Enterprises have long realized the importance of improving profits by curbing upstream supply chain costs, as evidenced by an increasing strategic approach to sourcing, e-procurement, and contract or spend management over the last several years (see The Hidden Gems of the Enterprise Application Space). However, this broad strategic approach, including education and discipline, has not been applied on the sales side. The kind of thoughtfulness recently seen amongst well-informed and disciplined buyers and purchasing managers has been lacking when it comes to deploying information technology (IT) systems for analyzing pricing processes, pricing optimization, sales force education, and price enforcement in the downstream components of the value chain. Another major deficiency is the dearth of software providers for the management needs of the entire price lifecycle, from price setting, price optimization, and price policy management, to deal execution monitoring, analytics, and reporting.
Justifying the "why" of pricing and profit optimization is fairly easy, since the objective is to increase profits and margins, and hardly anyone could disagree with that objective (see Profit Optimization—Can We Possibly Argue with the Objective?). But the "how" of the optimization is not easy. Although a simple analysis of the profit increase equation may prescribe raising prices, cutting expenses, or simply selling more—and all of these seemingly simple solutions are right in principle—the real problem is far more complex. For example, if one raises prices, will the customers continue to buy, or will they rebel?
On the other hand, if one cuts expenses drastically, will the product quality suffer as a result of resentful, underpaid, overloaded workers, or equally resentful (beaten up) suppliers delivering cheaper but inferior products? Will this drive customers away? Will the consequent warrantee cost increase to the extent that expenses actually rise instead? Moreover, at many companies, there is little cost-cutting maneuver space within operations, given that most enterprises have been watching their procurement costs closely, and evaluating their trading partners. The option of selling more is not simple either, because no one can control customer needs: one cannot know for sure that they will buy more. Some indications show that volumes would have to rise about 19 percent to offset the profit impact of a 5 percent price cut, and such demand sensitivity to price cuts is quite rare. And even if customers do buy more, the question then becomes, can this upsurge in demand even be delivered?
Thus, it appears that raising prices justifiably is the most effective way for enterprises to increase (or maintain) profits in times of both economic boom and slump. While this holds true for most environments, it is particularly true in the razor-thin-margin retail and commodity manufacturing establishments, where prices and availability are the only levers of competitive differentiation. Savvy and dynamically optimized pricing can then mean the difference between survival and failure. The Power of Pricing, the well-known 2003 McKinsey & Co. report, showed that a price rise of 1 percent, at constant volumes of sale and costs, should generate an 8 percent increase in operating profits, which is 50 percent greater than the impact of a decrease of 1 percent in variable costs (materials and direct labor costs), and more than 300 percent greater than the impact of a 1 percent increase in sales volume, even if one ignores the fact that increased production typically increases costs.
It is often not even necessary to raise prices, but rather to make sure that the customer is charged the theoretically right price (or something close to it) at the end of the day. Corporate nominal list price information might be visible in back-office systems, but the trick is to incorporate real-time, transaction specific, on- and off-invoice price adjustments (such as rebates and promotions, consignment costs, cooperative advertising, end-customer discounts, chargebacks, payment terms or cash discounts, online order discounts, performance penalties, receivables carrying costs, slotting allowance, stocking allowance, freight charges, or volume incentives). The real art is in discerning the actual price each customer has been charged per transaction, after accounting for actual deductions, many of which come only after the fact, from the nominal price. Related to this is the notion of the "pocket price waterfall" to display how much actual revenue the enterprises really keep in their pockets from each of their customer transactions, which thereby helps them diagnose and capture pricing opportunities.
Justifying the "why" of pricing and profit optimization is fairly easy, since the objective is to increase profits and margins, and hardly anyone could disagree with that objective (see Profit Optimization—Can We Possibly Argue with the Objective?). But the "how" of the optimization is not easy. Although a simple analysis of the profit increase equation may prescribe raising prices, cutting expenses, or simply selling more—and all of these seemingly simple solutions are right in principle—the real problem is far more complex. For example, if one raises prices, will the customers continue to buy, or will they rebel?
On the other hand, if one cuts expenses drastically, will the product quality suffer as a result of resentful, underpaid, overloaded workers, or equally resentful (beaten up) suppliers delivering cheaper but inferior products? Will this drive customers away? Will the consequent warrantee cost increase to the extent that expenses actually rise instead? Moreover, at many companies, there is little cost-cutting maneuver space within operations, given that most enterprises have been watching their procurement costs closely, and evaluating their trading partners. The option of selling more is not simple either, because no one can control customer needs: one cannot know for sure that they will buy more. Some indications show that volumes would have to rise about 19 percent to offset the profit impact of a 5 percent price cut, and such demand sensitivity to price cuts is quite rare. And even if customers do buy more, the question then becomes, can this upsurge in demand even be delivered?
Thus, it appears that raising prices justifiably is the most effective way for enterprises to increase (or maintain) profits in times of both economic boom and slump. While this holds true for most environments, it is particularly true in the razor-thin-margin retail and commodity manufacturing establishments, where prices and availability are the only levers of competitive differentiation. Savvy and dynamically optimized pricing can then mean the difference between survival and failure. The Power of Pricing, the well-known 2003 McKinsey & Co. report, showed that a price rise of 1 percent, at constant volumes of sale and costs, should generate an 8 percent increase in operating profits, which is 50 percent greater than the impact of a decrease of 1 percent in variable costs (materials and direct labor costs), and more than 300 percent greater than the impact of a 1 percent increase in sales volume, even if one ignores the fact that increased production typically increases costs.
It is often not even necessary to raise prices, but rather to make sure that the customer is charged the theoretically right price (or something close to it) at the end of the day. Corporate nominal list price information might be visible in back-office systems, but the trick is to incorporate real-time, transaction specific, on- and off-invoice price adjustments (such as rebates and promotions, consignment costs, cooperative advertising, end-customer discounts, chargebacks, payment terms or cash discounts, online order discounts, performance penalties, receivables carrying costs, slotting allowance, stocking allowance, freight charges, or volume incentives). The real art is in discerning the actual price each customer has been charged per transaction, after accounting for actual deductions, many of which come only after the fact, from the nominal price. Related to this is the notion of the "pocket price waterfall" to display how much actual revenue the enterprises really keep in their pockets from each of their customer transactions, which thereby helps them diagnose and capture pricing opportunities.
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