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1.3 Why Target Pricing Operations

Almost every marketing primer starts with the 4Ps (product, price, promotion, and place), the marketing decision variables or marketing mix that are in a company's control. Getting this mix right is critical in order to successfully market and sell a product. Yet few companies are confident that their pricing practice can execute to their business strategy with consistency. Companies constantly invest resources in modifying pricing tools, methodologies, information systems, and training to address an ever-changing market place.

These companies do so because of the significance of price improvement to the bottom line. Consider, for illustration, an income statement with $100 in revenues, $80 in cost of goods sold, and $10 in selling costs. Then the corresponding 1% increases in earnings before interest and taxes are 8% for a 1% drop in cost, 1% for a 1% increase in volume, and 10% for a 1% increase in price. Table 1-1 shows the relative impact of improving the realized price. Therefore, it makes sense to target pricing among the three options to have the most impact on the bottom line. Of course, this is not easy, and it is the purpose of this book to show how to improve price realization by building better internal controls.

Table 1-1. An Illustration Showing Impact of Price Increase Relative to Unit Sales Increase or Cost Decrease

Income Statement Item

Actual Amount

Amount Projected with 1% Decrease in Costs

Amount Projected with 1% Increase in Volume

Amount Projected with 1% Increase in Prices

Revenues

$100

$100.0

$101.0

$101

Cost of goods sold

$80

$79.2

$80.8

$80

Selling costs

$10

$10.0

$10.1

$10

Earnings before interest and taxes (EBIT)

$10

$10.8

$10.1

$11

Percent increase in EBIT

8%

1%

10%

Similar analysis has been done by various consultancies on different groups of companies like 2,463 companies in Compustat (by McKinsey) and the S&P 500 (by A. T. Kearney).6 The results are different for the two sets of analyses, but both indicate price as proportionally the most important driver for profits (see Table 1-2). On an average, a 1% increase in price without a drop in volume can lead to operating profit improvements of 11.1% for the Compustat companies and 8.2% for the S&P companies. The corresponding increases for 1% improvements in variables costs, sales volume, and fixed costs are much lower. Essentially, because price enhancements carry no corresponding increase in costs (for example, potential variable cost associated with increased volume), they flow directly to the bottom line.

Table 1-2. Average Impact of 1% Improvement of Driver on Operating Profit

Driver

Compustat Companies

S&P 500 Companies

Price management

11.1%

8.2%

Variable cost

7.8%

5.1%

Sales volume

3.3%

3.0%

Fixed costs

2.3%

2.0%

(Source: Phillips 2005: p. 14)

Despite price being so important, it is also something over which companies feel they have the least control. Clearly, given that the lack of control on pricing is mostly within the company, pricing operations is an area where companies should assert control to bring about price improvement.

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