Pulling the Last – and Largest – Profitability Lever

by Joseph Lackner and Mark Beischel

Industrial companies today face an increasingly difficult reality: more demanding customers, shorter product life cycles and pressure from offshore manufacturers. Many of the big cost-cutting and efficiency programs – like re-engineering, Six Sigma, strategic sourcing – are reaching the point of diminishing returns. Still, investors and executives clamor for profit growth. So where can the industrial enterprise turn for greater profits? One of the largest untapped opportunities is pricing – specifically, how to understand it better and manage it more effectively.

First, industrial enterprises must realize that price is a reflection of the economic value a product delivers to a customer, rather than simply a mark-up over cost. The next step is for the enterprise to quantify the value it creates for customers across its entire offering – product, distribution, service before and after the sale, and communication. Then the enterprise is in a stronger position to capture a greater share of the value delivered to customers through price. This is the foundation of value-based pricing.

Value-based pricing
Simply, value-based pricing is the concept that a customer will pay for value delivered. The industrial enterprise delivers more economic value to some customers and therefore has the potential to elicit higher prices from those customers. The enterprise must quantify the link between cost, value delivered, and price across three areas to effectively capture the advantages of value-based pricing:

• Differences in the cost to serve customers.
• Differences in value delivered to the customer through all elements of the offering.
• Overall market structure (i.e., supply and demand) and likely competitive reactions.

Cost to serve
Understanding the cost to serve customers is the start of any sound pricing strategy. A customer profitability analysis (which often includes activity-based cost models) highlights how different customers consume different levels of the company's resources. It demonstrates how the industrial enterprise is delivering greater economic value to some customers than to others. These differences must be defined and quantified so that the enterprise can leverage this in its communication and transactions with its most valuable customers.

Value delivered
Pricing based solely on cost is not enough to meet a company's goal of maximizing profit or to determine the optimal price for a customer. The value the customer derives (or perceives) from a transaction with the supplier is the true determinant of his willingness to pay and, therefore, must be considered. Focusing only on cost leaves potential profits in the customer's hand. The industrial company must become expert in defining and evaluating the economic impact that its offering has on its customers' businesses.

Competitive environment
A basic step in any of these efforts is to understand the relationship between prices, demand and competitors. Will demand rise as prices fall, or are there other dynamics at work in the market? How will competitors react to price changes? Will they try to undercut your pricing moves? Are there alternative products or solutions available to customers to substitute for your offering?

In industrial markets, where fixed costs in plants and production capacity are high, market exit costs are often prohibitive. Capacity cannot be easily shut down, and economies of scale have a large impact on overall profitability. A detailed analysis of the relationship between cost, market capacity and likely competitive reactions is required to establish an effective price strategy. The percentage of capacity that competitors control, their strategic intent and their likely reaction to price moves must be effectively analyzed.

Mastery of the pricing process
Few things have the potential to impact profit on a recurring basis as dramatically as positive shifts in price. The process is difficult. It requires rigorous analysis and a determined organization to effectively succeed. Fortunately, industrial companies are used to applying analytical rigor to achieve engineering and manufacturing excellence, and this rigor can be applied to pricing effectiveness. Successful industrial enterprises will generate unique and sustainable competitive advantage through the mastery of the pricing process.

Bio: Joseph Lackner, Charter Consulting principal, is a member of the products industry practice in Chicago. He has 12 years of consulting and marketing experience, with a focus on helping customers leverage market insights to improve their competitive performance. He can be reached at jlackner@charterconsult.com.

Bio: Mark Beischel, Charter partner, is a member of the products industry practice and leads the company's geographic practice in Cincinnati. He has 23 years of industrial and consulting experience specializing in analytical approaches to profit maximization. He can be reached at mbeischel@charterconsult.com.

About Charter Consulting
Charter Consulting is a Chicago-based firm specializing in helping its clients grow profitably. Charter focuses on the business-to-business market, often using SAS solutions to perform the analytics required to understand and increase profits.