The Path to Maximizing Margins
Can an obsession with product costs ultimately hurt profits? Can products be too good for their own good? Such questions reflect the complicated relationship between product design and pricing. Companies that manage this relationship skillfully can maximize their gross margins and, in turn, fatten their R&D and marketing budgets. But this path isn’t easy to find.
At first glance, the plan seemed simple enough to the handful of executives gathered in a small conference room. They would cut costs by replacing or eliminating some of the more expensive components of their top-selling chain saw. The product had served the company well, providing 20 years worth of solid profits. Then a design engineer posed a question, “What about customers who had counted on the saw’s long life?” He wondered if they would need to replace it sooner if a less expensive part, say a plastic on-off switch, doesn’t endure for any significant length of time? A marketing executive chimed in. “Could these changes ultimately cost us more in lost sales than they will save in design?” The room fell silent.
Questions like these cut to the heart of the close relationship between product design and pricing. Companies that deftly manage this relationship can maximize their gross margins and, in turn, fund other initiatives crucial to new product development. The higher their gross margins, the better positioned a company is to out-invest rivals in R&D, marketing and sales. The process turns into a self-propelling cycle of increasing returns on products to pay for developing new products and everything that supports them—from marketing and sales to brand building and customer acquisition.
But it’s not easy to get into this cycle. It requires looking both at the design-to-cost and design-to-price aspects of a product and then defining the relationship between the two.
Managing for Margins
Combining cost and supply perspectives with pricing and marketing approaches can maximize gross margins over a product’s life cycle. There are ample opportunities to do so, particularly in certain industries. In automation and power equipment, for example, gross margins typically range between 20 and 40 percent. Margins in mobile phones and other communications equipment can sometimes stretch to 65 percent.
The implications of combining cost and price strategies can be profound, but it requires a deft balancing act (see figure 1). The company must take into account how customers’ preferences influence a product’s features, the cost of complexity that changes may introduce into the supply chain, and the ways in which price increases improves gross margins.
We can use our experience with a technology equipment company to help illustrate this point. Threatened by drastic price differences and aggressive international suppliers, the company was constantly under pressure to reduce costs. In 2004, faced yet again with the need to cut costs but worried that further design changes would damage its superior quality and consequently its price-premium brand image, the company tried a new approach. Instead of slashing costs across the board, the company first analyzed the total cost of ownership of its product—determining what its customers valued about the product and why they valued it. With this information, the company added features that mattered to its customers and removed features and costs that didn’t. The result: stable, even slightly increasing, market share and, more important, a rise in gross margins on a mid-life-cycle product.
The technology company learned a valuable lesson: The hunt to improve margins is more than reducing costs and protecting prices. It requires looking at the price impact a suggested product change will have on customers, and then weighing the implications against the potential cost savings.
A few years ago, a well-known PC manufacturer used this approach when it considered eliminating an automatic monitor shut-off feature because it required a costly non-standard power supply. The manufacturer performed a standard conjoint analysis to determine the price premium customers would be willing to pay for the feature, but soon found that the analysis alone was not sufficient to develop an overall pricing strategy. There were other questions to answer: If this feature is eliminated, will enough unique features remain to justify the product’s current premium price? How does the new offering compare with basic offerings already in the company’s product portfolio? How does the offering compare in price-sensitive markets?
To answer these questions, the manufacturer had to know the size of its customer segments and gain a better understanding of their preferences. Essentially, the company had to find out if a customer segment would balk at paying a fee for an option that used to be a core feature and head instead for a competitor’s products.
Such pricing implications can be ascertained through a total-cost-of-ownership analysis in which the economics of a product are calculated. By determining total cost of ownership, or even better, the total benefit of ownership, the company evaluates the product from the customer’s perspective. Knowing which features customers value and which subsystems and components support these features, the company can then put appropriate focus on these areas, while reducing costs in others. Think back to the executives considering design changes to a popular chain saw. If customers value certain features—for example, controls that are sturdy and easier to use or a sharper chain—it makes sense to keep them, raise the price of the product, and then become more aggressive in communicating the product’s superiority. If this sounds too optimistic, then, at the very least, the company could look for other features and aspects of the product that are less valued or even invisible to the customer and cut costs accordingly.
Another technology equipment maker had a large measure of success with this approach as well. The company included a cold-start heater unit in all of its products—something that’s not needed in warmer climates. When executives decided to offer the cold-start feature as an option for an additional fee, they lowered the price of the basic unit and raised the price on the option, which in turn created a healthy profit margin.
In short, it requires performing a conjoint analysis to determine the benefit of ownership and then prioritizing features that really matter to customers while designing toward “core cost” to identify the theoretically lowest attainable cost. Ultimately, the goal is to determine the best trade-off between these two perspectives.
Design Toward Core Cost
In our work for clients, we typically begin with a core-cost analysis in which the minimum achievable product or service costs are pinpointed along several dimensions: product function and features, specifications, design, manufacturing operations and supply. The company identifies features that are not essential to a product and then assesses each one to determine if it should be eliminated (because customers are not willing to pay for it), turned into an option (because only certain segments of customers are willing to pay for it), or retained (because it is core to the product). These nonessentials can account for more than half of total product costs. Figure 2 shows a typical example; in this case, an auxiliary control unit’s core costs account for just 35 percent of the product’s overall costs.
During a core-cost analysis, companies usually discover problem areas such as “gold plating”—where a product offers features customers do not need, will never need, and would prefer not to pay for. For example, high-grade fire resistant seats that are required for trains that travel through tunnels is superfluous on a train that will never go through a tunnel. The analysis also identifies waste in the design process and points out ways to align the product’s initial design with the most economical supply base. For example, when one of our industrial clients worked with a supplier to redesign its castings, making them smaller and loosening tolerances, the company was able to move to a cheaper offshore supplier, thus reducing costs by 20 to 40 percent.
Also, by looking at competitors’ products, companies can identify best practices and determine where they need to catch up. A maker of auto instrument clusters discovered that its use of incandescent bulbs and plastic dials to distribute light was hopelessly out of date; its rivals had long since changed to less costly LEDs that do not require a dial.
A good core-cost analysis also requires identifying specifications that are not absolutely necessary or more demanding than the bare minimum needed for the product to function. Finally, all waste in the manufacturing process becomes a target for cost reductions. While it is not possible to eliminate all non-core costs, savings of 30 to 40 percent are often possible.
Pulling It All Together
A relentless focus on driving down product costs is critical, but if a sales team operates in a cost-based pricing mode, the effort will have little impact on margins. In fact, one of the dangers of this approach is giving away hard-earned cost reductions by carelessly applying cost-plus pricing.
This brings us to value-based pricing. Quantifying and articulating the total cost of ownership of a product—or the total benefit of ownership to the customer—requires a focus on value. Keep in mind that value must be defined from the buyer’s point of view, not the seller’s. Companies sometimes make the mistake of overemphasizing the features of their products, when they should focus instead on the hard and soft benefits that the customer can gain from the product. For example, a company should not tout its software features when its major competitive advantage is its hardware.
Additionally, value is often sold as a “bundle” rather than as a stand-alone product, when companies offer additional services or more flexible financial solutions. These bundling tactics are said to belong to mobile phone operators that usually have too long a list of options to properly sort through the value of each. By bundling products and services, they not only create more customer value, they can tailor the offering to meet the needs of specific customer segments. And the price increase is buried somewhere deep within the bundle.
Naturally, for any of this to work, the value of an offering must be clearly superior to that of alternatives. Otherwise, the price will end up being set either by the least sophisticated or most aggressive competitor. The implication is that if a company cannot meaningfully differentiate its product or service, it is unlikely to be able to put a price on its value. Firms that successfully engineer their products and prices with a clear view on maximizing total benefit of ownership for the customer will be paid back in well-deserved margins.
And the right team will make a big difference. Companies can dramatically improve their gross margins by getting the right cross-functional group in place. The team must be interdisciplinary, meaning that it must be able to consider all categories of waste, ranging from gold plating, which requires input from marketing, to poor design for supply, which can be identified with help from manufacturing. By the same token, the team must be permanent, continuously identifying opportunities over the product’s entire life cycle. Finally, sales people should be trained to effectively communicate to customers both the absolute and relative total benefit of ownership
Designing products efficiently is difficult and is just as challenging as determining a price that satisfies both buyer and seller. But put the two together, and the results can far outweigh the obstacles.
Consulting Authors
Thomas Kratzert is a vice president and head of A.T. Kearney’s Nordic region. He is based in Stockholm.
Michael Broquist is a consultant in A.T. Kearney’s Munich office.
The authors wish to thank Stephen Bradley for his help in writing this article.
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