Global markets are facing prolonged periods of deflation, and many B2B company leaders are more closely considering the impact of that market dynamic on pricing and margins, especially as they are faced with increasing pressure from customers to lower prices.
This leads to some very difficult questions, such as: “When do I need to start lowering my prices? How far do I need to go?” “For which customers and products do I need to lower price?” Holding onto price while costs drop can lead to more profits, however, it can be taken too far, leading to losses of customers, revenue and profits.
Whether the cost change is a result of prolonged deflation, occasional spikes in cost increases or decreases, or regular cost swings, it’s critical to have a clear, data-informed strategy during these times rather than leaving decisions completely in the hands of sales and “letting the market tell you” what prices should be.
This article will discuss how advanced data science can provide predictive insights to help answer these tough questions across broad customer and product portfolios.
Analyzing Cost Strategies
Before setting your go-forward strategy to mitigate cost changes with pricing, it’s essential to analyze and understand what history can teach about how customers and product lines have responded to price and cost changes in the past. Meaning, when costs have increased in the past, have prices increased, decreased or remained fixed? What about when costs decreased?
For example, in figure 1.1, a diagnostic of price-cost changes revealed that as costs decreased, prices also declined in response. In this case, the company passed along the savings to its customers.
In figure 1.2, the same diagnostic performance revealed that as prices decreased, prices remained fixed. For this time period, the company held onto the cost savings.
In figure 1.3, it was discovered that as costs decreased, prices increased. Finally, in figure 1.4 prices were declining while costs increased. This is clearly the least optimal scenario as the company was experiencing margin erosion as costs increased, likely not at all what was intended with the price strategy.
So, which of the remaining three figures is ideal? At first glance, it could make sense to look at figure 1.3 as the optimal cost pass-through strategy. After all, the company is gaining margin as costs decrease, but how would customers respond to increased prices in a low-cost market? A few micro-segments might not be sensitive to these increases, but some might be highly sensitive and respond in kind by taking their business to a competitor.
In figure 1.1, margins are remaining steady, with price declines following declines in cost. Would this approach have the desired effect of holding volume steady? Perhaps, but an unintended consequence of this strategy is that a significant amount of money is likely being left on the table with customers that aren’t as sensitive to price, meaning it wasn’t necessary to pass along those cost savings.
Finding the best strategy can vary greatly from company to company depending on how volatile costs are, whether or not the company is selling commodity-based products rather than non-commodities, vertical industry dynamics, and customer price sensitivity. In reality, the smartest strategy for responding to changing cost conditions will be quite diverse within one company, with discrete micro segments each having their own optimal strategy.
Passing Cost Changes on to Customer: When, Where and By How Much?
After a thoughtful diagnostic, there are a few key considerations to roll into the strategy. First, companies should consider if the cost increase or decrease is isolated to their organization, or if it’s industry-wide. Their strategy is likely to vary if the company and its competitors are all experiencing the same cost swing, versus if they are experiencing it alone.
Most industry-wide cost swings are tied to commodity prices, and in those cases, customers are likely to anticipate a price adjustment as a result. For example in the oil and gas or metals industries, customers have high visibility into cost decreases and are expecting cost savings to be passed along.
If it does make sense to adjust prices as a result of cost volatility, next consider the amount, or the “how much?” part of the equation. Here company leadership should determine if the percent of cost pass-through should be large or small. In some cases they may want to pass through 100 percent of the cost increase or savings to customers. In others, it may make sense to pass through a smaller percentage to some customers.
Next is the timing, answering the question “when should price be adjusted in response to a cost change?” Or, “when should the price change with respect to the effective date of the cost change?” (Date of the cost change is defined as the actual date at which new costs will be experienced by the seller.) It could be before the change, for example, effective date minus 90 days, to begin selling existing inventory at higher prices to provide extra cover of the upcoming cost increases. In some cases, it could make sense to wait until after the date of the cost change, perhaps with some fairly long lag times.
Finally, knowing where to pass along costs is critical. As noted above, an across-the-board price change in response to cost won’t suffice. It’s well known that price segmentation is the key to capturing the maximum margin-dollars available to a company in the marketplace. And the basic equation is pretty straightforward: The more price segments a company can scientifically identify, measure the sensitivity of, and make operational, the more margin that company can capture through differentiated pricing.
Consider, for example, a large distributor with thousands of products and customers and millions of transactions. How many price segments could exist in its market? Hundreds? Thousands? The answer is that this type of market actually contains tens-of-thousands of discrete pricing segments – each with a different price sensitivity. Once sales reps have visibility into each segment’s relative sensitivity they can discern that it may not be necessary to reduce prices as costs decline in low sensitivity segments of their business. Yet it may be essential that in high sensitivity segments companies pass along those cost savings in order to maintain volume and wallet share. A smart and effective pricing strategy should not only address the “how much” and “when” parts of the equation, but also the “where” across these discrete micro segments.
Experts and Equations Lead to Smarter Strategies to Mitigate Cost Volatility
Setting the optimal pricing strategy for each unique business, and discrete micro segments within that business, requires the input of in-house experts. In an approach called “experts plus equations,” industrial B2B companies are empowered to take a smarter, more scientific approach to understanding and setting pricing strategies that mitigate cost volatility. Certainly, getting to this level of granularity and applying discrete cost strategies isn’t possible with in-house analysis, but it is possible with advanced pricing optimization.
First, pricing scientists can provide visibility into the price-cost relationship with a historical cost analysis, revealing unprecedented insight into how prices have actually changed in response to cost changes in the past.
Next, in-house experts apply their knowledge on dynamics unique to their company to determine when, where and by how much to pass along cost changes to customers. For ease in analysis by the expert, micro segments are often bucketed on similar attributes.
Finally, those discrete strategies are applied to the deal-specific, market-aligned price guidance generated by a price optimization software application and delivered to the sales team in a simple, actionable format. Closing the loop on a smarter approach to responding to cost changes via price, the historical analysis is performed as often as is necessary for the business, typically on a weekly cadence. Company experts can continue to refine and adjust when, where and by how much to pass along costs to customers.
With this scientific approach, industrial B2B companies no longer have to be restricted when costs swing, and they can instead set more effective strategies based on a comprehensive understanding of how well they’ve responded to cost strategies in the past. For instance, a specialty chemical manufacturer was able to deliver 185 basis points in margin rate improvement, despite an environment of high cost volatility.
As B2B companies manage through this prolonged deflationary period, they have to consider how to respond when costs and commodity prices inevitably rebound and they need to raise prices in order to protect margins. Regardless of the economic condition, a scientific and thoughtful approach to pricing strategy can help companies weather the cost volatility storm.
Pete Eppele is Senior Vice President of Products and Science at Zilliant.