Knowing the Price is Right
Producers must take care when measuring price opportunities at the market or location level. A company with different competitors in each region who measures itself the same way across all regions will be hard pressed to understand the true causes of price variation.
“The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you've got a terrible business.” -Billionaire Warren Buffet
I was chatting with a senior level guy recently and he went on an unexpected rant about the lack of consistency and structure used in the pricing of his company’s products. The words used were especially colorful. It might have even been funny if the products he was referencing didn’t generate almost $300m in revenue.
And soon the pricing pressures will be mounting. If you believe the recent intelligence from Dodge Data and Analytics, housing demand is slowing with nonresidential down 3% (YTD), residential building down 12% and non-building construction off 10%. When this translates to EBITDA getting squeezed, can you still hold the line with variable cost reduction initiatives and reductions in labor force?
In such an environment, managers might think it lunacy to talk about holding or even raising prices. But the opposite is true. Pricing right is the fastest and most effective way for managers to increase profits.
Consider the income statement of a large materials producer: a price rise of 1 percent, if volumes remained stable, would generate a 4 percent increase in operating profits (Exhibit 1)—an impact nearly 2.5 times greater than that of a 1 percent fall in variable costs and more than 3 times greater than the impact of a 1 percent increase in volume. (Note: unfortunately, a decrease of 1 percent in average prices drops profits by 4%.)
Exhibit 1
Consider again this same company, competing in many locations and segments. It’s not that pricing isn’t analyzed by its managers. It’s merely that the comparisons they use aren’t very meaningful. For instance, classification by location is arguably misleading, as the physical location by itself doesn’t indicate the level of market competitiveness. And benchmarking pricing by customer type or size ignores the scope of demand. In order to really assess whether average selling price is too soft or too hard, we must understand two things: the competitive intensity (supply) and the scope of opportunity (demand.)
How do you currently do this? Usual intelligence gathering like customer surveys or sales rep anecdotes to gauge the pricing landscape is useful to some. However, the population size is small and subjective, and it can take just one customer story who balked at price to paint the wrong picture. A better way forward involves collecting raw and objective data from each region, location or branch. This can be done annually and should include these three things:
1. The number of true competitors each location battles against for sales
2. Revenue growth the past few years
3. % of orders that customers rejected initial bid price
Based on what the numbers tell us, we can plot supply vs. demand in a simple chart (Exhibit 2).
Exhibit 2
In the booming economy we have enjoyed the past 8 years, robust demand and cost-cutting programs have driven up earnings. But an imminent economic downturn will slow growth. And if the easiest cost cutting has already occurred, the shortfall in pricing capabilities will be exposed. Given pricing is the most powerful lever for driving operating margins, knowing when to hold ‘em and when to fold ‘em will be the single most important decision a business in this industry makes.
Ryan Brown is the founding consultant at Next Level Essentials LLC., a profit improvement practice that seeks to help operations minimize landed costs, maximize margins and streamline the problem-solving process. Contact him at [email protected] or visit www.nextlevelessentials.net