Using Activity-Based Costing to Improve Shared Services Allocations

White Paper

Effective Pricing

Using Profitability Insight: A Best Practice Guide

Torsten Weirich

Chief Technical Officer, Acorn Systems

March 2009

©2009 Acorn Systems

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Introduction

The benefits of an effective pricing practice are significant. A McKinsey report on pricing estimates that the

average 5% improvement in return on sales from improved pricing creates $1.5 billion in additional value over 5

years for the average S&P 500 company.i In today’s tough economic climate companies cannot afford to leave any

potential revenue on the table.

An effective pricing practice consists of two main processes: price setting and price execution. In each process, it is

critical that a company incorporate insight into the net profitability of their customers and products. It is the only

way to be sure that the prices being set are effective. However, few companies do this today. This paper is a guide

that will show you how to incorporate profitability into your pricing practice.

Successful and Sustained Pricing

Figure 1 - Price Setting and Price Execution

The purpose of price setting (or defining the pricing strategy) is to extract maximum value for each product sold to

the customer. Price execution (executing the strategy) prevents the margin leakage that inevitably occurs at most

companies as they sell products to their customers. One without the other leads to lost revenue and reduced

profits.

While pricing strategy is usually confined to a small organization within any company, price execution touches

many parts of the company. In fact, a good pricing strategy requires accurate data from the whole company. This

complexity often drives companies to make poor decisions or poorly implement the good decisions they make,

resulting in loss of revenue.

Companies that enjoy competitive advantages from pricing have the following common characteristics:

They have accurate transaction-level information (order line item, order, product - SKU, customer,

channel, etc.) that includes all aspects of contribution margin

They base their decisions on contribution margins using the Waterfall

They reinforce their pricing strategies and policies by aligning all involved organizations, using

contribution margin instead of volume-based compensation

They empower their organizations with sustainable and repeatable pricing processes

They focus on continuous improvement efforts supported by effective monitoring and analytics

Price

Setting

Price

Execution

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The majority of Acorn’s customers with profitability initiatives have found that their biggest profit opportunities

came from improving their pricing.

Transaction-Level Insight is the Key to Success

Each company’s revenue stream is built one transaction at a time. Without a complete understanding of what

happens at the transaction level, the company will consistently fail to improve price performance. To succeed, the

company must

Build a model that captures the complete process and lifecycle of the transactions that drive its business

Analyze revenue and operating profit across multiple dimensions, including invoice line item, SKU,

customer, channel, salesperson and region to determine the true profitability of a transaction

Focus on the subset of SKUs that represent the majority of the business

Constantly re-examine the customer segmentation model used to set prices - making sure the

assumptions are still valid

Stop using gross margin to set sales force compensation or make other pricing decisions

Most Acorn customers understand that time-driven activity-based costing enables them to gather these key

insights quickly and reliably.

Creating an Effective Price Strategy

Developing a pricing strategy is a fairly complex process that incorporates a variety of critical insights about the

company’s marketplace, competition, customers, channels, products and its own capabilities. From an external

perspective, the company should examine growth prospects in the markets for its products and how products are

positioned within those markets. Obviously, it also needs to consider product price elasticity. Understanding the

competitive landscape is equally important; including market share, the availability of other products in that

market and how those products can be differentiated. The company should also understand the key drivers of

customer and product profitability, such as the customer’s cost-to-serve requirements and any value-added

service features associated with its products. It should consider customers and products as a portfolio of assets.

Customer Segmentation

Customer segmentation is an important part of pricing strategy. It links many aspects of what drives a customer to

purchase a particular product. Specific elements of customer segmentation that need to be taken into account for

an effective pricing strategy include:

Customer needs

The value a customer represents to a company

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How a company reaches their customers through sales and marketing channels

The appropriate product mix for various customer groups

The perceived value proposition of products and services

These insights allow a company to create price points for each segment, based on buyer behavior, product value,

sales channel and cost-to-serve. The most effective report for this analysis is a customer rating matrix (figure 2).

Figure 2 - Customer Matrix

By charting each customer, using actual revenue and contribution margin, a company can see how customers drive

overall company performance.

Figure 3 – Customer Contribution Analysis

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The biggest impact can usually be achieved by focusing on the top and bottom 10 percent of customers.

Figure 4 - Customer Segment Performance Analysis

It is important to analyze the overall performance of each segment using segment criteria (figure 4). Companies

can experiment with different segmentation strategies by repeating this analysis using different criteria. Effective

segmentation must be validated in the market as well as with the company’s ability to enforce the price points

associated with each segment.

Creating effective segment profiles can be very difficult to do, and many companies struggle to create profiles that

make sense. Powerful data mining tools can help with this, and are easier than ever to use. They can analyze

customers, identifying customer attributes with the strongest correlations. From this, more effective segment

profiles can be developed. By including customer transaction data as part of this analysis, the company can get a

better understanding of what customer behavior is driving customer profitability.

Product Profitability

Product profitability is an extremely important factor in pricing decisions. Product pricing decisions are often made

using gross profit margin information. Before any decisions can be made about the price of a particular product,

the company must understand not only how much it costs to produce the product, but also those costs incurred

getting the product to the customer, in other words fully loaded costs. These additional cost-to-serve elements

often take the form of services required by the customer to get the most out of the product, and can greatly

impact product profitability. The primary report for understanding product profitability is the price/profitability

waterfall at the transaction level.

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Figure 5 - Price/Profitability Waterfall

The waterfall identifies aspects of the transaction that add to and take away from the overall profit contribution of

the transaction. Each cylinder in the waterfall represents a potential margin leakage point that must be addressed.

Experience has shown that companies with a sustainable and repeatable process for analyzing waterfall data have

a much better understanding of their overall economics and transaction leverage points.

Once a company understands the key drivers of product profitability, it is in a much better position to analyze how

it will price its products in the market. As with customers, a product pricing strategy must also be aligned with

product portfolio and market opportunities.

Figure 6 - Product Price Analysis

Low Medium High

Low

M

ediu

m

Hig

h

Price

Dif

fere

nti

atio

n

Unique or new products that are priced too low

Products priced to accelerate market adoption

Market leading products command

consistent price

Mature or declining products being

harvested

Mature or declining products that are not rationalized with the

market

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Number of Products

Cu

mu

lati

ve R

even

ue

(in

mill

ion

s)

Focus price improvement efforts here

Focus SKU rationalization efforts here

0 8000

$40

It is helpful to map each product in a rating matrix that compares the product with the price of similar products in

the market (figure 6). This helps a company understand where to price its products against the competition. It also

provides insight into what products should be retired.

There are a variety of reasons a company may decide to carry a product that does not provide a significant

contribution to revenue. For example, a product might have strategic significance, without which the company

would not be competitive with its other products. More often than not, companies have products that were at

one time significant revenue contributors, but have declined over time and no longer provide a significant revenue

contribution. A company must periodically review its product portfolio to identify these products as potential

candidates to be cut from the portfolio. The SKU velocity analysis is a Pareto-based technique that helps the

company to identify the top 10% or 20% of SKUs that drive 80% to 90% of revenue.

Figure 7 - SKU Velocity Analysis

SKUs on the long tail of the chart are candidates for rationalization because they may be dragging down profits at a

much higher rate than other products. Rationalization decisions can be made with confidence, especially if used in

conjunction with a product contribution analysis or product profit-revenue rating matrix analysis.

Pricing New Products

A company must also examine any new products it has in the pipeline so that it can evaluate their impact on any

pricing strategy it is considering, and also evaluate whether or not these products should be brought into the

market in the first place. Key questions need to be asked, such as

Does the product leverage existing channels or will it require additional investments in new channels?

Can the product be built profitably? Product profitability should be by design and not an afterthought.

How well will the new product fit into the existing set of products? Will it cannibalize a successful product

or replace a weaker offering?

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What price strategy should be employed (e.g., skim, penetration, etc.)?

At the end of the life cycle, were the targets for the product achieved? What did the company learn from

this?

It is critical to examine these factors whenever a company is considering bringing a new product to market.

Predicting the profitability of a new product can be difficult. Analyzing the costs of current, similar products and

projecting them as costs for new products can help companies make more accurate predictions. The simplest way

to do this is to use the historical unit driver rates for existing products.

Figure 8 - Cost per Unit Analysis

Channel and product development costs can be amortized over the expected product life. With sophisticated

profitability modeling tools, companies can use this type of report to anticipate the costs of new products, and

thus set more realistic prices.

Price Execution

Having the best price strategy in the market doesn’t guarantee a profitable outcome if a company is unable to

execute it effectively. There are a number of reports a company can use to gain the insight necessary to improve

profitability through effective pricing.

One of the best reports available is a cumulative customer contribution analysis or whalebone chart (figure 9). As

with the previous contribution analysis, the whalebone chart graphs customers in decreasing profitability order.

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Figure 9 - Customer Cumulative Profitability

It serves as a road map for where to focus efforts and identifies what activities will lead to the best overall

improvement. For example, customers who are on the declining portion of the curve and reducing overall

profitability should be carefully examined. One possible action a company can take is to renegotiate its relationship

with these customers, using individual customer P&Ls that highlight the source of their unprofitability. Another

option would be for the company to terminate its relationship with that customer, allowing them to become a

problem for a competitor.

A company will want to expand its selling efforts with the most profitable customers by selling them profitable

products that they are not already buying or increasing the overall volume of the profitable products it is already

selling them. Providing sales with this analysis will help them maximize efforts for time invested.

Even the best strategy can fail if the company is unable to execute it effectively. A company needs to be able to

monitor how well it is able to enforce (or execute) its price strategy. The product price band analysis (or product

categories) is a good indicator of a company’s ability to enforce price points along its existing customer

segmentation strategy.

Figure 10 shows what happens when a company is unable to enforce price points effectively. In this example, a

number of transactions involving the product were below the minimum target price for each segment and

represent margin leakage - or money left on the table. It is imperative that the company determine why it is

unable to enforce price points. It may be an indicator that the segmentation strategy does not work for certain

product categories. In this case, the segmentation strategy needs to be further refined to take into account these

product categories.

Number of Customers

Perc

enta

ge o

f o

vera

ll p

rofi

t

Focus selling efforts here to drive volume

improvements

Focus re-negotiation efforts here using product/service

bundling or customer attrition

0 15000

200%

50%

150%

100%

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Figure 10 - Price Band Analysis

Other reasons for ineffective price enforcement may relate to internal sales processes. For example, the price

strategy may not have been effectively communicated or it could be so complex that it creates confusion within

the sales organization. The solution may be as simple as more effective sales training.

Other possibilities include a segmentation strategy that is difficult to implement in the field or inadequate

alignment of the sales force. Alignment is most easily addressed by linking compensation to pricing goals and

profitability. However, if the company does not provide tools that help the sales organization succeed, it will once

again fail to execute its price strategy effectively. Successful sales people optimize their time to maximize their

profit or revenue quota. They will rebel if the process required to comply with price policies requires a significant

amount of time, because it detracts from their ability to use that time to meet quotas. If sales people are

compensated on deal profitability, they will need the tools to determine how the terms of a deal affect the deal’s

profitability.

Many companies have tried to address the issue of ineffective price enforcement by creating a price desk that is

responsible for vetting any deal whose terms deviate from the published price list. However, highly competitive

markets or tough economic climates often create price pressures that increase the number of deals the price desk

must evaluate. Eventually, the price desk is overwhelmed and the sales team is once again frustrated.

The best solution is to provide the sales team with the facts they require to quickly evaluate a deal’s feasibility.

They need to be able to create various pricing scenarios, and see how each scenario lines up with company pricing

strategy as well as deal profitability. Other factors, such as the strategic value of the deal or customer can also be

factored into the overall deal score.

Companies can further streamline the process by automating the deal approval workflow. Depending on the score,

the deal can be accepted or automatically approved to be submitted for processing. If the score does not meet the

minimum required for automatic approval, it can be escalated to a manager for review. If the manager considers

the deal acceptable, they can reroute the deal to a member of the finance team for final approval. There are a

variety of solutions on the market that offer these capabilities, but many ignore profitability analysis.

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Quick Wins

Sometimes companies do not have time to create a new pricing strategy, but still need some quick wins. They

want to review the effectiveness of their current pricing strategy, and determine how they can improve it. SKU

velocity, SKU cumulative profitability and customer cumulative profitability reports can help.

Companies can often achieve outstanding results by simply doing a top 10 and bottom 10 analysis of their products

and/or customers.

Figure 11 - Cumulative Customer Profitability

As shown in figure 11, the top and bottom 10 customers are usually located on the steepest sections of the

cumulative profitability graph, which means their profit impact is significant. In this example, by simply returning

the 10 least profitable to break-even, margins could be increased by double digits.

Number of Customers

Perc

enta

ge o

f o

vera

ll p

rofi

t

The top 10 customers drive the most profit

The bottom 10 customer erode the most profit

0 15000

200%

50%

150%

100%

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Figure 12 – Customer P&L

The company should then examine each customer’s cost-to-serve activities in more detail to identify those that

deviate from the company or segment average. Comparing these costs using their percentage of revenue is a good

way to do this. In most cases, renegotiating the terms of an agreement with these customers using a customer P&L

that includes profit drivers will lead to quick and dramatic results. The results of a top and bottom 10 summary

analysis identify which customers to target.

In most cases, renegotiating the terms of an agreement using a customer P&L that includes profit drivers will lead

to quick and dramatic results. A top and bottom 10 summary report identifies which customers to target.

Similarly, a top and bottom 10 summary report of a company’s products (figure 13) shows which products a

company should concentrate its sales efforts on and which products they should consider fixing or flushing.

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Figure 13 - Top 10 Products

Figure 14 - Product P&L

Fix or Flush

Expand Sales Efforts

Understand the causes of variability from company average

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The company should then examine each product in more detail to identify the activities or other costs that are

causing this product to deviate from the company or category average. This can be done by comparing the

percentages of activities or other costs.

Most companies pursuing this tactic are often surprised by the ease with which they can extract additional profits.

The results from these efforts can then be reinvested to drive additional gains elsewhere. This tactic can also be

used on a continuous basis, leading to a sustainable and repeatable profit improvement process that never ends. It

is also the first step to instilling a profit culture that permeates throughout the organization.

Summary

Customer and product profitability are critical elements of good pricing. Below is a summary of key reports that

will help you create an effective pricing strategy and execute it well.

SKU Velocity Identifies high volume SKUs for price improvement action and

low volume SKUs for ongoing rationalization

Cumulative Product Contribution Identifies profitable SKUs that can be used to expand

relationships with existing customers

Cumulative Customer Contribution Identifies which customers to target and what kind of action

should be taken with these customers

Price Band Analysis Identifies “fix-or-flush” transactions or possible re-

segmentation opportunities

Customer Segment Performance Analysis Validates segmentation and identifies potential issues with

customer segment assignments

Price/Profitability Waterfall Identifies margin leakage

Customer Profitability P&L’s Identify all aspect of revenue, costs, and net margin for every

customer

Product Profitability P&L’s Identify all aspect of revenue, costs, and net margin for every

product SKU

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Companies who have invested in transaction-level profit modeling and optimization solutions can reap immediate

benefits from this investment by improving the price strategy process and execution. Companies that have not yet

made this investment can accelerate their efforts by leveraging industry templates to achieve faster time to value.

***

About the Author

Torsten Weirich is the Chief Technology Officer at Acorn Systems. A veteran of technology innovation and

performance optimization with over 25 years of experience in commercial software product development, Torsten

is responsible for developing Acorn’s long-term product strategy and architecture road map. He evolved Acorn’s

core technology into the leading enterprise-class profitability optimization solution and is actively engaged with

customers to maintain this leadership position.

Torsten joined Acorn from BMC Software where he served in a variety of roles including Product Development

Manager and architect for BMC's PATROL for Diagnostic Management suite and lead developer for BMC's PATROL

DB database management products. He was a also a member of an elite product development group which

created new products incorporating advanced technologies, such as automated network configuration

management, statistical analysis and data mining.

Torsten graduated from Middlebury College where he studied Economics and Computer Science. He currently

lives in Austin, TX where he is an avid outdoorsman and enjoys fishing, wakeboarding, wakesurfing, and cycling.

About Acorn Systems

Acorn is the leading provider of profit improvement solutions for growing revenues profitably, reducing costs, and

improving operational efficiencies. Over the past 12 years, Acorn has delivered profit improvement results for

Global 2000 companies in the Financial Services, Retail, Consumer Products, Manufacturing, Distribution, Logistics

and Services sectors. Utilizing a trademarked technology and proven methodology, Acorn reveals profit

opportunities across the enterprise, including customers, channels, segments, products, vendors, and processes.

Acorn's unique approach enables clients to make continuous, fact-based decisions to improve their bottom line

and Earnings per Share (EPS), yielding over $5 billion in profit improvements and creating billions in new

shareholder value. For more information visit www.acornsys.com, email sales@acorn.com, or call 1.800.982.2676

i Kiewell and Roegner, “The CFO Guide to Better Pricing”, McKinsey on Finance, Autumn 2002