Price Waterfalls: Part 1
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?
