Price and Margin Management is Crucial to Boosting The Bottom Line
In today's era of cost cutting, price and margin management tends to be ignored. What do companies need to watch out for?
Consultant's corner
James Mason/917 Consulting
IN TODAY'S uncertain economy, companies are devoting considerable attention to cost cutting. However, by comparison, very little time and effort is spent on improving pricing and margin management practices. Indeed, many managers have not learned the skills to price their products effectively and manage their margins.
In addition, financial systems are often designed to meet the needs of accounting, and are typically inadequate to provide timely, granular information on customer profitability down to the invoice level.
Without this information, particularly in times of volatile raw material costs, managers are merely guessing on margins based on variances from the previous month's financial statements. Also, many are saddled with manually intensive processes for price changes and approvals, which are slow and result in errors and customer dissatisfaction.
Because of the lack of pricing expertise and inadequate managerial information systems, the following are eight common areas where companies can improve their margins, and in many cases, lower their costs and improve service.
PRICE LEAKAGE
Price leakage is largely a result of inadequate price and margin management tools. In many organizations, there is not a systematic and simple approach for viewing price leakages, such as freight and warehousing costs, returns, corrections, claims, unearned discounts or rebates.
As companies invest in information system infrastructure to provide detail down to the invoice level, they will discover price leaks that usually can be plugged easily and expeditiously. Often these leaks are in unexpected areas and of large value.
INCREMENTAL CASH BUSINESS
Managers are tempted to take on low margin business when faced with spare capacity. Aside from the potential negative impact this marginal business can cause with other accounts, it is likely that over time, everyone will forget why this business was taken in the first place. This marginal business will morph from incremental to entitled.
As plants approach capacity, managers present boardrooms with good news that they need to expand. Seldom do boards examine the margin distribution and require it to comprised positive earnings before interest and tax (EBIT) and stronger margins. Should they take this step, many capital projects would never be approved.
FIXED COSTS
Although costs classified as fixed may be correct from an accounting viewpoint, managers should be asking the following questions: Are these costs fixed forever, or could they be reduced or eliminated some time? Are there components of fixed costs that are variable? If plants were to close, what costs would remain next year?
Executives understand the high-level financial numbers. However, managerial accounting is largely ignored, or the importance is simply not well understood.
Unlike the financial functions, managerial accounting is often staffed with entry-level employees, or those who don't understand the manufacturing processes.
When examined in detail, fixed costs can often be reduced, or we discover they are partly variable. Managers are at the mercy of this data. Even if they have granular cost data and powerful IT systems, managers can make what seem like good pricing decisions, but then suffer unexpected negative results. Few companies have the forensics to understand why they fell short of their forecast.
In the table above right, the total standard costs are correct, but the allocation of costs causes a negative outcome.
MANAGING THE MIDDLE
Commonly managers refer to product lines as if they were homogeneous. "Product line x returns a 28% margin, but product line y only returns 9%" is typical. What is not well understood, much less managed, is the broad distribution of margins.
Often, the average is accepted with no analysis. Without understanding the wide range of margins that make up the mean, little effort goes into understanding what drives the profitability of the right side of the curve and how to maximize these revenues, or conversely, how to fix the left side of the curve.
After a detailed analysis, one client discovered that a large account was much less profitable than previously thought. This volume was shifted to customers that placed a higher value on the offering. The 1m lbs that was shifted from the left side of the curve to the right was a relatively small part of total output. However, monthly margins increased by $400,000 (€300,000).
COST TO SERVE
Typically, the smallest 50% of customers return 5% or less of revenue and gross margin. Often, companies are reluctant to serve these accounts through alternative channels, although when companies examine the incremental selling, general and administrative (SG&A) expenses employed to serve them, many times they find that the costs exceed the margins received.
Middle management reluctance to employ alternative channels comes in various flavors, including: they have been with the firm for a long time, they might grow to be big some day, they depend upon our technical service, they purchase at a higher than average price, or they will not buy from an alternative channel.
COST-PLUS PRICING
Lack of understanding of the true value of product offerings and how this value compares with the offering of competitors typically results in cost-plus pricing decisions.
As value drivers change over time, companies typically see their margins erode as well. Without a value-based pricing strategy, companies fail to understand the multiple segments they serve, and under-price and under-serve some segments, while over-pricing and providing unwanted service to others, resulting in low margins or loss of share.
NONDIFFERENTIATED OFFERING
Even companies with well thought-out segmentation programs often fail to recognize that accounts in the same geography, size and application typically have different needs and place value on different attributes.
Clear, concise account plans that recognize the value drivers at key accounts will enable firms to design specific action plans that will both strengthen their account relationships and develop win-win initiatives.
NONSPECIALIZED PRODUCTS
Surprisingly, even many large firms have not made the effort to understand the price elasticity of their large commodity-oriented products.
Without an in-depth understanding of how incremental price changes will impact profitability and market share, and without clearly being able to model how reference prices work, pricing becomes more guesswork than science and competitor behavior seems illogical, or ever aberrant.
Ironically, during this economic downturn, companies are focused on reducing costs to improve cash flow - important to be sure, but they have ignored pricing - their largest lever for improvement.
Executives' vision of what can and should be done with pricing is often not shared by their line management (although usually not openly).
Marketing and sales professionals fail to understand their degrees of freedom and get many of their data points from purchasing staff that underplay the importance of the supplier's offering and emphasize price as the only important buying attribute.
Executives who insist on skilled pricing practices can improve their companies' financial performance.
Consultant's corner
James Mason/917 Consulting
IN TODAY'S uncertain economy, companies are devoting considerable attention to cost cutting. However, by comparison, very little time and effort is spent on improving pricing and margin management practices. Indeed, many managers have not learned the skills to price their products effectively and manage their margins.
In addition, financial systems are often designed to meet the needs of accounting, and are typically inadequate to provide timely, granular information on customer profitability down to the invoice level.
Without this information, particularly in times of volatile raw material costs, managers are merely guessing on margins based on variances from the previous month's financial statements. Also, many are saddled with manually intensive processes for price changes and approvals, which are slow and result in errors and customer dissatisfaction.
Because of the lack of pricing expertise and inadequate managerial information systems, the following are eight common areas where companies can improve their margins, and in many cases, lower their costs and improve service.
PRICE LEAKAGE
Price leakage is largely a result of inadequate price and margin management tools. In many organizations, there is not a systematic and simple approach for viewing price leakages, such as freight and warehousing costs, returns, corrections, claims, unearned discounts or rebates.
As companies invest in information system infrastructure to provide detail down to the invoice level, they will discover price leaks that usually can be plugged easily and expeditiously. Often these leaks are in unexpected areas and of large value.
INCREMENTAL CASH BUSINESS
Managers are tempted to take on low margin business when faced with spare capacity. Aside from the potential negative impact this marginal business can cause with other accounts, it is likely that over time, everyone will forget why this business was taken in the first place. This marginal business will morph from incremental to entitled.
As plants approach capacity, managers present boardrooms with good news that they need to expand. Seldom do boards examine the margin distribution and require it to comprised positive earnings before interest and tax (EBIT) and stronger margins. Should they take this step, many capital projects would never be approved.
FIXED COSTS
Although costs classified as fixed may be correct from an accounting viewpoint, managers should be asking the following questions: Are these costs fixed forever, or could they be reduced or eliminated some time? Are there components of fixed costs that are variable? If plants were to close, what costs would remain next year?
Executives understand the high-level financial numbers. However, managerial accounting is largely ignored, or the importance is simply not well understood.
Unlike the financial functions, managerial accounting is often staffed with entry-level employees, or those who don't understand the manufacturing processes.
When examined in detail, fixed costs can often be reduced, or we discover they are partly variable. Managers are at the mercy of this data. Even if they have granular cost data and powerful IT systems, managers can make what seem like good pricing decisions, but then suffer unexpected negative results. Few companies have the forensics to understand why they fell short of their forecast.
In the table above right, the total standard costs are correct, but the allocation of costs causes a negative outcome.
MANAGING THE MIDDLE
Commonly managers refer to product lines as if they were homogeneous. "Product line x returns a 28% margin, but product line y only returns 9%" is typical. What is not well understood, much less managed, is the broad distribution of margins.
Often, the average is accepted with no analysis. Without understanding the wide range of margins that make up the mean, little effort goes into understanding what drives the profitability of the right side of the curve and how to maximize these revenues, or conversely, how to fix the left side of the curve.
After a detailed analysis, one client discovered that a large account was much less profitable than previously thought. This volume was shifted to customers that placed a higher value on the offering. The 1m lbs that was shifted from the left side of the curve to the right was a relatively small part of total output. However, monthly margins increased by $400,000 (€300,000).
COST TO SERVE
Typically, the smallest 50% of customers return 5% or less of revenue and gross margin. Often, companies are reluctant to serve these accounts through alternative channels, although when companies examine the incremental selling, general and administrative (SG&A) expenses employed to serve them, many times they find that the costs exceed the margins received.
Middle management reluctance to employ alternative channels comes in various flavors, including: they have been with the firm for a long time, they might grow to be big some day, they depend upon our technical service, they purchase at a higher than average price, or they will not buy from an alternative channel.
COST-PLUS PRICING
Lack of understanding of the true value of product offerings and how this value compares with the offering of competitors typically results in cost-plus pricing decisions.
As value drivers change over time, companies typically see their margins erode as well. Without a value-based pricing strategy, companies fail to understand the multiple segments they serve, and under-price and under-serve some segments, while over-pricing and providing unwanted service to others, resulting in low margins or loss of share.
NONDIFFERENTIATED OFFERING
Even companies with well thought-out segmentation programs often fail to recognize that accounts in the same geography, size and application typically have different needs and place value on different attributes.
Clear, concise account plans that recognize the value drivers at key accounts will enable firms to design specific action plans that will both strengthen their account relationships and develop win-win initiatives.
NONSPECIALIZED PRODUCTS
Surprisingly, even many large firms have not made the effort to understand the price elasticity of their large commodity-oriented products.
Without an in-depth understanding of how incremental price changes will impact profitability and market share, and without clearly being able to model how reference prices work, pricing becomes more guesswork than science and competitor behavior seems illogical, or ever aberrant.
Ironically, during this economic downturn, companies are focused on reducing costs to improve cash flow - important to be sure, but they have ignored pricing - their largest lever for improvement.
Executives' vision of what can and should be done with pricing is often not shared by their line management (although usually not openly).
Marketing and sales professionals fail to understand their degrees of freedom and get many of their data points from purchasing staff that underplay the importance of the supplier's offering and emphasize price as the only important buying attribute.
Executives who insist on skilled pricing practices can improve their companies' financial performance.
quoted from: www.ICIS.com
