manage its U.S-based customer needs and the company’s 800,000 pricing lines. Installing the software with the leadership of senior management enabled the company to set prices aligned with the mission statement, and customized to individual customers, segments, and volume. Knowledge of the sales process and sales environment were integrated in the final capability of the software. This successful customization provided sales with timely, consistent, and customer-specific pricing, and eliminated arbitrary and unstructured price adjustments.

Pricing processes benefit when they are straightforward, transparent, and efficient. A cursory Internet search of ‘pricing execution process maps’ reveals inefficient operational procedures and pervasive examples of “rogue” discounting. For example, customer negotiations, or intense rivalry in the market, often lead companies to consider additional discounts. Yet, approvals and reviews of same absorb time and effort. (See Exhibit 1) Unintended result: the cost of such activities (as measured by Activity Based Costing) more than doubles the decrease in profitability from granting the discounts in the first place.

Integration and Coordination

While companies have adopted a variety of tools to manage information and big data, there has been less progress in systematically rethinking the role of pricing in organizations. Challenges remain in integrating customer value and pricing information in processes, functions, and internal operations. As a result, price-optimization models are frequently compromised.

Pricing decisions are frequently made ad hoc by employees who respond to a number of factors: incentives, customers’ ability to negotiate, internal organizational structure, and legacy decision-making systems. For example, sales teams are still mostly compensated on revenue. They naturally push for price decreases, ignoring software recommendations. Pricing processes also often create significant internal conflicts. Responsibility for pricing in organizations often is defined very narrowly. For example, the role of a pricing specialist may include working on quotes or analyzing account data. Pricing teams can be isolated and their focus internally defined.

Economic theory states that a firm’s pricing decisions need to be based on customer value and willingness to pay. Yet, empirical evidence shows that many firms continue to define prices based on a cost-plus basis, with a perplexing variety of fixed-cost allocation methods. Forgotten is the fact that fixed costs are sunk and therefore irrelevant for pricing.

Pricing policy in organizations should depend on good data. That’s a given. In order to create accurate individual profit-maximizing pricing the modeling must take advantage of all available company information and enterprise resource planning systems.

Understanding this, Dow Chemical Company purchased Vendavo’s pricing software (which in partnership with SAP) provided Dow with an opportunity to establish more efficient pricing processes and improve profitability. Dow’s senior executives led the changes, as well as articulated the company’s pricing strategy. The lesson from Dow is that pricing strategy must begin at the top and then be executed in a team-based matrix structure, with all critical stakeholders—such as finance, marketing, sales, operations, and purchasing—working together.

Shaw Industries, a Berkshire Hathaway company that produces and distributes carpeting and flooring, implemented Zilliant’s software by closely integrating its modeling tool with an existing CRM system. Unfortunately, difficulties in data and systems integration continue to hamper effective pricing implementation in many organizations. But, the goal remains clear: Pricing teams need to have timely and accurate variable and fixed-cost information, by customer and by product, in addition to all the relevant information about customer willingness to pay and competitor information. That’s critical in allocating plant capacity to maximize profitability and therefore deciding which accounts to serve.

In the arena of product development and innovation, the main hurdles are time to market and delivering items for which the customer is willing to pay. Many companies lack the knowledge for integrating value creation into their varied processes and functions, to say nothing of monitoring how value capture might be executed. Proper support of product development requires timely and accurate data on how the customer defines “value.” An R&D function that’s not working closely with marketing research is more likely to build excess or unwanted “value” into a product or service.

Put another way, timely and integrated data is the backbone of value-driven product development. It boosts companies’ capabilities to compete by delivering products at a price that customers are willing to pay. It also supports a product (rather than cost) differentiation strategy.