Using Big Data to Make Better Pricing Decisions
Transaction pricing is the key to surviving the current downturn—and to flourishing when conditions improve.
February 2003 | by Mr. William Andrews, Executive Vice President
At few moments since the end of World War II has downward pressure on prices been so great. Some of it stems from cyclical factors—such as sluggish economic growth in the Western economies and Japan—that have reined in consumer spending. There are newer sources as well: the vastly increased purchasing power of retailers, such as Wal-Mart, which can therefore pressure suppliers; the Internet, which adds to the transparency of markets by making it easier to compare prices; and the role of China and other burgeoning industrial powers whose low labor costs have driven down prices for manufactured goods. The one-two punch of cyclical and newer factors has eroded corporate pricing power and forced frustrated managers to look in every direction for ways to hold the line.
Such an approach to pricing—transaction pricing, one of the three levels of price management—was first described ten years ago. The idea was to figure out the real price you charged customers after accounting for a host of discounts, allowances, rebates, and other deductions. Only then could you determine how much money, if any, you were making and whether you were charging the right price for each customer and transaction.
Transaction pricing is one of three levels of price management. Although distinct, each level is related to the others, and action at any one level could easily affect the others as well. Businesses trying to obtain a price advantage—that is, to make superior pricing a source of distinctive performance—must master all three of these levels.
Industry price level. The broadest view of pricing comes at the industry price level, where managers must understand how supply, demand, costs, regulations, and other high-level factors interact and affect overall prices. Companies that excel at this level avoid unnecessary downward pressure on prices and often emerge as industry price leaders.
Product/market strategy level. The primary issue at this second level is pricing a product or service relative to the competition. To do so, companies must understand how customers perceive all offerings on the market and, most particularly, which attributes—product as well as service and intangible attributes—drive purchase decisions. With this knowledge, companies can set visible list prices that accurately reflect the competitive strengths (or weaknesses) of their offerings.
Transaction level. The focus of transaction pricing is to decide the exact price for each transaction—starting with the list price and determining which discounts, allowances, payment terms, bonuses, and other incentives should be applied. For a majority of companies, the management of transaction pricing is the most detailed, time-consuming, systems-intensive, and energy-intensive task involved in gaining a price advantage.
A simple but powerful tool—the pocket price waterfall, which shows how much revenue companies really keep from each of their transactions—helps them diagnose and capture opportunities in transaction pricing. In this article, we revisit that tool to see how it has held up through dramatic changes in the way businesses work and in the broader economy. Our experience serving hundreds of companies on pricing issues shows that the pocket price waterfall still effectively helps identify transaction-pricing opportunities. Nevertheless, in view of evolving business practice, we have greatly expanded the tool's application. The increase in the number of companies selling customized products and solutions or bundling service packages with each sale, for instance, means that assessing the profitability of transactions has become much more complex. The pocket price waterfall has evolved over time to take account of this transition.
Today, it is more critical than ever for managers to focus on transaction pricing; they can no longer rely on the double-digit annual sales growth and rich margins of the 1990s to overshadow pricing shortfalls. Moreover, at many companies, little cost-cutting juice can easily be extracted from operations. Pricing is therefore one of the few untapped levers to boost earnings, and companies that start now will be in a good position to profit fully from the next upturn.
Advancing One Percentage Point at a Time
Pricing right is the fastest and most effective way for managers to increase profits. Consider the average income statement of an S&P 1500 company: a price rise of 1 percent, if volumes remained stable, would generate an 8 percent increase in operating profits—an impact nearly 50 percent greater than that of a 1 percent fall in variable costs such as materials and direct labor and more than three times greater than the impact of a 1 percent increase in volume.
Unfortunately, the sword of pricing cuts both ways. A decrease of 1 percent in average prices has the opposite effect, bringing down operating profits by that same 8 percent if other factors remain steady. Managers may hope that higher volumes will compensate for revenues lost from lower prices and thereby raise profits, but this rarely happens; to continue our examination of typical S&P 1500 economics, volumes would have to rise by 18.7 percent just to offset the profit impact of a 5 percent price cut. Such demand sensitivity to price cuts is extremely rare. A strategy based on cutting prices to increase volumes and, as a result, to raise profits is generally doomed to failure in almost every industry.