Historically, cost has been the main driver in setting prices. A target markup over cost has been the go-to pricing methodology for most manufacturers.
One inconvenient truth is that final pocket price is the result of a series of discounts from cost-plus catalog prices, with discounting policies having little or no controls and varying greatly across customers, markets, products and salespersons. Another inconvenient truth is that cost of production has almost no bearing on a customer’s perception of a product’s value and their willingness to pay for it.
Cost management and cost reduction—and the technology and systems to assist in these efforts—have been the focus of most investment of B2B companies. What is neglected to be seen (or acknowledged) is that of the levers at a company’s disposal to maximize profit, controlling or lowering costs is the least effective. The future of a company, its health, growth and potential lie ultimately in the outcome of the activities of a company’s sales organization in generating and satisfying marketplace demand.
The Problem with Controlling or Lowering Costs
Sales is responsible for generating or harnessing demand to provide revenue to the firm, ideally profitable revenue to sustain and fund growth. Profit is what lies between the revenue and the costs of manufacturing.
PROFIT = Revenue – Costs
In a free market, equilibrium is where demand and supply meet and, ultimately, price is determined. Economic theory suggests this is also the optimal value (i.e., price) for both buyer and seller for a product.
When determined by cost plus a markup, price does not reflect the value of a product to a customer or the market. Although forecasted demand is an input used to inform manufacturing processes, pricing is predominantly determined by internal factors and does not appropriately consider market factors. Most organizations do not collect the data or invest in the technology or talent to synthesize the volume and velocity of data necessary to calculate optimal prices. Instead, sellers allow the discretion and gut of sales teams to determine final price, which typically is done with a short-term focus on revenue and not the value of the firm. And because sales teams are incentivized to generate demand above all else, price is often lowered to increase demand.
The Most Efficient Way to Increase Profit
Repeated research shows that the most efficient way to increase profit is by an improvement in price. Research from Wharton, AMR and all of the big consultancies has proven time and time again that of the three levers to increase profit (increased volume, decreased costs and increased price), a 1% increase in price has the most significant increase on profitability.
Source: AMR Research
Pricing is the most impactful lever to impact profit and to enable companies to execute against many long-term goals. Yet investing in and elevating pricing to be a strategic, competitive advantage of a firm is rare in mid-market B2B companies. Market leaders or large companies have and continue to invest in technology to enable increasingly dynamic, data-driven pricing, while companies with revenue below $1 billion annually remain laggards.