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Getting Your Pricing Right

Tuesday, March 1, 2011 - 08:30

Pricing is an issue for all organisations. Ron Wood outlines the common mistakes and the key areas to focus on when developing a pricing strategy.

How many meetings have you recently attended where pricing strategy, aggressive competitors and customers' procurement techniques were an issue?

On top of this, your finance team is reporting margin contraction across a range of key products and customer groups, yet revenues are actually higher than last year. What could be the problem?

Over the past 20 years several major trends have emerged to make pricing strategy perhaps the critical profit lever for business. These include:

  • low-cost country sourcing
  • the commoditisation of many products and services
  • mergers and acquisitions to create scale leading to markets with two and three major players and a suite of niche competitors
  • the rise of the professional procurement manager.

These have shrunk margins from highs of around 45-50 per cent down to 25-35 per cent. The average net profit margin for an ASX-listed company is now 4-8 per cent. This means the margin for error is tiny. Companies are learning that, in mature markets with average gross margins of under 40 per cent, you cannot discount your way to growth.

In fact, with average earnings before income tax margins of just 8 per cent for the ASX 200, a 2 per cent improvement in margins would result in a 25 per cent improvement in earnings year on year. There is no customer, product or cost-down opportunity that can generate this kind of profit.

Strategic pricing should be a top three priority for boards and executive teams. The common mistakes companies make including the following.

Decentralised pricing strategy

Unstructured pricing management and decision-making leads to inconsistencies in the valuation of goods and services. This is quickly picked up by customers who then have a basis to negotiate prices down. The result is margin contraction, channel conflict and missed sales.

Cost-plus pricing

Nearly 85 per cent of companies use some form of cost-plus mark-up to set prices. This fails to maximise profit in several ways.

First, if your business secured cost-downs on products or services, and your sales force are used to adding 30 per cent mark-up to the costs, all those cost-down gains will be traded away. The unit-gross margin will also decline, meaning you now have to sell more product just to make budget.

The second danger is the failure to maximise the yield per sale. Most managers understand the concept of customer segmentation and that customers value different elements of the product or service. This often does not translate into pricing strategies that maximise what customers are willing to pay. How many times have you bought something where you thought, 'I would have paid more'? But how often do we tell the vendor at the time of purchase? Yes, never.

The third key mistake is to overcharge and thereby miss the sale completely. Many companies have pricing policies that insist on certain margin hurdles. This ignores that prices may have dropped beyond what is either strategic or sustainable. A good example is shown by how USB memory stick prices continue to fall by up to 15 per cent annually for the same memory specification.

Effective customer segmentation

The failure to develop effective market segments supported by a suitable pricing structure is a crucial reason many companies fail to maximise profits. Effective segmentation can be achieved by identifying the features, benefit and value each segment requires and, importantly, the customer behaviours seeking this value. This understanding forms a sound basis to build an effective segmented pricing architecture.

Lack of resources

Many companies are struggling with this at present. Australia is about 10 years behind the US in terms of building an organisation structure that effectively incorporates a pricing management function.

Many employ a lone junior pricing analyst to provide strategic and commercial advice. This timid approach leaves a company at risk of believing they have the pricing challenges covered, when in actual fact margins are as at risk as they always were.

How do I know if I have a problem?

It is hard to know that pricing is wrong simply by looking at the prices themselves. Better clues are:

  • shrinking margins
  • channel conflict
  • loss of market share
  • severe excess in production capacity
  • general noise in the form of emails about pricing levels between sales, marketing and finance
  • customer aggravation with your pricing
  • perception of bureaucracy around pricing decisions.

In summary there are seven key areas of focus to build pricing capability and margins:

  1. Value pricing is the key: know how to define, communicate and capture value.
  2. Pricing power: know the source of this, whether it is unique products/services, economic cycle, or competitor offers.
  3. Price architecture: design a pricing structure that will allow your business to have a systematic and process-driven way to maximise margins.
  4. Economics: with contracting gross margins, every point counts. Design and implement powerful pricing-decision support for pricing models.
  5. Pricing tools: ensure your pricing-decision support tools are issued and managed centrally. Avoid multiple spreadsheet decision-making models.
  6. Engagement: bring the team together to align sales, marketing, finance and operations to understand the commitment and requirements to drive value-based pricing throughout the business.
  7. Focus: pricing should be one of the top priorities of your board and executive management team.