In many companies, the scope for improving profitability through cost reductions has become narrower. The implementation of efficiency improvements often requires great efforts on the part of companies. Price measures, on the other hand, are easier to implement and offer significantly better opportunities for a substantial but also sustainable improvement in profitability.
What pragmatic approaches quickly create scope for margin improvements? Jan Ulrik Holsten, partner at enomyc in Berlin, will discuss approaches and offer practical examples for achieving improvements in pricing.
FREQUENTLY USED – THOUGH STILL BAD: THE DISADVANTAGES OF THE COST-PLUS METHOD
We often observe that “cost-plus procedures” are being used for price formation. For this purpose, the manufacturing costs of a product or service are identified. Prices are formed by calculating a profit markup. With a lot of luck, the price determined in this way will meet the price expectations of the customers. However, it is more likely that the price will either be lower than that which the customer is willing to pay, and thus wasting valuable margins, or will be too high, thus destroying any sales opportunities.
A further disadvantage of cost-plus approaches is that the coupling between price and costs is often system based and thus not reflected. If a company succeeds in reducing its costs, this carries the risk of an unwanted price reduction. The biggest weakness of these approaches is that the customer and the customer’s willingness to pay are hidden. Benefit-oriented approaches can provide a remedy.
FROM ADDED VALUE TO WILLINGNESS TO PAY: BENEFIT-BASED PRICING
Why are products and services purchased? Because customers expect to benefit from them. Frequently, this is not just a singular benefit but a bundle of several individual benefits that are assessed as a whole by buyers.
For example, buyers of a charcoal barbecue not only evaluate the primary benefit of the preparation possibilities of their barbecue but also – with a view to its cleaning possibilities – downstream benefits. After all, they are prepared to pay an additional 75 euros for a simple ash container.
This shows that benefit-based pricing profits from price differentiations: it must go hand-in-hand with product development or variation. Furthermore, it can be seen that it is not the objective characteristics of a bundle of benefits or individual benefits that are important but rather the perception by the customer and the resulting willingness to pay.
Practical approaches also concentrate on identifying value drivers for product features or focus on performance components in the value-creation process that are not self-evident.
Low cost airlines are a prime example of this approach. A “simple transport service” is offered as a basic service – extras cost, well, extra. The willingness of many people to pay for these extras is enormous: we observe that people are obviously willing to pay 20 euros or more for a glass of tomato juice. The same applies to services such as preboarding or a free choice of seats.
Another example of benefit-based pricing comes from the automotive industry – namely, the pricing for a metallic paint. While the manufacturing costs between standard and metallic paint only differ by a few euros, some buyers are willing to pay a price difference of more than 700 euros for a metallic paint!
In the B2B sector, potential benefits for customers often result from the possibility of flexibility and variability of service provision and logistics processes. Insurance-related services are also used for this purpose. Some companies, for example, already realize more than 50 percent of their profit margin from surcharges for short-term order acceptance, from surcharges for the realization of desired delivery dates, or from comprehensive, carefree service packages.
ELASTICITY-BASED PRICES – THE ROYAL DISCIPLINE OF PRICING
For many companies, a particular challenge in the context of practical pricing is limited knowledge of price elasticity.
The question is, To what extent does demand and, consequently, the contribution margin change in the event of a price variation upward or downward? This question concerns manufacturers of consumer goods as well as plant and mechanical engineering companies when it comes to setting prices for spare parts.
Whether out of ignorance or disinterest, we still frequently observe annual, flat-rate price increases, especially for spare parts. So, with the proverbial “shotgun application,” price increases are evenly spread across all product groups despite it being easy to identify characteristics that, for example, allow demand needs and competitive constellations to justify different price elasticities in different product groups.
Why, for example, should drawing-based parts be adapted to the same extent as specialist trade parts, which are significantly more interchangeable? Here, even with simple, qualitative approaches, additional margins can be achieved through elasticity-based price increases or decreases.
RECOMMENDATION FOR ACTION: THE ANALYSIS OF THE CURRENT PRICE AND CONDITIONS SYSTEM
Another pragmatic approach to quickly identifying scope for margin improvements is to analyze the current price and condition system. The aim is to identify a “real” price that influences the profit margin of a company as a profit variable.
Our experience of more than 17 years of top line optimization shows that there are sometimes considerable differences between the invoiced price and the realized net proceeds. The reasons for this are discounts, rebates, allowances, grants, freight costs, and other factors that prevent the full amount of the sales proceeds from being reflected in the profit and loss account.
Furthermore, our analyses often show a relatively large discrepancy between the differently planned list price and the realized “real” price. However, the wider the distribution, the easier it is to achieve small price increases within the bandwidth. In addition, targeted sales expansions at the upper end – as well as defensive behavior at the lower end – lead relatively easily to an increase in the average price.
If we also consider the normal fluctuation margins according to the customer’s purchase volumes, we can gain further valuable insights from this. For example, the bargaining power of large customers often leads to lower prices being granted to them on the basis of the quantities purchased. In fact, however, it can also be observed that small customers with a low level of acceptance and subordinate relevance for the business relationship are often paying particularly low “real” prices.
STARTING POINTS FOR IMPROVING PRICES AND MARGINS
Additional starting points for improving prices and margins can be derived from this. Below, we have listed some of the approaches that have proven to be particularly successful in our projects:
- Summary or deletion of individual discounts
- Reductions of discounts through revision of content
- Introduction of surcharges (e.g., packaging, energy, lot size)
- Expansion/penetration of price-sensitive customer segments
- Portfolio adjustment – product/customer combinations
- Price variation in unattractive clusters
- Invoicing of customer-specific cost drivers
This article focuses only on a subtheme of the service portfolio for “increasing sales and margin improvement” and is intended as a stimulus for further discussion.
What questions do you have on this subject? Talk to us. We look forward to hearing from you.