Lifecycle Pricing for Service Parts

Lifecycle pricing for service parts Ways to stay on top of the market and ahead of competitors through innovative pricing strategies Lifecycle Pricing for Service Parts 3 Executive summary Calculating the most appropriate pricing for after-market service parts is a substantially different process from establishing prices for core products. For starters, there's the sheer magnitude of the task. Depending on your industry, tens or even hundreds of thousands of unique stock keeping units (SKUs) must be actively managed at any given time. Each part has its own cost structure and mean time to failure, and many are bundled with services rather than sold independently, thus increasing the complexity of the pricing process. Plus, although parts frequently make high-margin contributions to your bottom line, the business units responsible for them are typically resource-constrained, and pricing often comes as an afterthought. Those are just the internal challenges. Companies also face considerable external pressures, including competi- tion from third-party parts manufacturers and the fact that that customer needs—and thus market demand— varies considerably throughout the parts lifecycle. In this article, we'll discuss the complexities of parts pricing and ways manufacturers have traditionally managed the process. We'll then present the basic components of an effective lifecycle pricing strategy. Finally, we'll make forward-looking recommendations on ways to enact more effective pricing strategies that can help boost revenues over the entire lifecycle of your service parts. 4Traditional challenges of implementing lifecycle pricing Lifecycle pricing involves looking at the entire lifecycle of a service part to determine the most appropriate price to charge at each stage from product introduction through retirement. But while lifecycle pricing has the potential to substantially increase the profitability of your parts business, the sheer mass of data involved, the lack of maturity of supporting technology, the lack of visibility into market and competitive prices, and organizational challenges have previously prevented most companies from wholeheartedly embracing this strategy. Among other challenges you must take into account when considering lifecycle pricing: Large number of SKUs. Manufacturers must address two key issues: how to effectively manage the enormous volume of SKUs in the market—most of which must be kept available long after the core product has been retired—and whether it makes economic sense to price all parts using a lifecycle strategy. Frequent lifecycle events. Parts can move very swiftly through their lifecycle. Manufacturers must be able to define and capture the triggers for various lifecycle events—including warranty expirations, sales of core products into secondary markets, and the entry and exit of competitors—before they can put the requisite processes and systems in place. Only then can they track sales volume and manage margins as parts progress through their various lifestyle stages. Lifecycle pricing can help balance cost and price. Dynamic segmentation triggers. Finally, there's the all-important task of accurately segmenting the market given that customer needs change throughout the product lifecycle, thus forcing continuous redefinition of customer and market segments. Despite these and other challenges, lifecycle pricing is now not only possible, but a key competitive differ- entiator. To begin with, critical drivers for improving existing pricing strategies have changed. For example, after-market parts are increasingly viewed as an important source of revenue that can either help manufacturers better manage the cyclical nature of core product sales or sabotage overall profit margins. There’s also a growing need to understand two things better: internal cost and pricing activities, and external market dynamics. Finally, technology is now mature enough to help you manage the vast amounts of data required to carry out a lifecycle pricing strategy. Many companies have ERP or similar systems that contain the data required to design and monitor an excellent pricing strategy. Newer software tools, with greater analytical capabilities for everyday users, are becoming available as well. While these capabilities are novel now, they’ll soon become standard among the better companies in every industry. Technology is now mature enough to help you manage the vast amounts of data required to carry out a lifecycle pricing strategy. • Suply chain / inventory costs • Regulatory requirements • Supplier limitations / restrictions • Contractual requirements • Raw material fluctuations Cost Price • Dealer / Distributor economics • Warranty prices • Margin expectations and requirements • Impact on core product lifetime costs • Competitive replace- ments (imported knock-off parts) Lifecycle Pricing for Service Parts 5 Possible parts pricing strategies Depending on how a manufacturer currently sets pricing, it can reap additional revenues—and increase its profit margins—by progressing upward through the price maturity model (see Figure 1). The stakes for doing this are high: even if a company currently makes the right pricing decision 90% of the time, an additional 2% improvement in pricing accuracy can add millions of dollars to the bottom line. The level of maturity of a manufacturer's current pricing strategy should drive investment in additional pricing strategies. Cost-plus pricing. Currently the most widely practiced strategy, this involves taking the cost of a part and marking it up to achieve a desired margin. But cost-plus pricing can result in missed opportunities. First, it can be difficult to capture all the relevant costs associated with making/acquiring, selling, and distributing a part. Secondly, this pricing model causes manufacturers who effectively negotiate better prices with suppliers to pass those cost advantages on to customers rather than leveraging the savings to improve their own profit margins. Finally, your customers are immediately and directly affected every time your suppliers raise prices, which can make your own pricing appear arbitrary, volatile, and driven by market whims. Competitive pricing. A more sophisticated pricing strategy involves actively monitoring competitors' prices and adjusting yours accordingly. This approach can work very well in some conditions as it keeps your pricing in line with the market and prevents lost revenue due to prices set either too low or too high. Point-of-sale pricing. Point-of-sale (POS) data that details channel partner transactions with end customers is increasingly available. This can help you analyze how revenues and margins are distributed throughout the value chain, and provides you with valuable information on the competitive landscape, including market share, customer loyalty, and price sensitivity. Lifecycle pricing. This "Holy Grail" of service parts pricing involves performing a detailed analysis of product and customer segments and using all the above pricing strategies at different points of time as appro- priate. Additionally, by managing large disparate sets of data while institutionalizing disciplined organizational processes, you can sustain the most appropriate pricing over time. Figure 1: Pricing Maturity Model Low High Pr ofi t i m pa ct HighCost to implementLow • Pricing based upon predicted market conditions; internal and external feedback • Sophisticated ABC • Total value chain included in price Preemptive Sample identifying Characteristics • Context-drive pricing • Prices composed of multiple factors • Effective traditional costig • Moderately strong marketing and price analysis Adaptive • List-based pricing based upon perceived market conditions • Moderately sophisticated approach to costingReactive • Cost-based pricing • Rarely price sales-oriented services • Limited understanding of cost and cost drivers (no activity-based costing) Primitive 6Key components of lifecycle pricing The drivers for more effective pricing strategies, coupled with the increased availability of supporting technology, are causing more and more manufacturers to turn to lifecycle pricing. There are four key components you need to address to effectively implement it: segmenta- tion, competitive alignment, data, and process. Segmentation Segmentation is the process of dividing a market into different categories, or segments, each of which has distinct needs or ways of behaving. By identifying these segments, and creating specific pricing plans to satisfy the needs and/or expectations of the customers in each one, manufacturers can begin to formulate strategies for getting the most revenue (“value”) through the lifecycle pricing of selected parts. Segmentation is the heart of an effective lifecycle pricing strategy. However, it's important to remember that although you can segment a market any number of ways—by product attribute, geography, or customer demographics, among other things—manufacturers need to view segmentation from a customer-needs perspective. This can be accomplished through conjoint analysis, interviews, surveys, or online tools, and can be useful at illuminating the ways customers view parts over the course of their lifecycles. It can also challenge your assumptions about how to best approach the market. Segmentation should be implemented in three distinct steps. Step 1: Identify which parts should be lifecycle priced. To prioritize resources, it’s first important to determine which parts to price using a lifecycle pricing strategy. As a starting point, you could determine the relative degree of differentiation and sales volume of various parts (see Figure 2). In this specific example, it makes little sense to lifecycle price proprietary low- volume products. Neither does it pay to lifecycle price high-volume, off-the-shelf parts. However, parts that fall into other boxes of the matrix will probably benefit from lifecycle pricing. Segmentation Step 1 - Not all parts need to be lifecycle priced • To prioritize resources, it is first important to determine which parts do we need to life cycle price? • The matrix below is a potential starting point for further segmentation. Not all parts need to be lifecycle priced. Low Volume Captive Low Volume Captive Low Volume Captive Life cycle Pricing Life cycle Pricing Life cycle Pricing Commodity Pricing Life cycle Pricing Life cycle Pricing Figure 2: Selective Lifecycle Pricing Lo w H ig h M ed iu m Pr od uc t D iff er en ti at io n Product Replacement Rate Note: These are thought starters and potential approaches. This is not based on actual data. HighMediumLow Lifecycle Pricing for Service Parts 7 Step 2: Determine which lifecycle events should trigger segment and pricing changes. There’s any number of lifecycle events that should cause you to re-evaluate your segments and pricing strategies. These include, but are not limited to, the end of the core product's warranty period; the point at which competi- tion may enter the market; and the point where compe- tition may exit the market (see Figure 3). All these events must be tracked closely at the part level over the entire lifecycle of the part. Segmentation Step 2 - What are various life cycle events that should trigger changes in segments and pricing strategies Different life cycle events and pricing triggers should be tracked closely at a Product level, such as: • End of warranty period • Competition enters • Competition exits Different lifecycle events and pricing triggers should be tracked closely at the product level. Figure 3: Lifecycle Events that Trigger Segment and Pricing Changes 0 12 141082 64 Business Strategy Market Impact Pricing Power Price Structure Price Level Age Sa le s ($ m ill io n) Note: These are thought starters and potential approaches. This is not based on actual data. Manage warranty costs Competitive Pricing. Margins vs Volume tradeoffs Competitions enters Competitions begins to exit Captive pricing. Higher margins Standard Product Lifecycle High servicing and inventory costs. Manage costs to optimize margins 8Step 3: Take into account other key segmentation guidelines. Once you’ve decided which parts are to be lifecycle priced and what events should trigger adjust- ments to your segments and pricing, there are a number of other guidelines that can help you effectively segment your parts business. • Perform a multidimensional analysis of parts to further identify segments. This involves looking at the degree of differentiation, the value proposition— including product availability and quality—replace- ment rates, market share, purchase loyalty, and price sensitivity across the lifecycle of each product. • Segment on an iterative basis. By building a history of transactions for a particular segment or sub- segment, you can gain insight that can be applied to other segments and sub-segments in a cost-efficient manner. • Don't over-segment. Once you realize the power of segmentation, resist the temptation to use the vast amounts of data available—demographic, geographic, or economic—to create too many segments. Keep in mind that too much information can muddy the picture. Instead, gain a clear understanding of your customers' needs, and then layer the various stages of the product lifecycle on top of that rather than getting bogged down in the details. • Focus your attention. Typically, manufacturers follow a 90/10 rule with service parts, where 10 percent of products drive the majority of revenues, and therefore get the most pricing attention. Yet precisely because these parts are so visible, you’re almost instantane- ously aware if a competitor enters the market, or if sales begin to drop off, and can take appropriate action. Segmentation is especially helpful with the other 90 percent of parts, as it provides you with greater clarity on what prices to apply to them at different points in their lifecycles. Competitive Alignment Analyses of prices on competitive products are not widely used to set parts prices today. Yet without considering what other manufacturers are charging for their products, you could lose a lot of money. A major challenge is that third-party manufacturers are always looking for opportunities to make money off of parts with high profit margins that are relatively easy to reproduce. And, while you have an entire portfolio of tens or even hundreds of thousands of SKUs to manage, competitors can cherry pick the ones with the greatest revenue potential. The fragmentation of distribution channels, lack of knowledge about when other businesses enter and exit the market, and the prices they charge based on lifecycle considerations increase the complexity of battling competition. And competitors can also focus on other value propositions than price, such as quick turnaround time for delivering specified parts There are four basic steps to address competitive alignment. Step 1: Perform research. First, determine the lifecycle stages at which competition exists. This data must be collected on a frequent basis so you can benchmark prices as related to the competition, track competitors' response to your pricing changes, and monitor pricing— both yours and your competitors'—throughout the parts lifecycle. Step 2: Set pricing. You then have to reposition your price relative to the market. This includes monitoring the price of a part throughout its lifecycle. However if you’re a premium brand with high customer loyalty, you might not necessarily always want to reduce your prices to meet those of competitors'. Step 3: Renegotiate costs. Depending on what your competitive analyses tell you, you may need to rene- gotiate costs with your supplier if you hope to make a reasonable profit on your parts. Step 4: Test your prices. Perform a pilot test to determine if your new prices are working. Track market reaction over time and modify as necessary. Lifecycle Pricing for Service Parts 9 Data Fundamental to a lifecycle pricing strategy is the data behind it. This includes product information across a number of dimensions at the transaction level, and includes all costs incurred at the point in the lifecycle in which the transaction occurred. You face a number of challenges related to managing the volume and complexity of the data you will collect. After all, data typically resides in multiple disparate systems within the organization, as well as in third-party systems. Additionally, you must collect data at both the SKU and transaction level along a multitude of param- eters, including price, cost, product replacement rates, inventory, POS, and pricing. As some parts are involved in as many as 25 million transactions per year, the costs of collecting, validating, and cleansing this data is high. Historically, this has been accomplished by tracking a part or group of parts over the course of a year to analyze pricing behavior throughout the entire lifecycle. But this raises significant technological challenges. A spreadsheet can only accommodate so many rows, and a basic database can handle only a few million trans- actions at most. Consequently, because service parts transactions routinely involve at least 10 million transac- tions, you’ll typically need enterprise-level technologies such as SQL, Oracle, SAP, and/or custom-built software to attempt to process all the data. An innovative—and much cheaper—way of coping with this is to take a single month's worth of data for a particular part and decompose it into different stages to piece together a picture of the entire lifecycle. This allows you, through modeling, to create multiple predictive scenarios, and has the advantage of involving current data that reflects the present economic situation as opposed to going back to a previous point in time. Processes The final component of an effective service parts lifecycle pricing strategy involves institutionalizing all actions taken thus far. Indeed, ultimately all the other lifecycle pricing components become aspects of process. There are three basic steps for creating processes that are both sustainable and repeatable: Step 1: Perform a current state assessment. Your first move should be to perform a current state assessment, during which you establish how you presently price service parts. Some of the questions to be answered during the current state assessment include: • What’s the current process you use to set pricing? • What sort of data do you use to price products? • How do you collect all relevant data and translate it into product pricing? • Where do you stand competitively in the marketplace? • Which original equipment manufacturers (OEMs) are best at satisfying customer requirements? • What do they do that you don't? • Do you let your channel partners make enough profit? • Are there opportunities to bundle products together to achieve higher margins? Step 2: Identify gaps. Once the current state assess- ment is completed, you can identify gaps between the way you currently do things and other more effective practices that support lifecycle pricing. Step 3: Design the process. This involves doing everything from specifying how data will be collected and compiled, to putting a framework in place to iteratively segment the market, to involving stake- holders in key decisions and determining ownership and responsibility for various aspects of the pricing process. Inevitably, you’ll need to invest in additional systems and supporting technologies in order to manage resources better, and change your organization so that effective pricing strategies are easier to execute. 10 Conclusion: Delivering impressive returns on investment Although it’s a big change from the way most manufac- turers handle parts pricing, lifecycle pricing can deliver impressive results. From our experience, the ROI of performing a transactional pricing analysis alone—which identifies those areas where a price is set incorrectly based on current market conditions—can be as much as seven times the return in margin for the upfront analytical investment. We have seen typical improvements from employing the above approach and tactics to lifecycle pricing improve the realized revenue for a part by 2% to 5%; which can have dramatic impact where it counts the most – at the bottom line. Following the steps outlined here, can help your firm transform its parts pricing strategy from a less-than-exact science to one that establishes a dependable financial annuity. Lifecycle pricing of service parts can help you increase revenues, balance unpredictable downturns in sales, and become a key competitive differentiator over the long term. Alice Wachol Principal Deloitte Consulting LLP Tel: +1 313 324 1355 [email protected] Manish Prabhu Senior Manager Deloitte Consulting LLP Tel: +1 312 486 4843 [email protected] Lifecycle Pricing for Service Parts 11 Deloitte’s Service Effectiveness Dimensions The right product at the right place at the right time at the right price. Deloitte works with the world’s leading aftermarket organizations and solution providers to help our clients get these three factors in sync. 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