Pricing: An Eternity of Frustration?

The issue of pricing sometimes feels like a Sisyphean task. It’s hard work to push price up a hill. Before you can reach your goal, the rock tends to fall back down. The potential value erodes, often cannibalized by excessive discounts, generous payment conditions or free-of-charge services. For all the work of setting a high price, companies rarely achieve that price. There is a better way.

BEFORE BEING CONDEMNED to the Greek underworld, Sisyphus had thought himself a clever man. He stole his brother’s throne, seduced his niece, betrayed the secrets of Zeus and even tried to trick Death by getting another man to wear his chains. That hubris was why Sisyphus was forced to roll a huge rock continually up a steep hill, only to have it fall back down before he could reach the top. The gods were, in the end, more clever—and so condemned him to an eternity of frustration.

Sisyphus suffered because of a curse. Will you too be cursed if you attempt to increase your profits by raising your prices? Apparently many companies think so. They refuse to think about pricing, because they fear that doing so will lead them to activities that are pointless, unrewarding and endless.

The Overlooked Route to Profits

We believe that companies have taken the wrong lesson from the myth of Sisyphus. Sisyphus was being punished for his deceit. He stole, murdered, lied and betrayed. But if attempting to achieve gains in profitability through pricing strategies sometimes seems a Sisyphean task, that’s not due to a curse from the gods. It’s due to poor strategic thinking and organizational follow-through.

Part of the problem is lack of confidence. Too many companies believe their products are not unique. They believe the only way to attract customers is by lowering prices. They believe prices are set by the market or the competition. And they’re always quick to look for opportunities to offer discounts.

For example, let’s look at beer. Worldwide beer demand is stagnant, and most markets seem oversupplied. So when beer companies decide to increase revenues, they think they have to boost volumes by lowering prices. They think of their product as a commodity. But are consumers’ behaviors (even in markets with oversupplied commodities) really always driven by discounts? Or do they buy items for reasons other than price?

If you want to grow revenues, you have only two options: volume and price. Increasing volumes—new products, new geographies, new ways of luring customers away from competitors—is the traditional route. Management meetings are often consumed with the difficulties of implementing volume-growth strategies in saturated markets. Price is the second option. We’ve found that most CEOs can’t remember the last time a management meeting took up the issue of pricing.

Many executives seem to think pricing is some sort of voodoo. They’re not sure if pricing is an art, a science or simply magic, but regardless of how it’s classified, they figure it’s mystical and complex. They figure there’s a great deal of mathematics involved, churning through data on customer preferences to develop figures on price elasticity that can change as soon as a new product comes to market. We beg to differ.

There isn’t a company in the world—regardless of the quality of its products—that can’t benefit from innovative pricing strategies. Sometimes this may involve tweaking the value proposition, but not always (see sidebar: The Most Valuable Things in the World). For example, consider insulators for high-voltage transmission lines. This is a rather utilitarian product: simple, low-value and invisible to most end consumers. However, high-voltage plants can’t run without them. An insulator manufacturer we worked with realized that its customers were gravely concerned about thunderstorms. When lightning struck an insulator and broke it, the plant had to shut down. When the insulator manufacturer included with its product a guarantee to deliver spare parts within 24 hours, the plants were more than willing to pay a much higher price.

When thinking about pricing, companies tend to focus only on factors they can measure. Sometimes they simply use their internal costs, ignoring the value to the customer. Other times, when they do analyze customers, they often examine ability to pay rather than willingness to pay. Again, it’s measurable: Market research and traditional go-to-market analyses can measure ability to pay (via consumers’ wealth) through standard statistics on demographics and household income. But willingness to pay is driven by more intangible factors, such as limitations in access to the product or channel, and psychological factors such as the urgency of the need.

Analyzing Value Erosion

We’ve been discussing top-line approaches, ways to empower Sisyphus to propel his boulder much higher much faster. (Call it value growth.) But the story of Sisyphus sticks in people’s minds because the boulder always tumbles back down. (Call it value erosion.) Are there ways to suspend those laws of gravity?

Pricing feels like a Sisyphean task because for all the work of setting a high price, companies rarely achieve that price. It’s eroded by a wide variety of discounts and hidden costs. Figure 1 presents an analysis from one of our recent client engagements. We call this figure the net pocket price waterfall. On the left is the list price, and the subsequent columns depict the waterfall of discounts and support costs that lead to a net pocket price (the amount that actually stays in the company’s pocket). Few companies have a true picture of this process. Yet in this case, which is not at all unusual, the net pocket price is almost 59 percent of the list price.

We use this analysis because it brings transparency to the pricing process, pinpointing the components of the erosion. Some of the components are intentionally granted, such as the competitive discount. Others are unintentional, such as increases in manufacturing complexity. Some are cash, such as rebates. Others are non-cash-related, such as on-site technical support. The components vary by company, of course, but every company faces numerous circumstances to justify erosion: a different sales channel, a different sales occasion (end-of-summer sale), a preferred customer or a difficult-to-serve customer. Yet each step in the waterfall represents potential profit waiting to be tapped.

The discounts and other cash components are often easy to measure, but there are less-obvious or less-traceable elements that are often ignored. For example, in B2B companies, logistical costs or technical support are not always charged to the applicable customer. Likewise, for B2C products, samples, warranty extensions, generous payment terms or free product add-ons (such as mobile handsets) all effectively reduce the pocket price. As Figure 2 shows, these erosions occur in every industry, at every step of the value chain.

For example, when we sat down with one client to look at freight costs, we found that they were invoicing their customers for just 2.2 percent of their actual freight-related costs. The other 97.8 percent, including items such as fuel, tolls, taxes and driver salaries, were written off as overhead. Another client offered a cash discount for customers who paid within 15 days of invoicing—but ended up extending the discount long past the period’s expiration, in the name of “goodwill.”

Prices and Incentives

Are such incentives necessary? Maybe. But the point is transparency. Only when you perform the net pocket price waterfall analysis can you see which activities erode which prices, to judge their effectiveness. In the case of the extended cash discounts, the analysis allowed the company to ask whether goodwill was worth a net pocket price reduction of $459,000—approximately 1 percent of its total revenues.

We’re not saying there’s anything wrong with giving an important customer plenty of incentives. But we have found that few companies know which are their most profitable customers. In figure 3, another client example illustrates a remarkably typical situation. We plotted the cost to serve each customer against customer revenue—with little correlation, causing our client to realign the way it offered incentives to customers.

When we perform a net pocket price waterfall analysis, we enter the findings in a database that allows performance evaluation across numerous dimensions. How does each business unit perform? How profitable is each customer? How effective is an incentive (such as technical services or cash discounts) for each product or service? Such analyses frequently generate action-oriented insights.

The analyses can even generate the insights needed to raise prices. For example, earlier we discussed the high-voltage insulator manufacturer that decided to offer customers a guaranteed quick replacement in exchange for a higher price. How did they know the customers wanted it? Because some of their employees (keen for goodwill) were already trying to provide that service. Incorporating it explicitly as part of the product transformed the practice from a price-eroding fault to a price-differentiating feature.

We’ve heard some companies argue that although they are aware of the issue of excessive discounts or misaligned services, they need data to address the issue. Since they don’t have the data, they can never achieve transparency, so there’s nothing they can do. Actually, the less data you have, the more likely it is that your discount chain is completely unmanaged—and, thus, the more room you have for improvement.

Reward Profits, Not Volume

At many companies, the problem is that salespeople are rewarded for volume rather than profitability. Because they get a bonus for a big order, they’re generous with discounts, special orders and lax payment terms. That generosity erodes the very profitability they are being rewarded for (not) achieving.

For example, when we did a net pocket price waterfall analysis for a prominent German consultancy, we found that partners were being awarded bonuses based on the volume of projects acquired or sold. But when you looked at project profitability, some of those big projects weren’t very profitable, so the “big hitters” weren’t really helping the company much at all.

Once the analysis made these issues transparent, management was able to change internal reporting systems, key performance indicators and bonus calculations. Under the new system, those heavy hitters were still heavy hitters. They are incredibly talented people, who respond effectively to incentive structures. But until transparency empowered the company to set up its incentives properly, their talent was being wasted chasing the wrong quarry.

How to Raise Prices

Our methodology is two-pronged. As we’ve just discussed, the first step in raising prices is not to raise the list price at all, but to use a net pocket price waterfall analysis to develop sales guidelines and tools to capture more of that price in your pocket. We put this step first because it’s pointless to implement price increases without addressing value erosion. As the parable says, the first rule of holes is to stop digging. We also put this step first because it leads to tangible, if sometimes incremental, results. Going through a net pocket price waterfall analysis is an analytical, dare we say slightly dull, exercise. But it helps companies see that pricing strategies can increase profitability. It sets the stage for the second phase.

After stopping value erosion, the second phase is to increase value. Much of our work in this area involves giving companies tools to foster creative thinking about prices, expanding their horizons as we did in the insulator discussion mentioned earlier. Broadening horizons often means “thinking outside the box,” and the first step is recognizing what the box looks like.

For example, one box that many companies live in is the notion that you have to decide on a price before you start selling the product. However, as figure 4 shows, even if we don’t often think about them, other modes of pricing are in fact quite common. Can you imagine a waitress requesting the tip before you sit down to your meal? Or an auto mechanic deciding on a price before he opens the hood? Customers accept these alternative pricing modes. So one question we like to encourage our clients to ponder is whether there are situations where these alternatives might increase profits.