Escaping the vice of pricing pressure – Margin Expansion Planning
Margin Expansion Planning or “MxP” is a framework to improve profitability.
Executives are under increasing pressure to find margin to drive earnings. It is hard to sell more because the market share game is often a zero sum game or in many cases, a less than zero sum game.
There are many management levers we need to manage everyday. Then there’s the blinking lights of email queries, corridor conversation problems and structured meetings that must be dealt with. We run out of time, or need to focus attention elsewhere to get through the demands of the day.
The result is that pricing decisions are often made in isolation using less than ideal techniques such as cost-plus mark-up pricing or following random pricing intelligence reports of what competitors are allegedly doing.
It has been said many times over the years that pricing is your most powerful lever to manage margins. To make it easier to see margin opportunities and various cause and effect dependencies, I created the MxP – Margin Expansion Planing framework.
The MxP framework is something I use to focus on margin problems and see patterns, relationships, trends and outliers than provide the clues as the probable success of one course of action over another. I say probable success because pricing is a game of probabilities and bell curve distributions.
Allocating to the time and mental bandwidth to think through your pricing and margin opportunities, along with engaging the help of colleagues across functions will generate a substantial payoff.
The Margin Expansion Plan framework is shown below:
Margin Expansion Planning framework is used to evaluate the revenue model and identify the dependencies and interactions associated with a business’s pricing structure.
The framework allows you to evaluate the companies revenues using this framework against their overall strategy and business model.
The framework is by no means exhaustive but does cover many of the pricing scenarios we come across every year.
There are 6 key elements to the MxP framework: Price, Discounts, Rebates, Costs, Volume & Mix.
I will address some of the variables in this MxP framework identifying its function and some caveats and considerations that should be used in managing each one.
List price: purpose is to create a starting point for an offer to market. Often the List Price is considered the Recommended retail price where there are multiple channel distribution points or a wholesales / re-seller business model in place. For example Bunnings use a RRP less 15% for trade model. For non-tradies who go to Bunnings you’re doing your bit to help the tradie make some margin when he shows you the materials were bought “at cost.”
For B2B markets where list prices are most common, many companies simply create these list prices by using a multiplier on cost – an effective mark up on cost or cost plus mark up as it is technically known.
The biggest issue we see with List Prices is that they are usually built from costs so they typically under-price goods or over price them. Cost is rarely a good proxy for the value that can be realised in the market.
Why is this statement so crucial?
In almost all buying situations, the customer’s reason for buying hinge not on your cost position but on their want state. What the customer wants is driven almost always by two factors: Motivation – the reason for purchase [ranging from discretionary to mandatory] and Application: how the product / service will be used [ranging from low risk to high risk].
Let’s look at an example. Surgical gloves. The Motivation is not discretionary. It is mandatory by rules and training that a surgeon wear a certain standard of surgical glove. The application is high risk. The gloves cannot break otherwise infection risk could occur for both patient and surgeon.
On the other hand, [pun intended], a sandwich glove used at a canteen is not mandatory and the risk of infection probably low. But still we all like to see the sandwich maker wearing one.
If these two types of gloves were priced according to cost it is highly likely that the sandwich makers glove would be overpriced and the surgical glove under-priced. In the case of the sandwich glove we would miss sales and in the surgical glove case miss margin.
Both result in lost profits. We see this scenario play out over 1000s of products across the dozen or so companies we work with each year.
The caveat here is to design your List Price according to value pricing principles. Make sure you have well thought out price point relativity between your budget, better, premium and ultra-premium products. The last category here is interesting as we often see exponential price differential opportunities in ultra premium.
What this means is customers for ultra-premium products often will pay 100 – 300% more for these products over the regular product.
Customer discounts refer to the price levels the customer is set. Almost all companies slot their entire customer base into one of five graded levels, often with an enormous five percent additional discount between each level. Often delineated as Levels 1-5 or My favourite AAA, AA, A, B & C.
The AAA provided the highest level of discount and hence the lowest prices. Can you see what happened here?
The started out with 3 levels A, B & C. When market conditions changed they simply added AA and when conditions changed again they added AAA. Unfortunately, after years of pricing from the hip, their credit rating could not be described as AAA.
What can you do with customer discounts to improve profitability? Once you have you channel strategy worked between the various pathways to market, you can optimise discounts by customer.
Here is a case example. We worked with a large transport company with over 11,000 active customers. They were split into the various pricing levels based on annual spend. We have found that annual spend isn’t the best way to determine customer price level or discount.
Using the principles of Application and Motivation discussed earlier, we can reclassify customers. We looked at industry by SIC, freight type – express or general, dangerous or standard good, freight point to point usage and growth and overall tones shipped.
Across these variables and a few others, we were able to develop a unique customer price level that was consistent with the value the customer was extracting from the fright network. This approach overrode the typical annual spend approach to customer segmentation and customer price level.
Force fitting customer pricing into 5 levels of levels of discounts leaves a lot of money on the table. The value optimised approach creates a customised price discount level for 11,000 customers. When your company is only making 5 percentage points of EBIT, offering up 100% of your EBIT margin profile as step change in discount levels is risky business indeed. Your customer guidelines will be neat and tidy and your P&L will be uncontaminated by profit.
Tactical Discounts are the daily bread of sales. Every sales rep around the world uses them to close deals. What wrong with that? Nothing except a world of hurt and heartache for these that have to clean up the mess of a rep who offered too deep a discount thereby creating channel disharmony or exposing their company to punitive action by their large customers who get tired of fighting off smaller competitors who distribute the same products but use the product as a loss leader to win market share of the larger players.
Does this sound familiar?
In many cases the discount provides useful psychological theatre to entertain the customers need for a bargain. Persian rug sellers have known this for 1000s of years. I don’t think you can buy a sign from the Persian rug supplies shop that says save anything less 60%. The List Price has already factored in the “discount”.
However, many companies are not a sophisticated as a Persian rug seller and instead go to market with “realistic” market prices that get promptly discounted because of the required “pricing theatre”. There is usually some authority sign off matrix that escalates to more senior levels when the discounts exceed nominated thresholds. The strange irony here is that the person that knows the least about the deal and the customer is the one that has to make the discretionary approval to offer the extra discount.
I once saw a Sales & Marketing director who had set up a Lotus Note email sign off process that did this very escalation process. When I looked at his email inbox, it was full. There were over 40 requests for discount sign off approval. The value of these requests amounted to over $500,000 in pure profit. This represented just two week’s discount requests. It was a system but not designed to improve profitability. But everyone as certainly busy “signing off” the discount requests.
What is needed to manage tactical discounts is a set of tactics guidelines issued by the Pricing Management function in consultation with the various departmental heads. Sales reps should be able to make pricing decisions on the spot if they fall within tactical guidelines. If we lose business due to tactical pricing levels then this should be tacked and a more informed / strategic decision made that supports total company profitability not just one region, territory or market segment.
One of the most misunderstood pricing mechanics in history is the rebate.
Much maligned and hunted down by managers who have been burned by them [usually CFOs don’t like rebates as they see the accrual as a balance sheet liability and it annoys their accounting minds – although I hear Alex Malley and his cabal are fond of a rebate or three]. Rebates are a bit like pre-nuptial agreements. They seem logical and well-intentioned but can often become a major drag and a cause of much disagreement once customer and supplier fall out of love.
Poorly set up rebates, poorly administered and the poorly communicated value of the rebate to the customer are all reasons not to have them. But do rebates actaully have any value?
The answer is yes, they do – in fact they can be crucial to drive the ideal customer behaviour not just to buy more of your products but to buy them in the right way. What do we mean by this? If you sell multiple product categories to the one customer their procurement manager will be exposed to low ball offers from multiple suppliers [your competitors] all looking to get a beach head into the customer’s buying program.
The Sales Target rebate.
By offering rebate across all the total revenue spend the customer will see that making a saving of 20% on one line item or SKU worth say $20,000 per year, will put a risk a rebate that is worth $200,000 per year. There is $180,000 more immediate economic value in your offer when compared at invoice level. [We will cover off the concept of value in another paper].
The Supply Chain rebate
The other type of rebate that generates value is the supply chain rebate.
Supply chain rebates are useful to lower the cost of doing business [CODB]. Lowering the CODB by driving customers to: consolidate orders and order less frequently, order up more on a certain product each time, order by electronic means such as online ordering not phone or fax all hep drive down costs to create a supply chain dividend.
This “dividend” can be re invested back into the marketplace to secure behavioural change and loyalty from customers.
Rebates are so valuable that it is worth having a full time rebate and discounts management team aka the pricing team manage this for you.
Some companies are still wondering if they should have a full-time pricing manager or pricing team.
The MxP framework is simple enough to walk through but a complex animal to manage and master. In the past many of the areas listed in MxP were handled by the sales team and some input from the accounting team all on an ad hoc part time basis to their regular jobs. As revenues under management grow and gross margins contract business profitability is now highly leveraged to price movements.
In 2017 pricing management is a full-time job and will be a lifetime career for many. The challenge to create and manage your own Margin Expansion Plan can be solved with a structure and a plan. Without a plan pricing will be deemed a black art.
Here is a checklist to start your own Margin Expansion Plan
- List Price relativities set up across each sub category, brand and SKU?
- Customer Discounts: price segmentation undertaken using behaviours to identify value vs pure spend metrics?
- Tactical discount guidelines issued each day / week / month to the sales force to allow them to make on the spot pricing decisions?
- Structured discounts such as order quantity breaks set up to allow the customer to extract more value whilst lowering your Cost Of Doing Business?
- Rebates set up to drive show of wallet purchase via sales targets built up at sub category or category level – not just 5% over last year’s total sales?
- Supply chain rebates set up where applicable?
- Lastly do you have the right team in place to manage your Margin Expansion Plan?