The power of pricing
Transaction pricing is the key to surviving the current downturn—and to flourishing when conditions improve.
Excerpt
This McKinsey article proposes a simple but powerful tool—the pocket price waterfall, which shows how much revenue companies really keep from each of their transactions— that helps them diagnose and capture opportunities in transaction pricing.
The increase in the number of companies selling customized products and solutions or bundling service packages with each sale, for instance, means that assessing the profitability of transactions has become much more complex. The pocket price waterfall has evolved over time to take account of this transition.
Today, it is more critical than ever for managers to focus on transaction pricing. Moreover, at many companies, little cost-cutting juice can easily be extracted from operations. Pricing is therefore one of the few untapped levers to boost earnings, and companies that start now will be in a good position to profit fully from the next upturn...
Following the pocket price waterfall
Many companies can find an additional 1 percent or more in prices by carefully looking at what part of the list price of a product or service is actually pocketed from each transaction. Right pricing is a more subtle game than setting list prices or even tracking invoice prices. Significant amounts of money can leak away from list or base prices as customers receive discounts, incentives, promotions, and other giveaways to seal contracts and maintain volumes.The experience of a global lighting supplier shows how the pocket price—what remains after all discounts and other incentives have been tallied—is usually much lower than the list or invoice price. This company made incandescent lightbulbs and fluorescent lights sold to distributors that then resold them for use in offices, factories, stores, and other commercial buildings. Every lightbulb had a standard list price, but a series of discounts that were itemized on each invoice pushed average invoice prices 32.8 percent lower than the standard list prices. These on-invoice deductions included the standard discounts given to most distributors as well as special discounts for selected ones, discounts for large-volume customers, and discounts offered during promotions.
Managers who oversee pricing often focus on invoice prices, which are readily available, but the real pricing story goes much further. Revenue leaks beyond invoice prices aren't detailed on invoices. The many off-invoice leakages at the lighting company included cash discounts for prompt payment, the cost of carrying accounts receivable, cooperative advertising allowances, rebates based on a distributor's total annual volume, off-invoice promotional programs, and freight expenses. In the end, the company's average pocket price—including 16.3 percentage points in revenue reductions that didn't appear on invoices—was about half of the standard list price. Over the past decade, companies have tried to entice buyers with a growing number of discounts, including discounts for on-line orders as well as the increasingly popular performance penalties that require companies to provide a discount if they fail to meet specific performance commitments such as on-time delivery and order fill rates.
Embracing a wide band
The pocket price waterfall is often first created as an average of all transactions. But the amount and type of the discounts offered may differ from customer to customer and even order to order, so pocket prices can vary a good deal. We call the distribution of sales volumes over this range of variation the pocket price band.At the lighting company, some bulbs were sold at a pocket price of less than 30 percent of the standard list price, others at 90 percent or more—three times higher than those of the lowest-priced transactions. This range may seem spectacular, but it is not very unusual. In our work, we have seen pocket price bands in which the highest pocket price was five or six times greater than the lowest.
A wide band shows that certain customers generate much higher pocket prices than do others
It would be a mistake, though, to assume that wide pocket price bands are necessarily bad. A wide band shows that neither all customers nor all competitive situations are the same—that for a whole host of reasons, some customers generate much higher pocket prices than do others. When a band is wide, small changes in its shape can readily move the average price a percentage point or more higher. If a manager can increase sales slightly at the high end of the band while improving or even dropping transactions at the low end, such an increase comes within reach. But when the price band is narrow, the manager has less room to maneuver; changing its shape becomes more difficult; and any move has less impact on average prices.Although the lighting company was surprised by the width of its pocket price band, it had a quick explanation: the range resulted from a conscious effort to reward high-volume customers with deeper discounts, which in theory were justified not only by the desire to court such customers but also by a lower cost to serve them. A closer examination showed that this explanation was actually wide of the mark (Exhibit 3): many large customers received relatively modest discounts, resulting in high pocket prices, while a lot of small buyers got much greater discounts and lower pocket prices than their size would warrant. A few smaller customers received large discounts in special circumstances—unusually competitive or depressed markets, for instance—but most just had long-standing ties to the company and knew which employees to call for extra discounts, additional time to pay, or more promotional money. These experienced customers were working the pocket price waterfall to their advantage.
In addition to these immediate fixes, the lighting company took longer-term measures to change the relationship between pocket prices and the characteristics of its accounts. New and explicit pocket price targets were based on the size, type, and segment of each account, and whenever a customer's prices were renegotiated or a new customer was signed, that target guided the negotiations.
Pocket margins become more relevant
For companies that not only sell standard products and services but also experience little variation in the cost of selling and delivering them to different customers, pocket prices are an adequate measure of price performance. Today, however, as companies seek to differentiate themselves amid growing competition, many are offering customized products, bundling product and service packages with each sale, offering unique solutions packages, or providing unique forms of logistical and technical support. Pocket prices don't capture these different product costs or the cost to serve specific customers. For such companies, another level of analysis—the pocket margin—is needed to reflect the varying costs associated with each order. The pocket margin for a transaction is calculated by subtracting from the pocket price any direct product costs and costs incurred specifically to serve an individual account.One North American company, which manufactures tempered glass for heavy trucks and for farm and construction machinery, sharply increased its profits by understanding and actively managing its pocket margins. Each piece of the company's glass was custom-designed for a specific customer, so costs varied transaction by transaction. Other costs differed from customer to customer as well. The company's glass, for example, was frequently shipped in special containers that were designed to be compatible with the customers' assembly machines.
Traditionally, the pricing policies of the glass company had focused on invoice prices and standard product costs; it paid little attention to off-invoice discounts or extra costs to serve specific customers. The pocket margin band helped it identify which individual customers were more profitable and which should be approached more aggressively even at the risk of losing their business. The company also uncovered narrowly defined customer segments (for example, medium-volume buyers of flat or single-bend door glass) that were concentrated at the high end of the margin band. In addition, it evaluated its policies for some of the more standard waterfall elements to ensure that it had clear objectives, accountability, and controls for each of them—for instance, it decided to base volume bonuses on stretch performance targets and to charge for last-minute technical support. By focusing on and increasing sales in profitable subsegments, pruning less attractive accounts, and making selective policy changes across the waterfall elements, the company pushed up its average pocket margin by 4 percent and its operating profits by 60 percent within a year.
Taming transactions
The game of transaction pricing is won or lost in hundreds, sometimes thousands, of individual decisions each day. Standard and discretionary discounts allow percentage points of revenue to drop from the table one transaction at a time. Companies are often poorly equipped to track these losses, especially for off-invoice items; after all, the volumes and complexity of transactions can be overwhelming, and many items, such as cooperative advertising or freight allowances, are accounted for after the fact or on a company-wide basis. Even if managers wanted to track transaction pricing, it has often been impossible to get the data for specific customers or transactions. But some recent technical advances have helped remove this obstacle; enterprise-management-information systems and off-the-shelf custom-pricing software have made it easier to keep tabs on transaction pricing. Managers can no longer hide behind the excuse that gathering the data is too difficult.Current price pressures should go a long way toward removing two other obstacles: will and skill. In the booming economy of the 1990s, robust demand and cost-cutting programs, which drove up corporate earnings, made too many managers pay too little attention to pricing. But now that a global economic downturn has slowed growth and the easiest cost cutting has already occurred, the shortfall in pricing capabilities has been exposed. A large number of companies still don't understand the untapped opportunity that superior transaction pricing represents. For many companies, getting it right may be one of the keys to surviving the current downturn and to flourishing when the upturn arrives. It has never been more crucial—or more possible—to learn and apply the skills needed to execute superior transaction-price management. 
