Pricing for profit Conway AR

Spin it any way you want: Profit still equals selling price less the expenses to fulfill a customer order. It almost need not be said that, for many U.S. manufacturers, it's getting harder to produce adequate profit. Indeed many owners and managers are constantly grinding away at the cost side of their business in hopes of protecting precious margins. Yet, healthy profitability is more than effective cost management. Sustainable profitability is dependent on a number of factors, most notably, an understanding of the market value of your products and services.

And while market value is in reality the ultimate price determinant, many manufacturers' view of pricing is too often narrowly preoccupied with labor and material costs. But let's face it; no matter what we would wish, the principle costs of operating our businesses aren't likely to go down anytime soon. There is little opportunity to improve profitability through the traditional approach of reducing the cost of either material or wages and salaries.

According to Paul Loftus, managing partner with Accenture, "many companies are losing up to 10 percent of their operating profit because they don't have the marketplace, competitive and customer insight to use pricing as a competitive weapon."¹ To better understand this assertion, it is useful to look at how companies typically approach pricing, and how others develop other strategies for pricing that focus on increasing profits rather than reducing certain direct costs and why these approaches might be better.

THE MECHANICS OF MARGINS

There are many ways in which margins can be positively influenced. Let's consider three of them at a high level. First, we can simply increase unit volume, and if we are profitable, the amount of profits will increase accordingly. However, this doesn't necessarily improve the percent of profitability directly.

Another way to improve profitability is to increase the unit value. An increase in the selling price with the same gross margin will yield higher margins. And the third and most traditional way is to reduce unit cost. There are a number of ways in which unit cost is reduced, but commonly, the focus is on the two largest components of cost: materials and direct labor.

As Table 1 on the following page illustrates, any reduction in cost results in an increase in margin. Yet any significant reduction in material or labor cost, say 10 percent, is unlikely, especially if one is looking to purchase the same raw materials for less or reduce salaries or wages. Therefore, significant cost reduction is really only available through continuous process improvements that reduce process waste and increase productivity.

Let's say a product carries a selling price of $5,000. We'll use this as our index. If our cost of goods is $2,600 and our operating expenses are $1,650, then our net profit for the product would be $750.

As shown, if all other costs remain the same, a 10 percent decrease in the cost of goods produces significant improvement to the bottom line. In this case the profit improves from $750 to $1,250 per unit — a 67 percent increase. This savings can be retained or passed on to the customer in the form of lower prices.

In the end, focusing only on reducing material and labor costs, while important, often ignores the meaningful upside available when concentrating on improving profit margins. Table 1 illustrates how a strategy to increase unit value will also positively impact profitability. An increase in unit value of the product by 10 percent impacts the profit by 32 percent.

In this scenario there has been a slight increase in cost of goods. This is offset, however, by a reduction in operating expenses. This is due to the fact that there is generally little or no increase in the indirect labor requirement to process higher value products. In this case unit volume remains the same while unit value increases.

Finally, we can see that while driving unit value does increase the amount of margin, it actually does not impact the productivity of profit generation. The table confirms the old adage that you cannot make up for margin with volume. An increase in unit sales volume (the index selling price of $5,000 plus 10 percent) produces more margin volume, but at the same rate. In other words, there is no real improvement in margin performance, only in the amount of total margin produced. Consequently, while more is better, there is no competitive advantage in simply increasing unit volume.

MARKET-BASED PRICING

So, if reducing unit cost and increasing unit value offer significant margin improvement opportunities, how does that relate to strategic pricing? For most manufacturers, pricing is a result of interpreting past performance, not a strategic business activity. Traditional wisdom tells us that cost-plus pricing — a selling price that is the sum of material cost, plus direct labor, plus overhead, plus operating expense, plus profit margin — is the most accurate way to produce and protect margins.

While this approach has worked well in a static commodity product environment, it has several inherent limitations in a world driven by customers demanding more choice. First, it assumes that customers are actually willing to pay the price you are asking based on your costing knowledge and assumptions. I say assumptions because full and accurate costing is a rarity today.

Most wood industry manufacturers, while quite good at producing a quality product, are actually, quite often, rather poor at identifying all of their true costs, especially on the indirect side of the equation. They lack the measurements and the systems to accurately associate specific cost components to specific products or projects.

Second, it assumes our costing is precise. If costing is inaccurate, the basis of overhead absorption and margining is also inaccurate, making for an inaccurate selling price — one way or the other. Inaccurate pricing penalizes both customers and companies alike by charging either too much or too little.

Alternately, a "price minus" strategy is often the better approach. It is the result of analyzing markets, customers and competitors to understand precisely where the price point for your product and services should be. Market pricing is set, profits are subtracted from the selling price, and the result is the net cost at which the product must be produced.

Ultimately, the marketplace is the true price determinant. Ignoring that fact is to relegate your pricing to the shallow end of the margin pool along with other competitors. Knowing the value your products and services hold for customers will determine how you set prices, manage cost and improve productivity.

DIFFERING STRATEGIC NEEDS

The strategic intent of the business will determine how a company approaches pricing and cost management. Being clear about your target markets and competitive differential will go a long way in assuring you will have an effective pricing strategy for your product and services.

Typically, companies may excel in either cost leadership or differentiation, but never in both. For example, if your business is focused on having a wide variety of products with highly differentiated features, it is not likely to be a successful low cost producer. Conversely, if you have a unique product or service, you wouldn't want to be selling at the lowest price, perhaps leaving money on the table when a customer perceives they are receiving significantly more value than they are paying for.

FIVE PRICING APPROACHES

According to Nancy Giddens, Joe Parcell and Melvin Brees, of the University of Missouri,² there are five basic selling strategies:

• Premium pricing — higher pricing based on higher market demand for unique product, limited competition
• Value pricing — medium price point based on known market value, moderate competition
• Cost/plus pricing — known costs and break-even with minimal mark-up to achieve market share
• Competitive pricing — selling prices based on known pricing of competition
• Penetration pricing — low selling price and margins to launch a product or increase market share.

Table 2 on the previous page illustrates the characteristics of each of the five approaches.

So pricing is not as simple as stacking up all the costs we incur to fulfill a customer order, then adding margin to it. Pricing is really about creating a strategy that allows us to capture the maximum revenue and profit while providing customers with unique, differentiated value.

Regardless of your approach, pricing should be strictly tied to your understanding of the customers' perception of the value contained in your products and services. For instance, pharmaceutical manufacturer Pfizer does not base its selling prices on the cost-plus strategy. If this was the case, their pharmaceuticals would be pennies per tablet.

Nor do they base their pricing on return on invested capital.³ Instead, their pricing is solely determined by the market's willingness to pay for the perceived value they receive.

Using market-based pricing will ensure you know what your customers value and what they will pay for it. Using this outside-in view will also ensure that your product and process design can efficiently and effectively produce your desired margin while meeting customer expectations.

Choosing the right pricing strategy means you must know your customers, markets and competitors intimately. You must have a clear understanding of how you are positioned in your markets and how you are perceived by customers and your competition.

Beyond knowing the external factors influencing pricing strategies, it is also necessary to fully understand the sources and structure of your costs. There are numerous costing methodologies including standard costing, activity-based costing, throughput accounting, cost of quality, economic value-added — each measuring the different sources of cost from different perspectives in differing manufacturing models.

At the end of the day, the amount of profit your organization creates really depends on one thing — how well you deliver customer value. Successful strategic pricing is the result of efficiently converting the voice of the customer into maximum value. If you aren't listening carefully to the voice of your customers, imagine who is.

RECOMMENDED READING:

1 Paul Loftus, "Pricing for Profit: How to Achieve Pricing Power in the Industrial Products Industry", Manufacturing.Net, © 2006 Advantage Business Media, http://www.manufacturing.net/article/CA6324541 html?industryid=44323

2 Nancy Giddens, Joe Parcell, and Melvin Brees, Department of Agricultural Economics, University of Missouri, http://www.extension.iastate.edu/agdm/wholefarm/html/c5-17.html, May 2005

3 Hank A. McKinnell, A Call to Action, McGraw Hill Professional, New York, NY, 2005

Ed. note: Strategy and business adviser to the wood industry, Don Shultz of J.E. Moran Associates (www.jemoran.com) collaborates with owners and executives to discover new customer and market possibilities, and to foster improved operational and financial outcomes. He can be reached at (608) 279-8089 or by e-mail at dshultz@jemoran.com.