Two Percent For Looking In The Mirror Twice
Recent work involving the use of pricing analytics has provided some interesting insights about profit management and the action items that are critical to an organization’s success. One of the tools employed in this process examines the factors that drive the changes in a firm’s profits from one year to the next, examining a spectrum of factors such as volume changes, price recovery, and productivity. Each such factor can be a positive contributor or a negative force. Price recovery, for example can be positive for firms that are able to increase the prices of their products more than the costs of their factors of production. But it can also be a drain on profits if, for example, purchased commodity prices increase without an offsetting ability to raise end product prices.
One executive that was involved in a project using these tools summarized the experience as follows:
“To paraphrase the saying that I used to hear before The 10 O’Clock News in New York City in the late 1960s, ‘It’s 2012. Do you know where your profit growth is coming from?’ It turns out we didn’t know, and when we learned the answer, it was a major wake-up call.”
The analysis suggested that for the business unit that this executive headed, over the past five years, 64.5% of its annual change in profitability was linked to success (or lack of it) in terms of price recovery. His business’ experience was not commonplace within his firm, where, on average, only 31.9% of the changes in profitability were tied to price recovery. And, the finding wasn’t driven by chance. Looking back even further, we found no years in which price recovery accounted for less than half of the annual changes in profits, and two years in which the percentage exceeded 80%.
This same executive summarized the response to this finding:
“At first, my reaction and that of my team was disbelief. The numbers had to be wrong. But after double- and triple-checking, we bowed to the facts. And then as we started to think more openly about our business, we concluded this made sense. We were in a rather stable, slow growing, sometimes not growing market. And my predecessor’s predecessors had pretty much wrung all the inefficiencies out of the business, in terms of sourcing and operations. It wasn’t that we were doing anything wrong, it was just that our market and our attention to efficiency over the years pretty much guaranteed that pricing-related factors were the only changes of consequence from one year to the next. And no one on our team saw that as likely to change.
“So we accepted the importance of pricing strategy to our success. One of my team noted that ‘Once you know what drives your annual bonus, you know where to focus your attention’. We looked at a lot of the metrics that had been developed for us as part of the analytics work, and learned a lot from them.
“Two findings provide stark examples. We learned that our ‘Zero to 60 Acceleration Time’ was 4.5 months. That’s how long it took before a price increase was reflected in 60% of our sales. We were about twice the company average on this metric, due to our contract structures and other factors. What that means is that when we announce a January 1 price increase, it is mid-May before a majority of our sales reflect the new prices.
“And we learned that the commodities we buy from third-party sources were about 50% more volatile than the company average. We weren’t the extreme across businesses on that metric, but we were up there. Occasionally, that volatility works in our favor. Occasionally, it guarantees a bad year. Everyone in the group voted that they’d prefer no volatility to the present situation. It basically took results out of our control.
“The impetus of all this was that we had to rethink our focus as a management team. We have now learned that what we do on price recovery pretty much determines how we do as a business. Believe me, all of a sudden everyone starting thinking like the innkeeper in Les Miserables, asking if there were any opportunities to charge ‘two percent for looking in the mirror twice’? When your results and your bonus depend on managing price recovery, you think hard about everything that enters into it.”
The experience described by this executive wasn’t unique, although there are as many instances where the spotlight is focused on volume gains or productivity or some other factor rather than price. The common experience is that understanding the determinants of profitability for a business can enable the leaders of that business to focus their attention appropriately, emphasizing the decisions that truly make a difference. And, while some of the applications of the underlying methodology that was used with this firm have yielded a conclusion that the key factors shifted from one year to the next, in most instances, there has been considerable stability in terms of what is driving changes in profitability, except in years in which there was a dramatic change in the external market environment due to business cycle swings or other factors.
The leadership team that was associated with this business identified and implemented quite a few action items designed to give them greater control over price recovery. For those that know the innkeeper’s song cited above, they did so without ever straying across the line to “bleed them in the end”.
Action items fell within two categories. The first set of them focused on the factors that determined swings in their cost structure. Getting a handle on the sources of cost volatility was an obvious first step in this regard, focusing not only on commodity prices, but also on exchange rates. Although I’m not yet aware of any firm that has mastered either of these factors totally, this group identified and implemented a series of actions that moderated the swings. A simulation of the actions that they took suggested that they would reduce the impact of volatility by about half, a major improvement from the previous situation. Some of these actions required renegotiating contract structures, while others involved tradeoffs that took volatility into account as a factor of importance. For example, deciding to incur a relatively small cost associated with higher inventories gave this firm considerable leeway in managing commodity purchases.
Some of the other actions to better manage costs were, in the words of the executive cited above, “pretty darn simple, as least after the fact”. One such simple action addressed timing differences between negotiations on costs (labor and contracts) and pricing actions. The previous timing implied a several month lag where this firm was suffering from higher costs without any corresponding relief from higher prices. Another set of decisions involved a renewed look at material substitution options, which had in the past been made strictly from the perspectives of product performance and manufacturing operations. In a few instances, there were choices available that didn’t compromise either of these factors materially and resulted in considerably less exposure to commodity price changes.
In terms of overall impact, there was a much greater focus on the revenue side of the equation. The executive responsible for this business knew that “We weren’t in a position to just raise prices, declare victory, and go out for a round of golf. Our customers were willing to accept reasonable price increases, but they made it clear that they weren’t in the business of giving money away. What we had to do was more in the category of ‘getting smarter about pricing’ than just being able to impose our will on the market.”
Working with the management team, we did some very detailed analyses of their business, focusing particularly on metrics that helped to determine whether they were successful in terms of adding to profits through effective price recovery programs. Some of their decisions, as was the case on the cost side, again required some tradeoffs. That was the case in terms of implementing a new set of contractual agreements for recalibration of prices on the basis of commodity price changes for several of their products that were significantly influenced by such fluctuations. While the point was made to customers that the changes worked in both directions, it nonetheless took some negotiations to get improved terms into place, including some concessions in other areas
One creative action emerged from an analysis of several product lines that were sold through a bundle that included equipment and also parts and consumables that were delivered over a several year period. The original intent of the bundling concept was to lock customers in for those aftermarket sales, which on average accounted for between 10% and 15% of the value of the bundle. But when the analysis showed that after only a few years, the firm was losing money on the parts sales due to the fixed prices that were included in the initial contract, the practice was changed. The firm continued to offer a multiyear bundle, but the out-year prices were pegged to indices that allowed this firm to realize realistic prices. Remarkably, in this instance, there was almost no volume loss or customer complaint.
The case study described in the paragraphs above is not at all uncommon among even very well run businesses. In instance after instance, we’ve seen examples of where business leaders are materially off the mark in their understanding of the factors that are driving changes in profitability. And, experience suggests that the more fine-grained the analysis is at a product-market segment level of detail, the more likely it is that judgments are off in this regard.
The first lesson drawn is that the question “Do you know where your profit growth is coming from?” is one that should be asked by each business leader on a recurring basis. As was the result in for the firm described above, the answer to that question can not only provide a wake-up call to the management team, but, more importantly, focus their attention on actions that they can take in order to guarantee that the profit growth that is realized meets their goals. The focus will not always be on price recovery as the driving factor, as was the case for this firm. But whatever the mix of factors that are important to a business, accurate knowledge can lead to focused actions that can produce results.
A second key lesson is focused on pricing. In far too many firms, pricing is considered a four-letter word, one best avoided in general and certainly in discussions with clients. But for best-in-class firms, pricing is a tool that can be used to deliver strong bottom-line rewards to shareholders. We see this over and over, and the importance of pricing is reflected in such statements as that made by Warren Buffet before the Senate Financial Crisis Committee in 2011: “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
But the second lesson is not just that pricing is of strategic importance or that it’s better to be in a business where you can raise prices by 10% than one where you have to give up another 10% in the way of discounts. The lesson is that pricing has many dimensions, and firms can get smarter about pricing if they focus upon that responsibility. If there is a business function where solid analytics can make a difference, pricing is probably it. The firm included in this case study gained considerably from taking an in-depth look at all dimensions of its pricing, from the “Zero to 60 Acceleration Time” metric to the analysis of whether they were making money in the out-years on parts that had been bundled into equipment sales.
Smart pricing also has its roots in creating value for customers. Especially in business markets with aggressive competitors and sharp supply chain managers always on alert, it is a reality that prices must reflect the value being delivered to customers. Firms that are delivering solid value, and ones that increase the value they deliver year after year, should and can be rewarded for it through prices that are attractive and yield results for their shareholders. Those that fail to do so, that offer nothing different from that of their competitors, are unrealistic if they think they can command premium prices. The heart of pricing strategy, and the heart of many of the metrics that can guide pricing decisions, is therefore around value creation as the foundation for value capture.
A third key lesson is that pricing is a decision with many facets. Several were reflected in the example provided above – the length of time prices were guaranteed, the nature of escalation clauses, etc. In fact, for that firm, the list of decisions that impacted on their success in terms of price recovery was several pages long. Not all of the entries on that list ended up contributing to their pricing strategy, nor will other firms have the exact same list. But among the decisions that helped this firm to gain control over price recovery were several that hadn’t been discussed by the management team in years.
I’ve worked with firms for which the only pricing decision they made was the amount of the annual increase that they would impose – plus ongoing decisions about responses to threats from customers and competitors. At the same time that I know that the list varies from firm to firm and that not all of the entries on the list will end up being relevant, I am sure that every firm has more to work with than a decision on the annual percentage increase in the prices of its products. The more tools that the firm brings to the table to work with, the greater are its chances of developing a winning approach to pricing strategy.
There is much to be gained from insights as to what truly matters to a firm’s ability to grow its profits, and much to be gained from a smart, strategic approach to managing price recovery among the factors that determine success or failure in meeting profit growth goals. The lessons outlined in this paper – getting an explicit handle on the factors that drive changes in profits, taking a smart approach to pricing that builds upon solid analytics and is rooted in a focus on value creation, and recognizing all of the decisions that eventually determine the degree to which a firm is successful in managing the trajectories of its prices and costs – can point the way to success in meeting this most critical management challenge, that of delivering sustained growth in profits to your shareholders.
Author: George F. Brown, Jr.