Pricing has always been considered to be one of the more fundamental factors in deciding quality, demand, supply and competition for a product or service. Companies from different industries are increasingly becoming aware of the importance of pricing and as a result pricing is now considered to be a fundamental multi-disciplinary area of corporate management. Nevertheless, several organisations have been slow to embrace pricing as a fundamental part of their corporate activities with the consequence that they have missed out and are still missing out on opportunities to improve their market positioning and their bottom line.
One extremely important tool for companies to identify areas of price erosion is pricing waterfall analysis. The primary goal of a pricing waterfall analysis is to identify and eliminate revenue leakages. The waterfall concept implies that the profitability of an organisation is determined at the transaction level since this is the point where margins are gained or lost. A waterfall analysis can be:
- used to identify and stop price leakages at the transaction level – the lost margin made on every transaction;
- used by pricing analysts to determine revenue leaks of past transactions;
- created for various products, customers and business units.
Managing prices at the transaction level has proved to be very profitable to organisations. A one percent price improvement, for example, usually yields an improvement in operating profit of about twelve percent.
For every transaction, the invoice price is not the real revenue that is eventually received by the seller. Discounts, allowances, rebates, payment terms and the like erode the profit margin. Because some costs, such as sales force costs, value-added service costs and freight costs, at the transaction level usually amount to a few Euros, Dollars, Pounds or cents, these are usually ignored by management. However, these seemingly trivial amounts cannot be ignored and need to be carefully managed since they could possibly amount to thousands if not millions of lost profits in the relevant currency every year. At times, even simple rounding up on single transactions can make a considerable bottom line impact.
A waterfall analysis starts with an examination of the difference between the list price and the pocket price (the actual earnings from every transaction, i.e. the difference between the list price and all costs) at the transaction level. This approach will eventually help the organisation achieve the best price for every transaction by controlling and eradicating price leakages.
A price waterfall visually captures the revenue leakages that occur after setting a price. The main benefits of waterfall analysis include the following:
- visually captures and quantifies the cost elements that are contributing towards revenue leaks in graphical format;
- highlights which cost elements need to be controlled;
- leads to higher profitability through the identification and eventual elimination of profit margin leaks;
- enables better cost control and improves the pricing process;
- enhances price variance analysis since price waterfall analysis enables the breaking down of the various revenue and cost components, thus permitting comparisons between actual and budgeted plans.
The pricing process is as delicate as it is complex, and as much of an art as it is a science. It normally entails the following steps:
- Customer Identification & Profiling
- Package Product Service In Accordance With Socio-Economic & Geographical Profile
- Market Positioning
- Tying, Bundling Strategies & Loss Leaders
- Ascertainment Of Cost Coverage
- Compliance With Pricing Regulation
Only after the process outlined above is completed does Price Waterfall Analysis usually kick in with a view to adding yet another level of optimisation to pricing.
More information on our pricing methodologies is available here.
Equinox Advisory provides support to a wide range of customers from the services, manufacturing and extraction industries to set or improve pricing strategies conducive to profitability improvements. Our pricing methodologies, backed up by years of experience, are geared to set up business processes and pricing systems that can help you improve your profit margins.