Redefine Your Pricing Strategy to Survive B2B Profit Decrease
If your profits are a disaster, we have the relief
When a natural disaster strikes, it triggers a wave of well-planned and organized responses to secure the area, clean up, and rebuild. In some cases, the affected area comes back even stronger than before.
B2B companies have seen ominous storm clouds gathering for some time. Typically, they find themselves caught between two intense pressure systems. This uncomfortable squeeze between higher costs and lower margins does not leave companies much room for error. On the cost side, suppliers are liable to raise prices, sometimes aggressively, as prices for industrial commodities increase. In fact, the World Bank said in January that it expects a “surge” in industrial commodities prices in 2017. On the customer side, B2B sales team are getting pummeled by procurement teams, whose size and sophistication grants them considerable leverage against the teams on the other side of the table.
“Sales team are getting pummeled by procurement teams.”
How a company responds to this squeeze can make the difference between surviving the storm and prospering in its wake, or succumbing to the pressures. In the latter case, the management team’s measures often inflict even more short-term destruction, turning a profit storm into a profit disaster: job losses, cost-cutting, factory consolidation, or even the withdrawal from markets, often accompanied by a plummeting stock price. Cost-cutting steps may shore up the bottom line in the short term, but they don’t leave much enthusiasm or resources for a rebuild.
If you think there must be a better way, you are right. The better way is called World Class Pricing.
Companies who address a small number of specific pricing issues will find opportunities in the uncomfortable squeeze. They succeed in shoring up their businesses, achieving quick wins, and prospering. They find the sunlight through the clouds. This also creates a heightened sense of vigilance to prevent similar problems from occurring again. They also find ways to anticipate future squeezes and lessen the pressures before they build.
The proven effects of better B2B pricing
The existence of pricing opportunities in competitive B2B markets has been well-researched and documented. McKinsey explained the profit impact of small price increases in an article in the Harvard Business Review some 25 years ago. Two of their consultants wrote that a 1 percent increase in prices will raise operating profit by 11.1 percent, assuming negligible volume loss. In our own experience over the last two decades, the extent of that gain in operating profit can vary, but the overall point McKinsey made has held up extremely well.
When a company faces the potentially disastrous profit squeeze we described above, pricing is where the restoration and the preventative actions should begin. Nearly every B2B company has enough opportunities to implement the kinds of price increases that can grow revenues without much volume loss. The make-or-break challenge is to find them. Hidden by unsophisticated pricing practices and bogged down in internal processes which have spiraled out of control, these opportunities take some effort to identify and then seize. It requires diligence, commitment, analytical skills, and objectivity. The operative word is “control”.
How to re-establish control
We say “re-establish” because we assume that the processes you have in place originally had a well-defined purpose. Perhaps you wanted to deliver faster quotes to customers, respond faster to service calls or accommodate special requests from customers. Over time, however, these processes accumulate exceptions, inputs, approval authorities, and sub-processes the way a ship collects barnacles. All of these changes can cause a process to get out of control to the point where the revised process often inhibits the original goal. Burdened by ad-hoc processes, you become less responsive in time and quality and too accommodating on price, while starving your salespeople for the information they need to make better decisions.
How do you fix this?
Sticking with the analogy of disaster relief and prevention, the first step is to secure the area. Assuming the business faces no acute or immediate survival risk, the company needs to make a quick but thorough assessment of its financial situation and its processes. There are two phases to securing the area.
First, you redefine the business at several different levels: customer (or segment), sales reps, territory, product, and solution. That may sound like a straightforward exercise, because each of these breakdowns is a known quantity. But that is the macro level. The difference in doing this work successfully lies in taking the most granular look possible at your business. This is the equivalent of going street by street and door to door to assess the situation and to begin setting priorities: where do you need an emergency response, where do you need a well-planned but less immediate response, and where can you wait for the time being. When you match your current and historical data – prices, sales volumes, terms and conditions – to this breakdown, you will see patterns.
The clean-up begins
At this deeper level of resolution, you will see a dispersion of current and historical prices in each of the areas you defined (customer segment, sales territory, etc.). One of the most striking findings from such a dispersion is the knowledge of what customers receive the best prices. They are normally not your best customers, but instead the best, toughest, hardest negotiators. This dispersion allows you to answer some fundamental questions clearly and with evidence, likely for the first time. Where are you giving away value? Where are your greatest profit leakages? Where, in detail, have you been too accommodating on price, terms, and conditions? Where are you perhaps overreacting to perceived competitive threats?
“It’s not the best customers’ who get the best price it’s the best negotiators”
An ideal way to visualize these effects is a price waterfall. The waterfall has two endpoints: your list or base price on the left, and your net selling price (the “pocket price”) on the right. In between those two poles you can document how and why your price decays from the starting point to the price of the final sale. You can see the impact of the discount ranges you provide your salespeople, the behavior around price thresholds, the effects of your internal approval processes, and the effects of granting special terms and conditions such as early payment, one-off rebates, and other terms.
“It’s not what you get, it’s what you keep that matters”
Reading a waterfall requires some experience and some context as well. At one extreme, a waterfall can have very few breaks between the list or starting price and the pocket price. This could be a list price, a base discount of, say 25 percent, and an additional 10 percent left to the discretion of the local salesperson. This begs the question of whether the pricing process has enough sophistication to allow salespeople to respond to the customer needs in different segments. It poses several other questions as well. Where did the ranges of 25 percent and 10 percent come from? Are they based on data and assumptions which were very relevant at the time, but are now inadequate, incomplete, or even obsolete? When was the last time you reviewed these data or challenged the underlying assumptions? This is where the seeds of a “we’ve always done it that way” mentality are sown. As data and assumptions get progressively older, the memory of their origins and their rationales starts to fade.
The other end of the spectrum resembles the out-of-control process we spoke of earlier. Imagine a waterfall with dozens of breaks between the list price and the pocket price, each designed to cater to some customer need. Some of these adjustments may have helped a company address a need in the market, but most of them begin as exceptions or temporary changes. These changes become permanent when no one goes back and revisits them or lets them expire. If left unchecked and unanalyzed long enough, they truly turn into barnacles and become taken for granted. Customers and salespeople alike treat them as entitlements rather than meaningful elements of an intelligent regime of terms and conditions.
What you are striving for here with these analyses is what Pricing Solutions refers to as Level 2 in our World Class Pricing™ framework, which comprises five levels. We label this level “Control”. The key is to realize that you can exert control over that dispersion you documented earlier. Control means you plan the dispersion by setting limits and enforcing them. The price waterfall gives you strong indications of where to set these limits. You can also engineer that dispersion, to your benefit of course, by redefining the processes that are causing the leaks. Our mix of lean and Six-Sigma analytics can help you uncover the root causes behind the leakages.
An improvement of 2 percentage points in profit margins can have a transformative effect on a B2B industrial supplier. The move from Level 1 to Level 2 turns takes that improvement from wishful thinking to reality. A move from Level 2 to Level 3 embeds the right processes to make such an improvement both sustainable and expandable.
Moving from Level 1 to Level 2
A large industrial supplier with numerous product lines and regional businesses came to Pricing Solutions with two objectives which we can summarize very succinctly: provide us the knowledge to improve our profitability and the means to sustain it. Pricing was their weak spot, as our initial analysis revealed. (They had a level of 1.7 on our 5-level scale, as shown in Figure 3 above).
The primary approach to establishing that knowledge base was a micro-segmentation. This means selecting understandable and measurable criteria for segmenting customers (the horizontal axis in Figure 4) and crossing those segments against the product segments. The highest margins should be in the top left (premium products sold to non-strategic customers) and the lowest margins should be at the bottom right (standardized products sold to strategic customers). This map for this customer revealed just how far this company was from achieving something even close to the ideal picture.
Providing this company the ability to set target margins was the first step in moving their reality to the ideal. It gave them firmer control over their margins, with evidence to back up each of the targets. The projected results in the first year represented margin improvement of 2 percentage points. But the work did not stop there. As we often say, pricing is a process and not an event. The company also identified and disseminated pricing best practices, derived not only from our experience but even more importantly, from great things its own sales and product managers had been doing on a small scale, in isolation. Finally, it began to build a pricing infrastructure.
“Pricing is a process, not an event”
A large portion of the companies we encounter are in the state we describe at the outset of the paper. This is Level 1 in our framework, which means processes and pricing decisions are more on an ad-hoc basis than a coordinated one. The 80/20 rule applies here as you aim for Level 2. That means you identify and clean up the biggest messes first instead of spending valuable resources to repair or adjust process leaks which will have only minimal impact on your profits.
Control is the essential prerequisite for taking the next step in our World Class Pricing™ framework. In this step, you work with the same dispersion, combined with your revised processes, and look for ways to price according to value.
Level 2 to Level 3: How to establish and extract value
Companies who want to start incorporating value into their pricing process need tools which go beyond dispersion charts and price waterfalls. Those two tools may be powerful diagnostics, but they are not sufficient to help you identify the key ingredient to pricing according to value. That key ingredient is knowledge of your pricing power.
Think of pricing power more as a bullet than a blanket. Precious few companies have the ability to make significant across-the-board pricing increases. In fact, we would argue that any company good enough to be in that position will have already been smart enough to tap into that pricing power. As our CEO Paul Hunt stated in very clear terms in a recent blog post: “I abhor across-the-board price increases; they have no connection to value and are driven by laziness and fear. Any price adjustment should be based on value.”
So where do you find this elusive but lucrative value?
A simple arithmetic example will show why you need to rely on the breakdown you made as you progressed to Level 2. Let’s say for the sake of argument that one third of your volume goes to very price sensitive customers, one third goes to higher-end customers who focus more on quality than price, and the remaining third goes to customers who have many competitors to choose from; prices and market shares have remained relatively stable in that segment for a long period.
You have two options. You can blanket all three segments with an across-the-board price increase, or you can be more discrete. Let’s say you decide to raise prices by 4 percent in the “quality” segment, cut prices by 1 percent in the “price sensitive” segment, and leave prices steady in the “stable” segment. The net weighted effect of these three price decisions is the equivalent of a 1 percent increase in prices, and we assume – for the sake of argument – that your volume in all three segments remains unchanged.
Compare that to a decision to implement a price increase of 1 percent across the board. That would have led to an awkward result in all three segments. You would still be underpriced in the quality segment, and you would have put considerable volume at risk in the “stable” and “price sensitive” segments.
The real world, of course, is far more fragmented and complicated than the example above. Most B2B companies have thousands or even tens of thousands of products (or even more!) and have hundreds if not thousands of customers. You will need to understand at a very granular level whether you have pricing power, and how that pricing power can translate into a price change. In some cases, you may have no pricing power whatsoever.
You can start gauging your pricing power by looking at the 5C’s (Competition, Conditions, Customers, Capacity and Costs). Each of the 5C’s can drive pricing power and should be considered in the context of adjusting prices. For example, the balance of supply and demand, and the role of your products in the customer’s supply chain are drivers of pricing power. The greater the demand, relative to supply, and the lower the competition, the higher you can expect your pricing power to be. At the same time, if your product plays a critical or even essential role in the customers’ products’, you may have a strong case for charging more.
The stronger rebuild begins
Pricing Solutions refers to the third level in its World Class Pricing™ framework as “Value”. Achieving Level 3 (“Value”) is your first step toward optimal pricing, not merely optimal prices. This is a forward-looking approach, building on the clean-up and control you achieved at Level 2. When we work with clients on the transition from Level 2 to Level 3, we could score pricing power based on the 5C’s .
For this analysis we remain at the micro-level or “street by street” level. Using the guidance we described above, we are looking for the greatest leverage to generate higher revenue. This could mean using price as the lever (selling at higher margins), it could mean using volume (selling more products at acceptable margins), or it could be a mix of both. But in our experience, by far the more underutilized option is to use pricing. It is also the more effective one, as we said at the outset of this paper, and also generally takes less time to implement.
The best way to think of this transition to Level 2 and then to Level 3 is a journey. It is not a sequence of specific measures, spaced apart at intervals. The goal is not solely to effect a positive change in the company’s financial situation. There are also a few other goals. The company wants to prepare itself to withstand market turbulence in the future and lessen the impact of any squeeze. It also wants to prepare itself to continue to the journey in our framework to Level 4 (“Optimize”) and then ultimately to Level 5 (“Master”).
But first things first. The stability in Level 3 comes from the creation of a model to support your pricing. You may have had spreadsheets in the past or even a software package to help manage customer relationships or generate quotes. These are all useful, but they don’t offer the outputs which facilitate better pricing decisions. This kind of model incorporates costs, so that you focus on more than revenue improvement. You can look closely at margins and total profit at a granular level. It also includes mix, so that you can look at the effects of changing prices in combination, creating bundles, or changing the product mix entirely. Combined with your target-setting for the coming financial period, you can calculate the financial effects which certain price changes would have, and adjust your decisions accordingly.
Think back to the case we cited earlier. When we referred to “pricing infrastructure” we meant that the company needed the means to build and apply the knowledge it had started to gain. In essence, this has two aspects: tools and people. The model is the linchpin for the tools. On the people side, the industrial supplier we worked with hired a corporate pricing analyst and established a senior-level pricing council.
They supported an annual pricing strategy process which included a review of a set of pricing metrics. Put most simply, the company put people and processes in place to track their progress from their previous reality to the ideal map (as shown in Figure 4 earlier).
The other aspect of people is skills improvement. The difference maker between having a target price and implementing that target price are skills. This includes a sales training program built around value-based selling as well as negotiation skills. The hard truth is that the people on the other side of the table (the procurement specialists) receive constant and sophisticated training and how to win in a world where winning, in their view, means only one thing: the lowest possible price they can extract.
Such a model demands investment and a greater level of sophistication. In our view, however, the rewards speak for themselves. These rewards are not purely financial, the boost which comes from a 1-percent improvement in pricing or greater. The effects transcend the financials and reflect the benefits which come with any process improvement. You can expect more efficiency, which means you can make better decisions faster. You can expect greater confidence, because you trust the numbers derived from your model and can convey that confidence to your salespeople. You can expect better information flows, as you collect only what you need from salespeople, from research and from third parties, and in turn, provide sales team with a lean package of useful information instead of drowning them in the firehose of unfiltered and uninterpreted data.
You can make the journey faster than you think
Pricing Solutions has a 12-week program which resembles the kind of well-planned response you see after a natural disaster, except our highly-trained teams focus on profits and pricing. We can help you do that street-by-street data gathering and analysis, assist you in getting your pricing process under control, and support you in finding the sources of pricing power which you can capitalize on. We can also help you design and implement the necessary model.
Of course, none of these transformations is perfect. Throughout the entire journey, a company has to keep the 80/20 rule in mind, not because of the precise guidance it may provide, but as a warning to make only high-impact price decisions. These could be price increases, decreases, or decisions to stand pat. It could also extend to decisions on which markets to serve better, because of the untapped potential, and which portions of the market you could deprioritize or even withdraw from.
There may still be traces of the original profit disaster or market storm once you reach Level 3. But the opportunities from the clean-up and rebuild should overwhelm them: it’s time to start selling value with confidence and control!