The Profit Leakage: The Price Waterfall
17 March 2006 Dr. Clemens Oberhammer
‘Take care of the pennies and the pounds will take care of themselves’ is the underlying philosophy of the price waterfall concept. The price waterfall helps an organisation to increase profit by identifying and plugging price leakage at the deal / transaction level.
Before we go any further, it is essential to understand the power of pricing. A 2% price increase would, on average, lead to a 15% profit increase for FTSE 100 companies. Exhibit 1 shows that this ranges from 5% to over 100%. Achieving a 2% price increase is ambitious, but possible. In most organisations, stopping the price leakage during price implementation will itself be sufficient to achieve these results. This article focuses on the price waterfall, a key methodology to stem price leakage.
WHAT IS A PRICE WATERFALL?
The price waterfall provides a measure of the achieved net and pocket prices and not just the price that is printed on the invoice, against defined target prices. This is done by gathering, organising and synthesising price and cost-related data. It can be pictorially represented, as shown in Exhibit 2. The price waterfall enables the organisation to achieve the best price in every transaction by identifying leakage at different price levels, i.e. list price, invoice price, net price, pocket price and pocket margin.
HOW DO YOU IMPLEMENT A PRICE WATERFALL?
(A) Preparation Phase
A price waterfall should be developed and implemented by an inclusive project team, made up of marketing, sales and finance. This is essential, as input will be required from all these functions and they will all have to work with the waterfall. Whether the IT-function should be part of the project team or not depends on the impact of the price waterfall system on the companies' software system.
The duration of a price waterfall project depends on several aspects, such as the current pricing system, data availability, and the change management efforts required. Our experience tells us that it usually takes at least one year from concept development to the final implementation. Hence, a team that can work well together and is accepted across the organisation needs to be selected.
(B) Concept Development Phase
The concept development consists of two main parts: identifying the main goals of the price waterfall and developing the waterfall structure, including the definition of the waterfall elements.
We observe that many companies make the mistake of setting up a price waterfall system without being clear on the goals. This can lead to the problem that after implementation, organisations realise that important information cannot be measured, as the price waterfall elements are not defined in the appropriate way.
The major goal of a price waterfall system should, of course, be to identify and eliminate profit leakages. Secondary goals can be: segmenting customers based on profitability; developing service strategies based on cost to serve; or developing new performance measures for the sales force based on transaction profitability.
One of our clients defined the goals of the price waterfall system in the following way: 'To develop a disciplined process of determining which products and services should be offered to which customers, at what prices, through which channels, in order to maximise profits and maintain the existing customer base.' This example shows that the price waterfall system can be used to connect different goals. Since the goals determine the structure and granularity of the price waterfall, it has to be clear and agreed by all project stakeholders.
Then the overall structure of the price waterfall structure needs to be determined, i.e.: which price and cost elements should be part of it, and how should they be defined? While this will differ by company, we have found the following general structure useful.
List price - every price waterfall should start with the list (or gross) price. Even if a company does not use it for its customers it should define a list price internally to make the pricing process more structured and internally transparent. The list price should reflect the overall product value, product strategy, and competitive strength, and should take into account the discounts and rebates granted and the standard services given away for free. Based on our experience, marketing should own the process of setting list prices, but to ensure that internal expertise is fully utilised, sales input should also be taken.
Invoice price - currently, most companies manage the invoice price which equals the list price minus on-invoice discounts (discounts mentioned on the invoice). It does not reflect the true worth or profitability of a transaction as it does not take into account off-invoice discounts (discount not mentioned on the invoice) and customer-specific costs (e.g. additional transaction cost due to small lot orders). However, invoice price should still be an element of the price waterfall because sales teams usually negotiate the invoice price with the customer, and only when they see the invoice price as an element can they follow the rationale of price waterfall.
Net price - in order to ensure that all discounts are reflected by the price waterfall, the business units have to define all on-invoice and off-invoice discounts they want to use. For optimal control and monitoring, each discount should be reflected by a single element in the price waterfall. Consequently, a net price should be calculated which equals invoice price minus all off-invoice discounts, i.e. allowances, rebates, conditions, terms, bonuses, etc. Off-invoice discounts can vary greatly between customers and sales reps and have a major impact on the transaction profitability. In a recent project we observed that some of the sales reps used freebies extensively to avoid higher discounts because their bonus was based on the on-invoice discount granted. The organisation was unaware of this until they implemented a price waterfall system, where these hidden discounts and transaction profitability were measured.
Pocket price - the next important element is the pocket price, which shows what the company is actually earning in a transaction. It equals the net price minus all customer-specific costs, which include:
- Transaction cost: freight (internal and external), cost of rush orders, cost of non-standard orders, etc.
- Service cost: sales team, customer service, training, promotions, cost of credit, etc.
Organisations that have more sophisticated cost-allocation mechanisms opt to drill down to the pocket margin, which is a more precise measure of transaction profitability. Pocket margin equals the pocket price minus all production (fixed and variable manufacturing) and overhead costs (HR team, finance team, IT, etc.) broken down to the transaction level. To determine pocket margin, the organisation has to answer the following questions:
Which cost elements should be included in price waterfall analysis?
Determined by the relevance of the cost element for the purpose of price waterfall and the ease with which it can be measured.
How the cost should be allocated between transactions, customers and products?
Straightforward for costs that are directly caused by a transaction (e.g. freight costs). For other costs, the cost resource (e.g. account manager), the cost driver (e.g. number of sales visits) and the cost object (e.g. product weight) have to be identified. Then, the organisation has to decide for which costs they want to set up activity-based costing (measuring the cost of an activity and documenting the activities).
The price waterfall is only as good as the input data. Hence, the project team should conduct business unit visits to understand the local terms and conditions, analyse local data, and get top management support to force the business units to comply and report the complete picture.
In addition, the price waterfall results must be continuously monitored to further improve the data quality and completeness. In our experience, different functions often have different interpretations of pricing terms and cost allocation logic. It is essential for the project leader to build a consensus, as people will trust the information provided by the price waterfall only if they agree to the basic concepts and definitions behind it.
Based on this and on the trade-off between the benefits of the waterfall and the implementation costs, the waterfall can become as granular as required, i.e. it can be implemented at the product, customer or transaction level.
(C) Implementation Phase
The key implementation aspects are software deployment and training. Organisations requiring a cost-effective solution usually use their existing business warehouse / ERP systems with an MS-Excel based front end. Whereas organisations that prefer a robust system opt for pricing software from specialist vendors such as PROS Pricing Solution, Vendavo and Zilliant, or build a full-fledged system internally.
Another key implementation aspect is training the people who will work with the system. Comprehensive change management is required to make sure that everyone understands the price waterfall system (both concept and application) and is convinced of its benefits.
MEASURING THE SUCCESS OF A PRICE WATERFALL IMPLEMENTATION
To measure the success of a price waterfall implementation, KPIs should be defined; both for the process of implementation and for its outcome.
Process KPI examples are the number of people working with the waterfall system, number of products included, percentage and quality of total cost measured and number of complaints received by IT support about the price waterfall software. The project leader or project sponsors should define and monitor target values for process KPIs.
Outcome KPIs are used to analyse the financial impact of the price waterfall system. Transactions that do not meet the target price levels should be measured as a part of the outcome KPIs and clear action plan must be developed to rectify discrepancies.
Target price could be the desired or minimum price, depending on the organisation's objectives. While this KPI leads to the price level improvement, it still does not indicate the quality of transactional pricing. Therefore, organisations should also define additional outcome KPIs such as 'number of prices below a certain threshold'.
For example, an organisation could set a 90% compliance target at pocket price level, which means that the achieved pocket price should meet the target pocket price for at least 90% of the transactions. Outcome KPIs should be applied to both the marketing and sales functions to ensure that the right prices are set and implemented. In our experience the mere fact that these KPIs are reported on a regular basis leads to improvement in pricing discipline.
WHAT ARE THE BENEFITS OF THE PRICE WATEFALL?
Higher profits - the primary function of a price waterfall is to pinpoint where the leakages are (customers, products and transactions) and enable the organisation to achieve the best price in every single transaction. For example, in Exhibit 2, there is no price leakage at the invoice price level and there is a price leakage of 6 index points at the net price level. Identifying and eliminating this price leakage (due to off-invoice discounts) can potentially improve the pocket margin from 14 points to 20 points, a 43% improvement in profitability for this transaction.
Better control - the price waterfall can be used as the basis of a disciplined data driven approach to measure and control the effectiveness of the pricing process (using outcome KPIs as mentioned earlier).
Improved planning - as the price waterfall enables the disintegration of price into different components, the organisation can compare the target and achieved price at different levels. For example, in Exhibit 2, the expected cost of transactions and services is 22 (target net price – target pocket price level = 22). However, the actual cost was only 18, challenging the assumptions made during the initial estimation of expected cost. Working with such disintegrated data over a period of time enhances the marketing and planning IQ.
Value based negotiation - some organisations prefer to provide disintegrated information up to pocket price level to the sales force. This allows the sales force to use multiple negotiating levers to achieve the best price, e.g. off-invoice discount or performance reduction (service level or transaction quality) for a price reduction.
In conclusion, transaction price management does not receive C-level executives' attention in many organisations as it pertains to the lowest level of detail for profitability management. However, a successful price waterfall implementation that optimises transaction pricing has the potential to improve profits substantially with the approval of internal stakeholders, without upsetting customers, and without the need for major strategy changes.
For further reading on some of the original work on the price waterfall concept please refer to Marn, Roegner, Zawada; The Power of Pricing; The McKinsey Quarterly 1/2003 and Marn, Rosiello; Manage Price, Gaining Profit; Harvard Business Review; September-October 1992.