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Setting the right price

In these uncertain economic times, managers might think it mad to talk about raising prices. Yet McKinsey asserts that it can be done.

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 other sources as well:

• 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.

• 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 these factors has eroded corporate pricing power and has forced frustrated managers to look in every direction for ways to hold the line.

In such an environment, managers might think it mad to talk about raising prices. Yet it can be done. We are not talking about raising prices across the board. Quite often, the most effective path is to get prices right for one customer, one transaction at a time, and to capture more of the price that you already, in theory, charge.

In this sense, there is room for price increases or at least price stability even in today's difficult markets. Such an approach is known as transaction pricing. The idea behind it is to figure out the real price a company charged customers after accounting for a host of discounts, allowances, rebates and other deductions. Only then can a company determine how much money, if any, it is making and whether it is charging the right price for each customer and transaction.

A simple but powerful tool--the pocket price waterfall, which shows how much revenue companies really keep from each of their transactions--helps 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.

The one-two punch...has forced frustrated managers to look in every direction for ways to hold the line.
Our experience in serving companies on pricing issues shows that the pocket price waterfall still effectively helps identify transaction-pricing opportunities. Nevertheless, in view of evolving business practices, 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 the 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.

One 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 revenue 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 market and industry.

Many companies can find an additional 1 percent or more in prices by carefully looking at what part of the list price of a product or service is actually pocketed from each transaction. Right pricing is a more subtle game than setting list prices or even tracking invoice prices. Significant amounts of money can leak away from list or base prices as customers receive discounts, incentives, promotions and other giveaways to seal contracts and maintain volumes.

The experience of a lighting supplier shows how the pocket price--what remains after all discounts and other incentives have been tallied--is usually much lower than the list or invoice price. This company makes incandescent light bulbs and fluorescent lights and sells them to distributors that then resell them for use in offices, factories, stores and other commercial buildings. Every light bulb has a standard list price, but a series of discounts that are itemized on each invoice pushes average invoice prices 32.8 percent lower than the standard list prices. These on-invoice deductions include the standard discounts given to most distributors as well as special discounts for selected ones, discounts for large-volume customers, and discounts offered during promotions.

A strategy based on cutting prices to increase volumes and, as a result, to raise profits is generally doomed to failure.
Managers who oversee pricing often focus on invoice prices, which are readily available, but the real pricing story goes much further. Revenue leaks beyond invoice prices aren't detailed on invoices. The many off-invoice leaks at the lighting company include cash discounts for prompt payment, the cost of carrying accounts receivable, cooperative advertising allowances, rebates based on a distributor's total annual volume, off-invoice promotional programs, and freight expenses. In the end, the company's average pocket price--including 16.3 percentage points in revenue reductions that doesn't appear on invoices--is about half of the standard list price.

Over the past decade, companies have tried to entice buyers with a growing number of discounts, including discounts for online orders as well as the increasingly popular performance penalties that require companies to provide a discount if they fail to meet specific performance commitments such as on-time delivery and order fill rates.

By consciously and assiduously managing all elements of the pocket price waterfall, companies can often find and capture an additional 1 percent or more in their realized prices. Indeed, an adjustment of any discount or element along the waterfall--either on- or off-invoice--is capable of improving prices on a transaction-by-transaction basis.

Taming transactions
The game of transaction pricing is won or lost in hundreds, sometimes thousands, of individual decisions each day. Standard and discretionary discounts allow percentage points of revenue to drop from the table one transaction at a time.

Companies are often poorly equipped to track these losses, especially for off-invoice items. After all, the volumes and complexity of transactions can be overwhelming, and many items, such as cooperative advertising or freight allowances, are accounted for after the fact or on a companywide basis. Even if managers want to track transaction pricing, it has often been impossible to get the data for specific customers or transactions.

But some recent technical advances have helped remove this obstacle. Management-information systems and off-the-shelf custom-pricing software have made it easier to keep tabs on transaction pricing. Managers can no longer hide behind the excuse that gathering the data is too difficult.

Current price pressures should go a long way toward removing two other obstacles: will and skill. In the booming economy of the 1990s, robust demand and cost-cutting programs, which drove up corporate earnings, made too many managers pay too little attention to pricing. But now that a global economic downturn has slowed growth and the easiest cost cutting has already occurred, the shortfall in pricing capabilities has been exposed.

A large number of companies still don't understand the untapped opportunity that superior transaction pricing represents. For many companies, getting it right may be one of the keys to surviving the current downturn and to flourishing when the upturn arrives. It has never been more crucial or more possible to learn and apply the skills needed to execute superior transaction-price management.

For more insight, go to the McKinsey Quarterly Web site.

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