ROLAND BERGER PRICING EXCELLENCE: How to become a profit champion by optimizing sales management

Regular version - English ROLAND BERGER PRICING EXCELLENCE: How to become a profit champion by optimizing sales management Skills profile for the Marketing & Sales Competence Center Ingmar P. Brunken Düsseldorf, July 2006 MUC-90006-043-09-01-G.ppt 1

There are six reasons why price management is a major challenge for most markets today > Market saturation and overcapacity > Strong price awareness through transparent knowledge of competitors' prices and product quality > Increasing concentration of buyer power (but with decreasing willingness to pay) > Increased competition due to deregulation and internationalization of markets (globalization) > Growing significance of services and secondary products (e.g. replacement parts) for profit and market success, although these are often neglected in pricing and in communication > Decreasing effects of managing systems (oversaturation from ads, flat discounts, etc.) PRICE MANAGEMENT OFFERS SIGNIFICANT POTENTIAL FOR IMPROVEMENT MUC-90006-043-09-01-G.ppt 2

Pricing excellence starts with the profit formula. But if that statement is as trivial as its seems Top-line growth = sales management Profit max. =! price X volume costs > Optimizing sales is more difficult than optimizing costs, because two variables have to be optimized simultaneously > Price determines volume, but what determines the price? MUC-90006-043-09-01-G.ppt 3

why do so few companies use this "trivial" formula? Why do most decision-makers feel poorly informed? PERCENTAGE OF RESPONDENTS WHO BELIEVE THEY ARE WELL-INFORMED ON PERCENTAGE WHO FELT DECISION-MAKING PRESSURE WITH REGARD TO Variable costs Fixed costs Competitive prices Customer product benefits Customer reaction to price changes Learning curve effects Willingness to pay 21% 34% 29% 84% 81% 75% 61% Advertisement After sales Distribution Internal staff/training Market maturity New competitors Product quality/guarantee Sales costs Price (service) Price (B2B goods) Price (B2C goods) 2.5 2.75 3 3.1 3.2 3.4 3.5 3.5 4.1 4.5 4.2 1 = Very low pressure 5 = Very pressure Source: Market survey, published in "Power Pricing" (Campus) MUC-90006-043-09-01-G.ppt 4

Answer: Pricing is subjective, not objective, which complicates mathematical optimizing "Top-line growth" = sales management Profit max. =! price X volume costs Price is a very subtle variable. The price does not affect volume (= sales) objectively. Instead, the impact on volume depends on the following four most important variables: > Subjective price perception by customers (benefits, competition) > Subjective willingness to pay of each customer (demand) > Communication of prices (relative positioning, timing, setting, etc.) > Modeling of prices (bundling, non-linear models, etc.) Price optimizing is impossible without an awareness of subjective price perception: PRICING EXCELLENCE! MUC-90006-043-09-01-G.ppt 5

Since pricing is often based on the "cost-plus" or competitor principles, profit potential remains untapped 1 Often a lack of clarity about > Actual willingness to pay for products trust in past experience, levels 1 and 2 > Structural relationships > Necessary information 2 Too little time, too few resources > Relation to impact on profit > No intelligent customer monitoring > No well-researched surveys of willingness to pay, no use of intelligent pricing models PROFITS ARE LOST DUE TO SUBOPTIMAL PRICING 3 Unwritten rules and intuition used for want of a better method > "Cost-plus" pricing > Adapting to competition > Short-term rather than strategic view > "You can only survive on the market by cutting prices" MUC-90006-043-09-01-G.ppt 6

We have developed a systematic process for optimizing prices and revenue: the Roland Berger Pricing Process Roland Berger Pricing Process and industry-specific levers PRICING STRATEGY PRICING ORGANIZATION PRICE SETTING PRICING IMPLEMENTATION 1 2 3 4 1.1 Define a clear target system 1.2 Ensure clear market/brand position relative to the competition 1.3 Decide on an effective price timing strategy (not too late/early) 1.4 Communicate prices appropriately and consistently (brand, signaling) 1.5 Assess strengths and weaknesses internally and externally 1.6 Design a consistent incentive system that truly motivates people 5.1 Reduce complexity and speed up pricing process 5.2 Increase speed of pricing process 5.3 Create flexibility in pricing process 5 2.1 Align price with customers' willingness to pay 2.2 Create a consistent price structure (across regions, customers, channels, bundles, etc.) 2.3 Introduce intelligent pricing models for differentiation (e.g. non-linear pricing) 2.4 Understand (internal/external) customer purchasing criteria 2.5 Educate/train employees to determine optimal prices 2.6 Design international pricing 2.7 Bundle products 5.4 Include balanced customer orientation in pricing process 5.5 Define basic features and distribute competencies for pricing 3.1 Develop a strict system of prices and terms 3.2 Avoid price erosion (e.g. by regularly monitoring promotions, cash discounts, targets, etc.) 3.3 Avoid free services 3.4 Make prices opaque and find ways to stand out from the (national/ international) competition 3.5 Organize customers/regions without overlaps and establish clear price competencies 3.6 Support price positions through excellent secondary processes (e.g. logistics, claims processing, etc.) 3.7 Institute an annual review process 3.8 Develop guidelines for processing orders and logistics INFORMATION MONITORING 4.1 Standardize databases between neighboring areas (e.g. regions, departments) 4.2 Leverage internal experience systematically (benchmarking, best practices) 4.3 Apply knowledge of external best practices 4.4 Manage offer and market complexity using a suitable sales information system 4.5 Be aware of how extra services affect costs (e.g. packaging, logistics, commissioning, special orders, small-volume purchases, etc.) Start MUC-90006-043-09-01-G.ppt 7

All aspects of cost, competition and willingness to pay are taken into account in the Roland Berger Pricing Process analysis General method of analysis 1 2 Initial offer/ list price Real price Pricing structure Discounts Rebates Commissions Benefits etc. 3 Price erosion Margin Cost inflation 4 Real unit + Free hotline cost + Special services + Good will, etc. Standard unit cost 1 2 3 Minimize loss of willingness to pay Optimize price components/models Minimize price erosion visà-vis competitors Unit price Margin Unit cost 4 Reduce free additional offers (cost inflation) Market pressure Residual margin MUC-90006-043-09-01-G.ppt 8

PRACTICAL EXAMPLE 1.1 OPTIMIZING A PRICE LEVEL A customer survey identifies customers' willingness to pay. Indirect methods 1) verify validity Step 1: Identify willingness to pay i.e. the number of customers who would buy in a given price bracket Percentage of customers 60.0% 50.0% The mean amount that customers are willing to pay is EUR 25 40.0% 30.0% 20.0% 10.0% EUR 25 0.0% n = 76 up to 20 over 20 to 40 over 40 to 60 over 60 to 80 over 80 1) Indirect method: No direct questions are asked about prices. Instead, selection methods (such as the conjoint measurement method) or by estimating corridors (e.g. using the Roland Berger method). Acceptable price brackets [EUR] MUC-90006-043-09-01-G.ppt 9

PRACTICAL EXAMPLE 1.1 OPTIMIZING A PRICE LEVEL When we include the profit function, we see that the mean value is (usually) not the optimal price Step 3: Calculating the profit function Volume/profit 50 46.1 OPTIMAL PRICE The mean value is not the optimal price 40 30 20 Mean value 35.0 Profit 21.6 Volume The optimal price is derived from volume expectations as a function of price This complex but extremely important calculation can be performed for any product 10 0 10 20 30 40 50 60 Price [EUR] MUC-90006-043-09-01-G.ppt 10

PRACTICAL EXAMPLE 1.1 OPTIMIZING A PRICE LEVEL This is the theory you will find in textbooks and hear from price theorists. However, if this were true in reality... Volume/profit 50 46.1 OPTIMAL PRICE Theory: 40 30 35.0 Profit 21.6 The price/volume function is a straight line, or at least a continuous curve Price/volume changes occur continuously along this curve 20 Mean value Volume The profit function therefore has only one optimal price 10 0 10 20 30 40 50 60 Price [EUR] MUC-90006-043-09-01-G.ppt 11

PRACTICAL EXAMPLE 1.1 OPTIMIZING A PRICE LEVEL then every salesperson could find the profit-maximizing price in two easy steps: 1) Set the direction; and 2) Vary the price! Determining the profit-maximizing price (according to the theory) Volume/profit 50 40 30 20 OPTIMAL PRICE 46.1 1 Initial price 2 Profit 35.0 21.6 Volume 10 0 10 20 30 40 50 60 Price [EUR] Theory: 1 Vary the price: See what happens to profits if you cut the price, for example 2 Identify the direction toward the optimal price (a price increase in this case) and take the necessary action until that price is reached MUC-90006-043-09-01-G.ppt 12

PRACTICAL EXAMPLE 1.1 OPTIMIZING A PRICE LEVEL Roland Berger has developed a unique, proven method to drill the PRF down to the level of the individual customer Comparison of workable methods to determine the price/volume function Method ROLAND BERGER METHOD CONJOINT MEASUREMENT EXPERT WORKSHOPS Benefit > Fast: Only 4 indirect questions on pricing per respondent > Efficient, effective, transparent, precise, reliable > Can reveal customers' willingness to pay for individual product properties > Extremely fast and simple > Quantitative visualization of existing market knowledge Drawback > Conjoint measurement is better suited to breaking product properties down into individual price components > Highly complex "black box", difficult for customers to grasp, vulnerable to errors > Often too theoretical > Very inaccurate, hard to distinguish between correct and incorrect statements Outcome Usage > Exclusively by Roland Berger (in-house development) > Widespread, although practical application often plays a subsidiary role to mathematics > Widespread; Roland Berger recommends this method as a first step only MUC-90006-043-09-01-G.ppt 13

PRACTICAL EXAMPLE 1.1 OPTIMIZING A PRICE LEVEL Unfortunately, the reality is more complex: The PRF curve is not constant, so jumps and spikes create the illusion of optimal prices Real-world example, steps 2 and 3: Identifying the PRF and the profit function Profit [EUR '000] "Cheap" "Expensive" "Too expensive" No. of buyers 200 180 160 140 120 100 80 60 40 20 0 Real PRF calculated by RBSC 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 = Localized optimum (example) Profit [EUR] 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 > The optimal price is EUR 29. At this price, 32,102 buyers and profits of EUR 186,192 can be expected > The volume-maximizing price of EUR 20 should net 40,127 buyers and profits of EUR 160,511 LESSONS LEARNED 1) The volume-maximizing and profitmaximizing prices are different 2) There are a number of "optimal prices" at which small price changes will drive profits down. There is only one optimal price that maximizes profits MUC-90006-043-09-01-G.ppt 14

PRACTICAL EXAMPLE 1.1 OPTIMIZING A PRICE LEVEL Jumps in the PRF caused by psychological barriers (e.g. EUR 9, 19 or 29 etc.) give the profit function a saw tooth curve... Real-world example, steps 2 and 3: Identifying the PRF and the profit function Profit [EUR '000] "Cheap" "Expensive" "Too expensive" No. of buyers 200 180 160 140 120 100 80 60 40 20 Real PRF calculated by RBSC Profit [EUR] 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 This supposedly "optimal" price could, for example, be improved by 16.25% 0 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 0 = Localized optimum (example) MUC-90006-043-09-01-G.ppt 15

PRACTICAL EXAMPLE 1.1 OPTIMIZING A PRICE LEVEL and the spikes give the (misleading) impression that a localized optimum is in fact a global optimum Real-world example, steps 2 and 3: Identifying the PRF and the profit function Profit [EUR '000] "Cheap" "Expensive" "Too expensive" No. of buyers 200 180 160 140 120 100 80 60 40 20 Real PRF calculated by RBSC Profit [EUR] 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 This supposedly "optimal" price could, for example, be improved by 25.6% This example also shows that the profit-maximizing price may in fact be lower than the current price 0 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 0 = Localized optimum (example) MUC-90006-043-09-01-G.ppt 16

PRACTICAL EXAMPLE 1.1 OPTIMIZING A PRICE LEVEL DETERMINING THE PRICE LEVEL FOR A NEW PRODUCT LAUNCH (BOOK) Compared to conjoint measurement only, the Roland Berger method taps 11% more profits Example: Using the Roland Berger method in practice Method Outcome CONJOINT MEASUREMENT ONLY ROLAND BERGER METHOD Lessons learned > Optimal price: EUR 23.50; maximum profit: EUR 168,000 > Optimal price was over 20% too low! > Profit-maximizing price was over 11% too low! > Optimal price: EUR 29.00; maximum profit: EUR 186,192 > 11% more profits than if the conjoint method had been used in isolation MUC-90006-043-09-01-G.ppt 17

PRACTICAL EXAMPLE 1.1 OPTIMIZING A PRICE LEVEL SERVICE PRICE COMPONENTS The conjoint method has its uses too, though. Adjusting service price components sharply increased profits Example: Using conjoint measurement in practice INITIAL SITUATION STRATEGY OUTCOMES Share of price Response time Repairs Replacement parts Share of value Availability Availability Response time Repairs Replacement parts Share of price Availability Response time = New = Old Repairs Repl. parts Base price > Service prices were calculated based on cost components > Repair work and replacement parts incurred more costs than availability and response times and were therefore more expensive Base price > Analysis of customers' preferences using the RB method found that, for fear of prolonged idle times, customers valued availability and response times more ly and were willing to pay a er price Base price > Offer structures were adapted to customers' value perceptions > Revenue and profits increased substantially > Sales volumes dipped slightly > RB method validated conjoint outcomes (reality check) > Profits rose by EUR 1,077,000 p.a. MUC-90006-043-09-01-G.ppt 18

PRACTICAL EXAMPLE: QUANTIFYING PROFIT GROWTH The full impact of the Pricing Excellence Process on profits is only seen when all actions are added together. +3% ROS is not unusual Actions in 10 areas Remarks Impact (% of ROS p.a.) Profit growth (EUR '000 p.a.) Create rules and guidelines for consistent pricing (volume utilization A.1 Strategic pricing framework 0.61 1,423 versus margins) A.2 Price signaling Implement signal actions by defining suitable content, media and timing 0.20 459 A.3 Market behavior Define strategic framework for market behavior Impact calculated together with A.2 B.1 Data harmonization Create the necessary data and data structure for successful pricing 0.39 918 Understand customer's value perception (by conducting conjoint B.2 Customer value perception 1.46 3,443 measurement interviews) C.1 Price differentiation Implement systematic price differentiation Impact calculated together with B.2 C.2 Discount system Revise the discount system (cash discounts, rebates) 0.38 895 D Management support system E.1 Process and decision structure E.2 Incentive system for profit and pricing Implement a comprehensive, easy-to-use information system (Pricing Pilot, market simulation tool, etc.) Create the organizational conditions for successful pricing focused on end customers Create the organizational conditions for successful pricing focused on end customers Project payback = 1 month! Impact calculated together with C.2 0.08 0.29 +3.41% 200* 689 EUR 8.03 m Source: Roland Berger Strategy Consultants, Pricing Excellence Group MUC-90006-043-09-01-G.ppt 19

Bottom line: Checklist to assess the quality of a price optimizing exercise > A survey of experts should only be the first step in identifying upside price potential > Where it is necessary to calculate individual price components, the conjoint measurement method should be used. At the same time, it is important never to use the ACA (adaptive conjoint analysis) variant, because this method does not includes a "no-buy" option and artificially inflates customers' supposed willingness to pay. One respected pricing consultant still uses the ACA method and then "corrects" the findings by applying an "epsilon factor" defined at random by a project manager not exactly a reliable method! to validate the outcomes of the conjoint method by applying a second method > Whatever the case, the method used to calculate the price/volume function must be able to display spikes and jumps in the function curve. Straight lines, smooth curves and single bends represent theoretical values only and do not occur in practice > The method is only tool to achieve the target. Basis for achieving this target however is to ask the right questions (fields of profit potential) and to derive the right conclusions and actions from the answers and to implement these actions with a secure buy-in approach within the organization MUC-90006-043-09-01-G.ppt 20

The five greatest threats to any pricing project THE THREAT OF FAILURE because the wrong questions are asked the wrong methods are used the wrong conclusions are drawn the wrong actions are taken defined actions encounter resistance from within the organization and buy-in is not secured ("Optimize our prices? What do you mean? What have we been doing wrong up to now?") MUC-90006-043-09-01-G.ppt 21

and Roland Berger's five specific responses > The threat of failure because the wrong questions are asked A systematic pricing process guarantees that the right questions will be identified > The threat of failure because the wrong methods are used The RB method validates conjoint outcomes while also enabling realistic price/volume functions to be calculated > The threat of failure because the wrong conclusions are drawn The validity of conclusions can be validated by reference to the Roland Berger case library (crosscomparisons, benchmarking) > The threat of failure because the wrong actions are taken Defined actions are piloted before being applied to the whole organization > The threat of failure because actions encounter resistance from within the organization and buy-in is not secured ("Optimize our prices? What do you mean? What have we been doing wrong up to now?") Actions are not defined in isolation from or against the will of the organization. On the contrary, the organization is involved in the entire process. The organization must give its full backing to actions before they are approved MUC-90006-043-09-01-G.ppt 22

BEFORE THE PRICING PROJECT The experts in almost all companies know that there is potential in pricing. The only difficulty is leveraging it! Selected representative statements from an interview round on identifying sales and price potentials (phase 1) "In the last few years we became price followers instead of the price leaders we used to be, where we were able to set our own prices. There are very aggressive players in the market, and the structures changed to our disadvantage." "Our strategy does not translate into effective price tactics. There is no clear process. It is also partly a problem of insufficient information." "Even though customers may be willing to pay more, it is very difficult to get a certain price premium in the market because the competition is so tough." "We have inconsistent prices, not just in all the different sales levels and channels, but also in between." "Our prices do not reflect any benefit to our customers." Source: Interview results of a pricing project, Phase 1 MUC-90006-043-09-01-G.ppt 23

AFTER THE PRICING PROJECT After the project, participants are convinced of its value and the results are measurably implemented. See below for references Selected representative statements from an interview round after the project was concluded "I was surprised at how many areas we found for improvement. It was also interesting to see that many of these areas intersected and how they could only be optimized in conjunction with one another, for example information gaps and price decisions." "I see now that there was a general information gap, not simply a personal one." "It's great that we can now systematically coordinate interfaces between planning and implementation. These should mean fewer missteps in management." "The results of this project were very impressive. I wouldn't have thought that it would be so successful." "I always felt paralyzed when it came to pricing I thought that I was just a puppet of the market. Now I know that I have opportunities to exert influence." Source: Interview results of a pricing project, feedback round MUC-90006-043-09-01-G.ppt 24

The initial phase delivers an in-depth understanding of the need for change Phase 1 of the pricing excellence project PHASE Goals Core content 1 ASSESSMENT/QUICK WINS > Ensure a common understanding of the target product range, brand positioning and distribution structure > Roughly analyze pricing and the system of prices/terms in order to prioritize improvement levers > Define the ongoing change roadmap and secure the backing of the organization > Pick out and immediately realize quick wins > Analyze past brand performance, future brand strategies and planned actions > Analyze the existing distribution structure, the need for change and the defined actions > Analyze existing pricing methods and the available room to maneuver > Apply a price/terms review tool (including selective customer interviews) to answer specific questions: What terms are in place? What budgets are in place for each customer and SKU? How are customers and SKUs actually performing relative to the budgeted terms? > Prepare a review workshop > Identify main areas for improvement and quick wins Define end-customer prices Pricing/terms system Pricing organization MUC-90006-043-09-01-G.ppt 25

In phase 1, areas of potential are identified and quantified by means of benchmark comparison Diagram of phase 1: assessment Assessment workshop Action 1 2 3 4 Time Decision about how to proceed in phase 2 Lever 1 2 3 4 etc. Profit effect p.a. EUR 234,500 p.a. EUR 89,900 p.a. EUR 788,200 p.a. EUR 412,000 p.a. etc. Pricing assessment matrix Quantification Assessment sheet price process Lever 1 Lever 2 Lever 3 Lever 4 etc. x x x x Evaluation of the price and market situation Profit effect Low High 8 Low 3 14 4 6 FOCUS 1 2 11 Implementation opportunities 12 13 10 7 5 High Discussion and benchmarking of assessment results low P rofit impact low Profit impact low Profit impact low Profit impact low Profit impact low Profit impact low Profit impact low Profit impact low Profit impact low Profit impact 2.4 2.1 2.4 MAX 2.1 2.4 MAX 2.1 Drivers Drivers 2.4 2.1 Drivers HighMAX 2.4 2.1 MAX 2.2 Drivers 2.4 2.1 S 2.2 Drivers MAX Excellence 2.4 3.3 2.1 S 2.7 2.2 2.7 Drivers HighMAX 2.4 2.1 2.6 ET S 2.2 Drivers HighMAX 2.4 3.6 S Potentials 2.1 2.7 2.6 ET S 2.2 Drivers 2.7 2.3 2.6 ET S 2.2 3.1 2.7 2.3 2.6 ET S 2.2 3.9 Potentials 2.3 M 2.6 ET S2.7 2.2 2.3 2.5 M 2.6 ET S 2.7 2.2 2.3 2.5 M 2.6 ET S 2.7 3.8 3.10 M ET 2.7 2.3 2.5 M 3.2 2.6 ET 2.5 M Quick 2.3 No 2.6 ET Go's 2.5 MIN M Quick 2.3 No Go's 2.5 MIN M Quick 2.3 No Go's 2.5 MIN M Quick No Go's Wins Wins 3.5 2.5 MIN M Quick No Go's 2.5 MIN Quick Quick Wins 3.7 3.4 Excellence Drivers low low low low low low low low low Excellence Drivers No No Go's Go's No No Go's Go's No Go's Roland Berger case library MIN MIN MIN Implementability MIN Implementability Implementability MIN Implementability Wins Implementability Implementability Implementability Implementability Implementability High High High Quick Quick Wins Wins Wins Wins l Implementability hi h MAX Source: Roland Berger Strategy Consultants, Pricing Excellence Group MUC-90006-043-09-01-G.ppt 26

After phase 1, the key improvement levers become the focus of attention Phases 2-4 of the pricing excellence project: examples ROS PHASE 2 ANALYSIS/ROUGH STRATEGY 3 DETAILED PLANNING 4 IMPLEMENTATION +3% Define endcustomer price > Survey customers' willingness to pay > Calculate competitor response scenarios > Define pricing models > Define target margin structure > Calculate financial effects > Describe pricing levers in detail > Draft internal and external implementation roadmap > Conduct trial runs (where appropriate) > Talk to customers about implementation > Verify implementation and validate effects Pricing/ terms system > Analysis budget terms in detail > Compare with competitor benchmarks > Define basic principles of pricing/terms system > Define future terms > Quantify possible bottom line effects (scenarios) > Validate legal aspects > Present system to selected customers > Make necessary modifications > Draft an internal implementation roadmap (e.g. for IT and KAMs) > Formulate detailed arguments as a guideline for talks with customers and the external implementation roadmap > Talk to customers about implementation > Verify implementation and validate effects MUC-90006-043-09-01-G.ppt 27

Delivering results! MUC-90006-043-09-01-G.ppt 29