Precision Pricing When Inflation Is Rising
Today’s inflation is caused by a unique mixture of shock waves stemming from Covid-related surges in consumer demand and supply shortages. These are disrupting the traditional supply-demand matches that underlie stable pricing. As Covid persists and people make alterations to their lifestyles and consumption, demand will continue to be relatively erratic both from time to time and from product to product. At the same time, supply disruptions caused by both near-term Covid shutdowns and longer-term institutional problems like constraints in port capacity and fragmented supply chains are likely to persist for some time, and to recur periodically. Precision pricing — which is highly targeted and enables managers to base prices on each product’s true, current costs and each customer’s true, current profitability — is custom-designed for this unstable environment. The authors offer four ways to implement precision pricing instead of traditional across-the-board price increases.
Precision pricing is the key to pricing in today’s inflationary environment and in the mixed-inflation markets we can expect in years to come. It’s highly targeted and enables managers to base prices on each product’s true, current costs and each customer’s true, current profitability.
Traditional across-the-board price increases, which treat all costs and customers the same, are much less effective.
This is a problem for all companies, but particularly for manufacturers, where standard costs for factor inputs (like raw materials, components, and embedded services) are typically set annually. In an inflationary environment, factor costs often increase within the year at various rates on different inputs. Because it’s too burdensome to reset input standard costs as the actual costs change over the course of the year, the differences between actual and standard costs are recorded as purchase variances (i.e., the difference between predicted and actual input prices). Since accurate costs are essential in pricing products, managers are forced to simply declare across-the-board price increases, which are difficult to enforce and often cause widespread ill will.
Today’s inflation is caused by a unique mixture of shock waves stemming from Covid-related surges in consumer demand and supply shortages. These are disrupting the traditional supply-demand matches that underlie stable pricing. As Covid persists and people make alterations to their lifestyles and consumption, demand will continue to be relatively erratic both from time to time and from product to product. At the same time, supply disruptions caused by both near-term Covid shutdowns and longer-term institutional problems like constraints in port capacity and fragmented supply chains are likely to persist for some time, and to recur periodically. Precision pricing is custom-designed for this unstable environment. Here are four ways to implement it.
Determine your actual costs and profits
Managers today have two critical pricing problems:
- They’re forced to rely on their company’s standard costs, which are often set annually. This prevents them from seeing the actual costs of each product.
- They’re forced to rely on the aggregate profit metrics of revenue, costs, and gross margins. This prevents them from seeing the actual profits of each customer.
Enterprise profit management (EPM) remedies both of these problems and enables managers to set precise, effective prices for every product in every customer.
EPM brings digital precision to pricing. It’s a SaaS software process that generates full, all-in P&Ls for every transaction in a company. Because the costs are sourced directly from a company’s general ledger, they’re precise, timely, and accurate. This enables managers to replace traditional standard costs, which were created before today’s digital era, with actual costs that reflect a company’s true cost picture and are updated periodically (usually monthly).
Because each transaction has a set of identifiers like customer, product, vendor, store, date, and so on, the EPM system can create an accurate, current profile of customer profitability using actual, current costs. As product input costs change, it shows the changes in product and customer profitability that are essential to highly targeted pricing. Companies that use EPM will find their customers fall into the following broad profit segments:
- Profit peaks: Their high-revenue, high-profit customers (typically about 20% of the customers that generate 150% of their profits)
- Profit drains: Their high-revenue, low-profit/loss customers (typically about 30% of the customers that erode about 50% of these profits)
- Profit deserts: Their low-revenue, low-profit customers that produce minimal profit
Consider these examples of four of a manufacturer’s customers. In each scenario, the cost of trans-Pacific shipping has doubled.
Company A is a profit peak customer with high revenues and high profits. If the cost of shipping doubles, it will affect only 10% of the company’s purchases. If the products have relatively high value and low weight/bulk, the shipping cost increase may only affect 5% of these products’ cost. In this situation, the cost increase will have only a minor impact on the company’s profitability in serving this customer. It would be counterproductive to try to assess an across-the-board price increase that would be zero-sum in nature and antagonize this customer.
Company B also is a large, profitable customer. The doubling of shipping costs will affect about 60% of this company’s purchases. Moreover, these products are commodities with low value but high weight and bulk. In this situation, the profit impact would be very high. It would warrant a serious consideration of how long the cost increase would last and how long the customer would be ordering these products. If it appears that this situation would last, it would be necessary to have a meeting with the customer to discuss a renegotiation of prices.
Company C is a high-revenue, money-losing profit drain customer. The doubling of shipping costs would have little impact on the products they purchase. In this situation, the customer sales team might approach the company with the proposition that they could avoid a general price increase if they cooperated on lowering the operating costs — for example, by reducing the frequency of orders or eliminating expedited deliveries — which could turn this losing customer into a high-profit account.
Customer D also is a large, money-losing customer. This customer has a product mix in which the majority of products are subject to the shipping cost increases. However, the company has a number of similar substitute products that do not require trans-Pacific shipping. Here, the customer sales team might offer a comprehensive product substitution program that would create a more profitable product mix. The threat of a large price increase on the current product mix may well be enough to motivate the customer to make the change. If the customer doesn’t accept this offer to change to the substitute products, the manufacturing company would be justified in forcing a fully compensatory price increase that covers both the additional cost of shipping and the other excessive operational costs that were causing the customer to be a money-loser in the first place.
Focus on your profit peak and profit drain customers
The EPM system can prioritize customers based on the magnitude of the profit declines caused by the input cost changes. This reflects: 1) the importance of the cost increases on product cost, 2) the impact of the affected products on each customer’s profitability due to its product mix, and 3) the customer’s profit segment based on the company’s profitability in serving that account.
The sales team has to be the most careful with the profit peak customers whose profitability will be significantly affected by cost increases. Even if the sales team determines that a profit peak customer’s profitability will not be strongly diminished by the cost increase, the team should underline to the customer that they are foregoing a general price increase even though their factor costs are rising.
Profit drain customers that will be significantly affected require particular attention as well, because the cost increase may push the account into deep enough losses to be unacceptable. In this case, the sales team has to be straightforward with the customer and explain what the customer will have to do for the company to remain its supplier.
The pricing action plan for low-revenue, low-profit customers depends on whether the customer is a development prospect: a new customer, or a large company with low share of wallet. If the customer is a development prospect, the sales team can offer to forego the price increase in return for profitable sales growth (unless the cost increase makes this prospect untenable). For other small, marginal customers, the sales team can create price-increase bands that reflect the impact of the cost increases on the profitability of serving each customer. The EPM system can produce this information.
Frame your customer contracts preemptively
In the contracting process, your deal desk should screen RFPs for major products with potentially volatile inputs that would adversely affect your profitability in serving those customers. Although many cost increases are widespread, some commodities and services (e.g., petroleum feedstocks and ocean shipping costs) are both volatile and very important to certain products.
If a prospective customer is likely or certain to buy a number of products that would be affected by possible factor cost increases that would make the customer unprofitable to serve, the deal desk team should include escalators or guardrails that ensure that prices automatically rise to reflect any significant cost increases.
Hunt for the right customers
While it’s important to incorporate provisions in contracts that protect your company from significant cost increases, the ideal situation is to avoid customers who are clearly exposed to major cost increases that are difficult to control and who have a history of refusing contracts with escalators and guardrails.
Your EPM system will enable you to do a sensitivity analysis that identifies the products and costs in an RFP that are likely to present major profit risks, along with the likely profitability of serving the prospective customer. This information should form an important element in your hunter sales reps’ prospective customer roadmap.
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Precision pricing enables managers to laser-target the customers who are appropriate candidates for price increases and to give their sales teams precise cost information to justify specific price increases. They can accomplish the needed price adjustments in a matter-of-fact discussion that’s grounded in actual data.
In other situations, especially with money-losing customers who are not majorly affected by a particular factor cost increase, the sales team can offer to forego a general price increase in return for the customer’s cooperation in reducing other operating costs. Similarly, the sales team can engage new accounts with the prospect of significant growth with an offer to forego price increases in return for substantial profitable growth.
Compare this process to the traditional practice of across-the-board price increases that set up a zero-sum relationship for all customers — regardless of a customer’s profitability and product cost profile — and eliminates the important opportunity to use the prospect of foregoing a price increase as a lever to increase customer profitability.
In this way, precision pricing generates profitable growth while increasing your customers’ goodwill, turning a zero-sum situation into a win-win.