Don’t raise your price, optimize it

Observation #43

carpedia-observation-43Pricing is the most powerful way to improve profit without the need for large-scale culture change. It is often said that a 1% improvement in price is worth a 10% improvement in productivity. Given that there is so much effort involved in trying to raise productivity by 10%, it’s somewhat surprising that price isn’t the first thing performance improvement groups focus on. But like the problem that many start-ups experience when they use similar math — “All we need to be profitable is a 1% market share” — getting that 1% gain can be very difficult.

Pricing is often something of a black art in many organizations. Many apply some kind of cost-plus-logic to determine their prices, but even the underlying costing methodology is a little cryptic (e.g., what costs are allocated). Many other companies set their prices based on what they believe the market can bear or based on what their competitors are charging. Actual negotiated pricing is often highly variable and can be significantly influenced by the size of the customer, what competitors do in bid situations, what procurement departments demand, the size and scale of the sale, future opportunities, etc. Prices are also influenced by personal relationships and even sales compensation plans. All of these factors result in a range in which prices for a certain product or service can vary.

Much like waste in a process, the opportunity in pricing lies in the variation. Raising prices is notoriously hard in many industries, so the key to remember is that the profit lever is average price. So focus on what we call “price optimization.” The objective is to increase the average price, not to raise prices. If you can reduce any of your discounting, you can reduce the variation and improve the average price, all other things being equal.

The key question, then, is to ask and to study: Who actually controls pricing? Often, pricing control is distributed throughout an organization, and various people are allowed to discount from a benchmark. Identify where prices are discounted and try to understand what is driving that behavior. If you can tighten the parameters around who has the authority and how much can be discounted, you can reduce price variation and improve your average price. The more complex part for a project-based initiative is that the consequences are often felt at an aggregate level fairly high up in the organization, well after the price has been discounted. It’s difficult to manage this gap between action and consequence.