Today is Halloween, but it is no time to be spooked by the challenge of increasing prices to fully capture the value of your products or services. In nearly every company, opportunities exist to capture more value from select customers or products. However, those opportunities are often not where you think they are, so do your due diligence. Avoid chasing the ghosts of phantom opportunities.
In many companies, pricing attention is driven by the 80/20 rule. That is, roughly 80% of the volume comes from 20% of the customers. Companies look at those large customers that deliver a disproportionate amount of sales to determine if there are opportunities to raise prices. It certainly seems easier to manage fewer customers and prices, and they can get more leverage out of small price increases. However, the companies then conclude they can’t raise prices because “We are locked into contracts”, or “We don’t want to cause the customers to put everything out for bid.” Unfortunately, that is not a good application of the 80/20 rule. Very often there is more money to be made in managing the long tail of prices to smaller customers and low-volume products.
When you look deeply into your transaction history, you will frequently find small customers receiving low, big-customer prices. Similarly, you will probably find low-volume products being priced as if they are fast movers. Correcting these underpriced items can improve your profitability. Although each transaction may be small, the improvements spread over all those products add up to real money. After all, a 5% increase on 20% of the volume results in an overall 1% increase.
Another tactic we often see is targeting customers with below-average gross margins for price increases. It seems simple and logical, but it is often wrong for two reasons:
- It does not consider the segment or the size of the customer
- It does not consider the inherent margin of the products that customer is purchasing
More specifically, in the B2B world, not all customers should get the same price. There is greater value for some segments than others, and often differences in the willingness to pay. When you look at the prices paid by segment, you will often find certain segments consistently paying lower prices. Similarly, the typical margins earned on sales are not the same across all products. For a variety of reasons, some products consistently deliver lower margins than others.
Your average gross margin is derived from sales to customers in all segments and sizes, and sales of all types of products. If you target price increases to customers who happen to be in low-value segments or customers who buy primarily lower margin products, you may be targeting customers who actually are already paying relatively high prices for the products they buy (high relative to the prices paid by similar customers you serve). If they are already paying high prices and you increase them further, you increase the risk of losing the customer completely. And although the gross margins may be below average, losing them would also mean losing whatever contribution margin they are delivering (gross margin less incremental variable costs), and lowering your overall profitability.
The final area that sometimes becomes a phantom opportunity is managing the pricing waterfall. The concept is simple – when you give away things you sometimes charge for, such as free freight, customization, extended payment terms, etc., your profit is leaking out like going over a waterfall. To manage it, you can calculate and evaluate Pocket Margin (Gross Margin less the value of all the free or enhanced services) for each customer. By looking at Pocket Margin, you are comparing customers based on what you actually keep.
Unfortunately, many companies target the waterfall as “low-hanging fruit” when looking to improve profitability, and they mismanage it. Because it can be difficult to manage exceptions, we commonly hear broad statements like “Effective January 1st, all customers need to pay for shipping,” or “No customers can receive 60-day payment terms without VP approval.” In the case of each statement, there is no connection to the Pocket Margin. It is simply cutting off the enhanced value items without examining what prices the customers are paying. If those customers are paying high nominal prices and provide acceptable Pocket Margins, these types of drastic actions can seriously disrupt the customer relationship. And if the customers leave, you will really be seeing ghosts.
To find real price and profit improvement opportunities, it is imperative to avoid broad approaches like the 80/20 rule, below-average-margin customers, and edicts in managing the waterfall. By doing detailed analyses to identify customers paying less than appropriate for their segment and size, or customers getting high-volume pricing on low-volume purchases, you can find real opportunities. And even though those opportunities may be individually small, they will add up to real value. Only by doing that detailed work can you avoid chasing phantoms. And the return for your efforts will be the real treat.
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