Chief Pricing Officer

Meat Demand - The Big Picture

Every day billions of us make decisions on what we will buy, and how much of each item we will purchase.  Those decisions are tempered by how much money we have to spend, the relative prices of the goods and services available to us, and our individual preferences.  Our preferences are probably more determined by social norms and habit than we would like to admit, and do vary greatly by country.

Meat demand around the world is no different than any other good.  Depending on a wide variety of local conditions there are significant differences in meat diets at any point in time.  For example, in Australia, Brazil, Argentina and the U.S. we observe that beef has a much larger share of the diet than in Europe or China.  The major reason is that beef consuming countries need large areas of land suitable for grazing a beef cow herd.  China and Europe are crowded places, with limited land available for extensive grazing systems.  So, in Europe and China pork and poultry make up the vast majority of the meat diet.

When we look at total meat produced and consumed over time the spatial differences at a point in time tend not to matter.  What does matter though is total income and resulting total consumer buying power.  Funds available for consumer spending have driven almost all the growth in meat demand since at least 1961 (and probably before that if the data were available). 

The relationship between total consumer buying power and total meat production is one of the most remarkably consistent in all of agricultural economics.  The results of a simple regression between consumer spending and total meat consumption is shown below:

Goodness of fit:

Where:

Y = Total global meat production from FAO, FAOSTAT database, 1961-2007

Consumer Expenditures = Global final consumption expenditures, $2000, from the World Bank, World Development Indicators database, 1961-2007

Graphically, the relationship between the variables appears below.  The statistical fit is not quite as good in the 1960s as it was in later years, but the overall pattern is still quite consistent.

Several functional forms, including logarithms and exponential, were tried. The simple linear form had the best statistical fit and least amount of autocorrelation. 

At the data means the elasticity of production to a change in expenditures is 0.91.  That is, a 1% increase in expenditures results in a 0.91% increase in meat production (the elasticity from a natural log functional form was also about 0.90).  The coefficient for expenditures indicates that a $1 trillion increase in $2000 expenditures results in about a 9 million ton increase in total global meat production.

Not included as a separate variable, but also of critical importance, is global population.  From 1961 to 2007 population more than doubled.  All else equal, that factor alone should have doubled meat demand.  Looking forward, the rate of population increase is expected to slowly decline over the next 40 years.  Slower population growth will slow the rate of increase in global total real income and consumer spending.  Thus we should expect some slowing in the rate of increase in meat demand and production.

The equation tells us several things about 1961-2007.  There is a strong and consistent pattern of globally increasing real incomes that drove real consumption spending, and that drove meat demand, and then production.  The relationship has been consistent enough to tell us that the preference for spending for meat has been strongly ingrained for the almost 50 years of available data.  Despite some news about increasing societal preferences for avoiding meat consumption there has been no measurable change in global meat spending behavior.

Another pattern seen around the world is that as economies reach higher levels of real income and spending the demand for meat tends to respond less to increases in real income.  Market saturation may have an effect on future responses to increases in real income on a global scale, but there is no sign of any weakness in that response through 2007.  Outside of the richest countries of the world there are still well over 5 billion middle and low income people who would very likely increase meat consumption if they had more income.  Population growth in low income countries also tends to be higher than the global average.

It is implied by the equation that future gains in the volume of meat produced in the world will depend almost entirely on demand increases driven by increased incomes and spending.  However, one significant item that has not been statistically significant, meat prices, could derail this relationship, at least temporarily.

In fact, the astute reader should have already asked: “But what about meat prices, don’t they matter too?”  The answer is yes, they do.  But from 1961 to 2007 prices on a global scale did not vary enough to disturb what consumers do with their meat spending habits. 

Looking forward from 2009 we are seeing, on a global scale, real costs of meat production coming from grains and oilseeds markets that appear to have quickly moved to new price plateaus.  Those higher costs are in the process of being passed through as higher real retail meat prices.  Will those price increases be enough to cause a permanent change in consumer behavior?  History would argue that we might not see a significant effect.

We saw this same thing happen in the 1961-2007 data used in the regression.  From 1972 to 1976 there was a similar step-up in real feed costs and real meat prices.  If you look closely at the chart 1973 global meat production did actually fall below the long term trend, but then recovered in 1974-1975.  Increases in real income overcame real price increases, and the long term trend resumed.

Prices do matter in other important ways.  The relative prices of meats have had an important effect on the global market shares of the major meats.  Beef, generally the most expensive meat to produce, has seen its global share fall.  Chicken meat, the least expensive of the major meats, has seen major global share increases since 1961. 

Prices also matter enormously on the scale of short time periods and individual country and species markets.  Here in the U.S. were are currently seeing a price-cost squeeze coupled with a decline in real consumer spending that is leading a significant reduction in total meat production.  However, if history and the regression results above mean anything at all, when the global and U.S. economy begins its recovery meat demand will resume its long term growth path.

Market-driven price signals are also essential in determining decisions all the way down to the level of how producers process and market individual meat cuts.  At an a very low level of granularity price signals can determine, for example, whether chicken leg quarters are deboned, exported, or sold in the fresh market.  These decisions are critical to producer profitability and to supplying consumers with the optimal mix of the many products that can potentially be made from a live animal of any species.

Finally, freely moving, market-driven, prices are a major driving force behind the long term growth of global meat production and consumption.  Prices are the signaling mechanism that, at a very low level in time and space, efficiently tell producers what to produce and consumers what to buy.  Market prices are the mechanism though which we can approach an efficient and optimal product mix that simultaneously avoids waste, gives consumers the products they want, and allows producers to earn a profit.  Paradoxically, at a very low level, prices are almost all that matter.

pricing and margin in disassembly businesses

Back in March, the Chief Pricing Officer wrote about the concept of a pricing waterfall, which was introduced by McKinsey in “The Price Advantage”.  Price waterfall is an important method to determine the pocket price and margin for many businesses, but for disassembly businesses the challenges in calculating margin take a different form. 

For disassembly businesses, such as meat processing or lumber, the challenge (which is caused by the nature of the business) is that the organization needs to buy the supply as a whole entity (e.g. animals to process; trees to cut, etc) and then disassemble that entity into sellable parts (e.g. beef primal cut or ground meat for a beef processor; 2×4x12 or 4×4x12 for a lumber company).

Beef Production

Lumber Production

Part of what makes this even more complicated is the fact that not all the products that are produced have the same value.  For example, in the beef business, consumers will not pay the same price per pound for ground beef as they will for New York Strip steaks. Each cut has its value to the consumer and determining the right prices requires in-depth industry knowledge as well as the appropriate toolset.

The lumber industry, encounters similar challenges when pricing the different grades; the price of wood chips is not the same as a 2×4 plank.

So why is this such a critical challenge?  Well, at the end of the day, these companies need to ensure that the revenue gained from selling all the finished goods covers their expenses, of which, the raw material often comprises the largest portion.

These challenges are the reason that understanding the historical margin at the supply unit level (e.g. live cattle or trees) is crucial to a healthy business.  So what does this have to do with pricing? 

In the meat processing business, the overall revenue from a carcass is referred to as the cutout. This represents the total revenue obtained by virtually reassembling the carcass considering each cut’s yield and the price achieved in the marketplace.  Said another way, the cutout calculation takes into consideration the disassembly bill-of-material (BOM) as well as the revenue for the different cuts or pieces. When comparing this overall revenue to the corresponding costs (typically the cost of the whole supply unit – live animal; trees – is adjusted to consider the actual yield of the finished goods), you get a good idea of the gross margin achieved. Historical prices support the calculation of a historical cutout and gross margin picture, enabling disassemblers to understand how their business performed in the past.

Even more important however is being able to look forward, by applying the cutout calculation logic to projected costs and selling prices – allowing disassemblers to view forward looking margin.  This is critical to making effective business decisions.

To better illustrate the complexity, the following illustrates how carcasses are broken-down into different cuts based on the countries:

Reassemble Beef Carcasses to Calculate Revenue

The lumber industry has a similar challenge as trees are broken down into different finished goods:

Reassemble Trees to Calculate Revenue

And this is what is common between those businesses and the used part dealer – the dealer needs to make sure that when the revenue from the different parts is added up for the tires, windows, body, etc, this revenue exceeds the cost of buying the car and the labor used to disassemble it and market the parts.

Managing prices and margin in a disassembly business is different from those portrayed in the previous price waterfall discussion, however mechanisms like cutout help disassemblers better understand historical performance and take proactive, corrective actions going forward just as the margin waterfall helps manufacturers in traditional assembly businesses.

Sounds pretty lofty and never an easy undertaking – transforming an organization.  But, even in this difficult economy and especially because of it, leading manufacturers are doing just that – transforming their pricing organizations to achieve better control over margins and profitability.

A 2008 AMR Research study “Building a Bullet-Proof Business Case for Pricing Improvement Initiatives” conducted by researchers Noha Tohamy and Heather Keltz asserts, “Companies that succeed in improving their pricing practices have typically centralized many of their pricing practices and invested in training their sales organization on fact-based pricing.”  A centralized pricing organization focused on using improved forecasting and optimization for more fact-based selling characterizes the companies that, in my experience, have successfully implemented pricing initiatives, as measured by their profit gains (ranging from over $1 million up to $20 million). Moreover they have been able to reduce price volatility.

There are four key elements at play in the success or failure of every pricing transformation:

1. Re-designed and Centralized Pricing Processes

2. Enhanced, Cross Department Communication

3. Effective Training, Integrating Process with Technology

4. Active Executive Sponsorship

Centralized Pricing Processes

In his recent guest post, Dr. Michael Freimer highlights the impact of price volatility and the need for tools and processes to control volatility.  Organizations that centralize the pricing function along with implementing better processes and tools gain better insight into customer buying patterns and improve fact-based pricing decisions.   For example, a growing commodity processor created a price management function focused on finding margin opportunities through changes in operations, product mix, and timing.  The price management function reports directly to the CEO and helps the organization execute their strategy to shift from spot to more forward sales of their commodity-based products.  Price managers have the responsibility for conducting detailed analysis of improvement opportunities using sophisticated forecasting and optimization software and communicating the results of their analysis to the sales team.  This provides sales with more fact-based and dynamic information that can be used in sales transactions.  In the fast-paced, transaction-oriented world of the sale representative, the time to conduct this type of analysis was virtually impossible without the benefit of the price manager’s role.

Enhanced, Cross Department Communication

Enhanced communication with the sales team is another benefit of a centralized pricing organization.  To achieve better communication, processes must be examined in light of the desired organizational change.  Cross-departmental communication can be facilitated through the use of common tools and by clearly defining the guidelines for how prices are quoted to the customer.  For example, one successful meat packer’s pricing team is accountable for establishing the final price quote for each transaction, while giving its sales team visibility to the same forecasting and optimization technology used for price setting so that both groups are consistent in their understanding of market trends. With this visibility, sales representatives have more “pricing courage” and provide better pricing guidance to customers, resulting in improved relationships with key accounts.

Effective Process and Technology Training

Training both the sales and pricing teams on the new processes and tools is also imperative for success during the transformation.   Understanding how to navigate forecasting and optimization applications may be fairly straightforward, however, understanding the use of these more sophisticated technologies within the pricing process is less so.  Effective training integrates both the process and technology use cases.

Active Executive Sponsorship

Too often organizations assume that by simply communicating a change and providing training that immediate execution will occur.  Training is only one aspect of managing the transformation, active sponsorship at senior levels must be present.  Executives who support structural and process changes as well as the implementation of new technologies and tools ensure that true transformation occurs.   Holding managers accountable and identifying champions for change from among the pricing and sales or buying groups are just two of the roles that executives play in managing the transformation.  Additionally, executives and managers must support shifts in the organization’s compensation structure to better align them with profitability goals.

AMR’s research points out the benefits of centralizing the pricing function as well as the risks.  Process redesign, implementation of improved forecasting and optimization technology, training and strong executive support represent the strategies for mitigating risk and achieving true transformation.   The true measure of the transformation is the attainment of profitability goals – that’s the real bottom line.

Professor Clive Granger, winner of 2003 Nobel Prize in economics, passed away on May 27, 2009. Few will argue that he revolutionized the field of economic time series forecasting. Professor Granger was particularly interested in prices and applied his theoretical ideas of causality and co-integration to financial stock market price time series.

He questioned bad econometric practices when he saw them….

“Before Dr. Granger’s studies, it was common practice for economists to take methods intended for stationary time series and use them to analyze nonstationary ones. But Dr. Granger — working closely with a colleague at the University of California at San Diego, Robert F. Engle — demonstrated that this approach could produce erroneous results” (http://www.nytimes.com/2009/05/31/business/31granger.html).

…and determined theoretically-sound concepts to overcome the underlying challenges.

“For want of better techniques, economists often applied statistics designed for stationary data to non-stationary data. But in 1974, Granger and his post-doctoral student Paul Newbold, building on the earlier work of the British statistician G Udny Yule, showed that pairs of non-stationary time series could frequently display highly significant correlations when there was no causal connection between them. For example, the US federal debt and the number of deaths due to Aids between 1981 and 2000 are highly correlated but are clearly not causally connected. Such “nonsense correlations” called into question the meaningfulness of many econometric studies.” (http://www.telegraph.co.uk/news/obituaries/finance-obituaries/5407598/Professor-Sir-Clive-Granger.html).

Professor Granger was awarded Nobel Prize in 2003 for his foundational work in the area of co-integration.

“His innovation has completely changed the way that economists estimate and build dynamic models of the macro economy,” Torsten Persson, an economist at the University of Stockholm who served on the Nobel Prize Committee for Economic Sciences, said at a ceremony honoring Dr. Granger in 2003. “Nowadays co-integration methods are literally used everywhere — by academically minded researchers in universities, as well as more practically minded investigators, be it in central banks or the private sector” (http://www.nytimes.com/2009/05/31/business/31granger.html).

As practitioners in the field of pricing, we owe a lot to Professor Granger and his lifetime of dedicated work.

The Two Faces of Price Volatility

Price volatility in agricultural commodity-based industries wears two faces. Media headlines often portray the ugly visage: market shocks such as the H1N1 outbreak and the spike in demand for ethanol disrupt industries that already face razor-thin margins. On the other hand, it’s often said that swings in market prices provide opportunities to make money, particularly if you’re better prepared to handle price shifts than your competitors. Which face is the true one? Should you try to eliminate price volatility, or actively manage around it?

One answer lies with understanding which factors cause prices to move up and down, whether those factors are at all predictable, and whether the resulting price changes represent dangers or opportunities. Agricultural markets generally exhibit strong seasonality – regular cycles of weather, biological processes, and consumer demand result in a certain amount of predictability in price swings. Such patterns are particularly apparent in the protein industry, which will be a focus of this blog entry. This kind of price volatility can be managed; a good forecast model can allow you to appropriately adjust your forward sales profile to up- and down-markets. The ability to spot market turns earlier and more accurately than your rivals is a competitive advantage. It allows you to adjust your prices sooner, so you avoid taking too long a position in an upswing or facing a fire sale in a downswing.

Seasonality is not the only source of market price changes. Other factors including market supply, access to export markets, changes in retail demand (think consumer downgrading from tenderloins to cheaper end meats in the face of the current recession, or the significant shifts brought about by the Atkins diet), and exchange rates also play significant roles. The predictability of these factors varies, and recent structural changes in agricultural markets have made spotting price shifts even more difficult. Feed prices, which are a driving factor in the price of beef, pork, and poultry, are now tied to the prices of oil through the increasing demand for ethanol. Energy commodities have historically exhibited greater volatility than corn, and some of this additional uncertainty has been translated to the protein and to other agricultural industries.

A common approach to managing unpredictable market price volatility is hedging. Unfortunately the salvage nature of the protein industry makes hedging difficult because orders are taken for products, but futures markets operate on the animal.  There can be significant variation of the product price relative to the animal. The correlation coefficient between product prices and animal prices can range from 0.9 on the high side all the way into negative territory. Hedging of long term contracts against futures may actually add to the contract risk rather than negate it. In general, it is very difficult to find the right hedge position to offset risk for specific transactions.

So market price volatility, while not exactly a benign face, at least provides you with opportunities to out-maneuver your competitors. Other sources of price volatility can be even more troublesome. The figure below shows sales data from a large U.S. meatpacker, altered to protect the source’s identity. We examined every transaction over the course of a year, and computed the percent deviation between the transaction price and the USDA market price. The graph’s horizontal axis shows the deviation from the market prices (0 means the transaction price equaled the market price), and the vertical axis shows the fraction of annual revenue generated by transactions at each deviation. 

Impact of Volatility on Revenue

Price Deviation (%)

While the actual data has been modified, the shape of the graph is correct. Most transactions took place near the market price, but notice that the curve is lopsided. More revenue (meaning a lot more volume) was generated at below-market prices than above the market. Customers recognize a good deal when they seen one, and they pick you off when quoted prices are too low. The result is that mistakes on the low side are a lot more significant than wins on the high side, so focusing on tools and processes that allow you to reduce this form of price volatility will lead to higher overall revenues.

The graph shows variability in the company’s product prices above and beyond any volatility in the USDA market prices. What causes this volatility? A variety of factors, most of which have to do with either the company’s supply position at the time of the transaction, or with the company’s pricing processes. Above-market prices may have been the result of a strong forward sold positions, while price below market may have resulted from a fire sale caused by too low a sold position. Alternatively a low price may reflect an inability to call the market, or a poor negotiation on the part of an individual salesperson.

So what is the true face of volatility: opportunity or risk? Both. Pricers should try to build a two part strategy. First, incorporate better forecasting technology to separate out random volatility from predictable market movements, thereby generating competitive opportunity. Second, stabilize pricing patterns that give customers the opportunity to exploit randomness and pick off low price events.

Cooperation Means More Pie for Everyone

In a downturn, especially one with deflationary moves at retail, you get enormous pressure on margins throughout the supply chain - that’s generally not debated.

There are several ways supply chain companies might react to this: manufacturers - especially those with frequent price and promotion changes - may apply analytics to the price setting process, to get much sharper about what wholesale price they’re willing to accept for their products. This advantage comes not only from quantifying their customers’ price elasticities, but also from understanding the relative margins available from various products they sell which compete for the same capacity and raw materials.

Analogously, the retailer might apply sharper analytics to the purchasing process, to more accurately measure their seller’s indifference points and minimize product cost.  While both of these measures can have a significant positive impact on margins, there is a different approach with much bigger potential: cooperation.

If the manufacturer and retailer simply work together, and make an effort to help solve each others’ “problems” there is usually a bigger advantage available to both. For example, if a manufacturer’s sales team works with its retail customer to optimize exactly which product promotions will work best in specific stores, in specific time periods, he provides his customer with knowledge acquired from a much larger data set than the customer has available on his own.

However, what really turbo-charges this model is that there are win-win opportunities available at times when the manufacturer is undersold or “long” on a product in some future time window, say six weeks out, and needs to solve this problem. In this case the manufacturer calculates how much discount it’s willing to offer to get back into “balance,” and uses analytics to decide exactly which retailer customer would get the most bang for the buck from putting this product on promotion in that window, and then works with that retailer to strike a deal. So the manufacturer fixes a problem, and the retailer gets help with a promotion tailored to their own customers’ preferences, and for which they bought the product at a very special price. This is much better for both parties than haggling - no matter how good they are at it!

The bottom line is that there are clear, and significant, advantages to manufacturer-retailer cooperation, when they work together as real partners.

Thanks to the advanced price and product mix optimization technology manufacturers and retailers are starting to use today, it is possible for the entire supply chain to sharpen their game - and their margins. BOTH sides can  get a bigger slice of the proverbial pie.

Mike Neal, Founder & CEO
SignalDemand
www.signaldemand.com

This blog has covered a lot of ground over the last eight months, from economics jokes to retail and wholesale pricing concerns, from the meat industry to the president’s inaugural address.

Though there’s a little something for everyone in the pricing field on the CPO blog, at its core it is dedicated to the issues touching the manufacturing pricer, strategist, executive.

Today’s post offers a handful of articles that create a sobering retrospective. My hope is that by acknowledging reality and embracing the means to a solution, the headline in 2010 will be a banner proclamation that the manufacturing industry has not only survived, but transformed itself into a model industry of transparency and intelligent business.

2009
The Collapse of Manufacturing
Economist
http://www.economist.com/opinion/displaystory.cfm?story_id=13144864

“The destructive global power of the financial crisis became clear last year. The immenisty of the manufacturing crisis is still sinking in, largely because it is seen in national terms - indeed, often nationalistic ones. In fact manufacturing is also caught up in a global whirlwind…

2007
For Manufacturing, a Recession Has Arrived
New York Times
http://www.nytimes.com/2007/02/28/business/28leonhardt-web.html?_r=1&scp=5&sq=manufacturing&st=cse

“Is the entire United States economy in danger of going the way of the manufacturing sector? Is it possible that we’re headed for a real recession?”

The manufacturing industry has a chance to reinvent itself and our hope lies in transparency. Transparency of price is a powerful point to start the ripple effect that will change the entire conversation throughout the supply chain -  and the economy. From another recent Economist article, this one on the finance industry, we are offered a truth that should be equally applied to all industries:

“When information is relevant, standardised and public, it fosters intelligent decision-making.”
Economist
February 21, 2009
http://www.economist.com/finance/displaystory.cfm?story_id=13144773

To me, that sentiment gives hope for the possibilities yet to be fully realized in manufacturing industry.

Ever since the concept was introduced by the smart folks at McKinsey & Co. in “The Price Advantage,” in which authors Michael V. Marn, Eric V. Roegner, and Craig C. Zawada explain how companies can build the pricing capability into a significant and sustainable competitive advantage, the price waterfall has been a powerful yet elusive management tool.

Despite its overwhelming potential, price waterfalls remain one of the most misunderstood and underused weapons in the corporate arsenal. So, let’s get our feet wet with PRICE WATERFALLS.

PRICE WATERFALL - DEFINED

The price waterfall is a graphic representation of how a List Price - the price a company officially states on its sales brochure, website or contract - is gradually reduced, discounted and sliced and diced down to a Pocket Price, the money you actually get to put in your pocket. There are better, more consultant-speak definitions available, but basically the price waterfall shows how you go from “what you want” to “what you got” in the pricing of your products or services.  The picture below, courtesy of consultants Simon & Kucher is a good example.

Source: Simon & Kucher

Getting this kind of graphic right is hard work: you need to gather, synthesize and analyze a tremendous amount of transaction-level data, you need to include a wide range of disciplines including representatives from sales, marketing, finance, procurement and your technology operations group, and you need to drive the initiative fast and furious as most markets today are evolving quickly.

Why go through all this trouble? Simple. The price waterfall offers the best way for companies to locate and stop profit leakage. In addition, the exercise is necessary to segment diverse customers based on customer profitability. The price waterfall is also helpful when developing new sales metrics that base compensation not only on customer revenues but also customer contribution and profitability.

Building a price waterfall means developing a disciplined process that will ultimately determine which products and services should be offered to which customers, at what prices, through which channels, to maximize profits. Simple as that. Of course, those goals are lofty and complex, which is why most price waterfall initiatives are sponsored out of the office of the CEO, CFO or a business line leader.

Source: McKinsey & Co.

How Do You Build a Price Waterfall?

List Price - Start here. This is the price you print on your website, on your sales sheets, in your contracts. Some call it the gross price. Whether you publish a list price or not, you have a starting price that is internally transparent and known to all. Express that price as a percentage. List price = 100%.

Next, reduce from that list price all of the discounts and rebates you allow sales to give away. Reduce it again by any standard services you give away for free. The more categories you can create, the better your analysis will be. Competitive discounts, sales specials, exception deals, quantity shipment allowances, direct factory shipment discounts and so on. Express all of these “discounts” in terms of percentage points off the list price. Most will be between ½% and 5%. That gets you to the Invoice Price.

Invoice Price - Usually, the invoice price is the list price minus all of the “on-invoice” discounts we listed above.  Still, invoice price is not the same as the price you put in your pocket. But we include invoice price as a stop in our waterfall because in most companies sales negotiates the invoice price with the customer.

Now we will reduce that Invoice Price down further to Net or Pocket Price.

Net Price - What are the off-invoice discounts you are allowing? Here’s where you include those: any cash discounts, annual volume bonuses, any product bonuses, co-op advertising commitments, co-marketing funds, special promotions, freight coverage, anything like that. Again, the more categories you can measure and express as a percentage off of list, the better. Off-invoice discounts vary greatly between customers and sales reps, which is why they are so difficult to measure. Off-invoice discounts also have the greatest impact on transaction profitability.

The result is your Pocket Price: the last stop on your price waterfall. The pocket price is what goes in your pocket; it is the amount you are actually earning in a transaction. Simply stated it is the list price minus all customer-specific costs.

After The Flood: Is the Waterfall Complete?

If you think you’ve captured all of the customer-specific costs in your price waterfall, check again. Most companies fail to include hidden transaction costs such as internal freight and customer shipping charges, non-charged rush orders and non-standard order costs. Hidden service costs are also tricky; be sure to include sales team travel and expenses, customer training and education, unique promotions or gifts, undisclosed sales freebies to win the deal and the cost of credit offered. Of course, there is a matter of relevance in the exercise: allocating telephone expenses in a multi-million dollar software license sale may not have a measurable impact on customer profitability. So don’t attempt to boil the ocean.

Source: SignalDemand Inc.

Finally, the price waterfall is only as good as the data that informs it. Gray water in, gray water out. It’s also just a snapshot, as the figure above demonstrates. Price waterfalls are dynamic, they flow as your business flows, and so should your analyses. Do not rely on a static picture of customer profitability over the long-haul: update and refine it as needed given your market, competitive and customer dynamics.

From all of this you can easily discern which stop along the waterfall is the price that influences customer demand and increases the probability of closing a deal or having the customer purchase a few extra cases.  (Hint: invoice price is a common point of negotiation).

Next up:  What are the Benefits of a Price Waterfall?

No surprise, we are in the midst of an economic downturn.  What are the three actions being taken by every company in this recessionary climate?  No surprise:

1.    Control costs, mostly by cutting back spending and reducing staff
2.    Dump customers, keeping only the largest, most profitable ones
3.    Stay the course, hoping to ride out the storm

Not much of a strategy, then again, many CEOs running companies today haven’t weathered an economic storm like this one.  It’s a fair bet that none of the Fortune 1000 executive ranks were managing a P&L during the Great Depression.  So we’re all in new territory, but everyone is relying on the old strategic formula.  Old habits die hard.

The playbooks and management strategies we’ve turned to in bull-driven, steady growth markets, those catchy business book titles from Competitive Advantage to Core Competencies to Quality Circles to Reengineering the Corporation to Customer Focus, need to make room on the shelf for a new breed of thinking.

Here are three business book titles I’d like to see hitting the shelves this year and what they would cover:

The Biology of Pricing: Profits Under The Microscopic

Most managers elect to focus on their company’s core competencies during troubled times.  But do you even know what your core competencies really are?  Forget hosting executive off-sites or surveying your employee base.  Your core competency is right in front of you, in every pricing decision you make.  If you can dig into transaction data, understanding your pricing decisions and resulting margins for each sale, you have the foundation needed to distill what you are really good at, who you are best at delivering value to, and where you should invest and divest your operations.  Look at your price waterfalls, segment your prices and margins by customer and product, and take a look at what’s really driving your company’s profitability.  Don’t forget to include trade spend, discounts and rebates, receivables and bad debt costs in your analysis.  The resulting visibility will guide you in building a strong foundation around your true competencies and will allow your company not only to survive the storm, but to thrive when the economy turns around.

Cost Cutting vs. Precision Pricing: The Enlightened Road to Victory

Cutting costs are easy.  It’s one thing you can control.  But it’s not the most significant lever in the profitability equation.  Price is.  And even if you do turn to cost-cutting, be wary of cutting across the board.  Today’s accounting rules and financial statements often hide the true dynamics between costs and production.  Again, this is where a thorough study of transactional pricing comes in handy.  By digging in to your pricing decisions, you can develop an alternative view to your cost structure that helps you determine which areas of the business are most profitable, and those that are a financial burden.  Cutting is a necessary part of growing a business.  But remember, trimming the sails is very different than tossing the crew overboard.  Make incisions from insight.

Firing Failing Customers

During tough times, most companies will hold onto all their customers and all that revenue, even if it means giving away services, cutting prices or offering additional incentives.  Under the guise of improved customer loyalty, many companies kill their profitability by giving away the store.  What’s worse is how much is given away to the unprofitable customers that should’ve been fired long ago.  Customer profitability is like religion, it is a powerful motivator, but not something easily understood, let alone put into practice.  But now is the time, and it starts with prices.  Transaction level pricing insight is the precursor to understanding customer profitability.  Once again, if you can determine margin contribution on individual pricing decisions by product, customer segment, you’re well on your way to determining which customers to keep and which to fire.  And by all means, fire the bad customers immediately.  They’ll come back when they are ready, and when you are ready, too.

The common theme, of course, is that business success and profits all lead back to optimizing your pricing decisions.  The books recommended should become required reading for managers today.

In these dark times, what business book titles would you like to see?

More and more companies today are investigating pricing improvement initiatives.  No wonder.  Improved pricing practices help companies increase profitability and recover costs.  But doing pricing right takes fortitude, executive level sponsorship, and a strong business case to win over internal naysayers.

My friend Noha Tohamy, a research executive at AMR Research, recently conducted a study of over 219 companies’ pricing practices and issued a Market Services Report entitled “Building a Bulletproof Business Case for Pricing Improvement Initiatives.”  While the report is available only to AMR Research clients, Noha has graciously agreed to allow me to share one of the results of this landmark survey.  It has to do with payback on investment in the pricing management arena.  The results may surprise you.

In today’s economy, companies are cutting back and capital investments are few and far between.  But one area where managers are not throttling back is in pricing practices, including pricing decision-making in price optimization.  One of the main reasons is that the payback on pricing investments has become even more compelling in these tough economic times.  Pricing is the great lever in improving profitability.

Noha’s research reaffirmed all of the benefits that companies typically realize when making investments in pricing initiatives.  According to AMR Research, half of the companies in the study indicated that they have achieved a return on their pricing investments in under a year.  Remember, most enterprise initiatives require multiple years to demonstrate an adequate ROI (if they do at all).

Here’s the breakdown from AMR Research:

For the pricing management initiatives you have undertaken to date, what has been your payback period (the time it took to recoup your initial investment and reap the financial benefits)?

Less than six months    17%
6 to 12 months        30%
12 to 24 months    25%
Over 24 months    6%
Not sure        22%

Clearly, the results of Noha and her team’s research underscore that pricing as an enterprise initiative should be on the top of every CEOs list of potential project investments.  If you like to receive a copy of the full report, please contact AMR research at www.amrresearch.com

Thank you, Noha for sharing your team’s work with the pricing community.