Seal Margin Leakage with The Price Waterfall Approach

By Philip Huthwaite on August 19, 2014

According to McKinsey research, a 1-percent increase in price can lead to an 8-percent increase in operating profit, provided that sales volume is unchanged. However, with the intense price pressure in today’s B2B selling, is there an easier way to improve profitability?

The answer is "Yes!" By looking a the various components that make up the price quoted (Price Waterfall analysis).

As its name suggests, a price waterfall requires a company to map out and keep track of a cascade of price leakages so that the true net price, or pocket price, is revealed. The reason this concept was introduced, is because in general, most companies only focus on list prices and prices that appear on the invoice, without realising that what they earn is far less than that due to many off-invoice leakages. A Price waterfall is thus used to measure the profitability of each transaction.

price waterfall

Depending on each company’s pricing policies and operations, different companies may include different sources of price leakage in their price waterfalls. Nevertheless, the basic structure and key components of a price waterfall are mostly kept the same as follows:

 

LIST PRICE

The stream of price leakage starts from list price, which is the price that companies initially quote to their customers. Generally, list price is the ideal price companies want to achieve. It is determined by taking into consideration various factors such as the company’s strategy, the product’s value, market competition, different promotions and discounts, etc.

 

ON-INVOICE PRICE LEAKAGES

List price, however, is rarely the price that will appear on the company’s invoices. There are many price leakages arising during sales negotiations that can potentially drive down list price, such as volume discounts, customer-specific discounts, and promotion discounts. On average, these leakages can account up to 33 percent of list price. Although discounting at this stage is not uncommon in B2B selling, not many companies have dedicated adequate resources to monitor those price leakages and set appropriate guidelines for the sales team.

 

OFF-INVOICE PRICE LEAKAGES

According McKinsey, on average, off-invoice price leakages can add up to 16.3% of the standard list price. However, they tend to be left unmanaged as these leakages usually happen after the sales transaction occurred and are scattered across many divisions. Some examples of off-invoice price leakages are cash terms, promotional allowances, rebates, freight, rush order cost, late delivery charge, etc. With the fierce competition in today’s market, selling companies have introduced a wide range of incentives to attract buyers, but without proper management, these incentives can easily turn into unnecessary price leakages.

 

POCKET PRICE

Pocket price is what a company has left after all of the discounts and incentives are deducted from list price. For companies that do not arrive at pocket price, it will be difficult for them to realise the actual margin they earn on each product unit. For example, if a company only manages on-invoice price and do not keep track of off-invoice price leakages, that company may think that its list price is already high enough to cover the unit cost, while in fact it is the opposite.

So how can price waterfall help businesses increase price and profit? The answer lies in its ability to help businesses have a better visibility of their price leakages and the actual pocket price, so that they can take appropriate actions. Even when the list price is maintained the same, if a company is able to raise its pocket price by reducing price leakages, this can translate into higher a margin for each unit sold.

The following are some aspects that businesses can improve thanks to price waterfall:

 

BETTER PRICING POLICIES

Without price waterfall, many businesses might not realise their pocket price is not high enough to give them the desired margin. They could have given away too much rebates and incentives, let small-volume customers enjoy unnecessarily high discounts, or simply not factored in freights and service costs when setting prices, etc. Re-distributing discounts and incentives, setting clear instructions for sales team, as well as raising prices to acceptable levels, are ways that businesses can improve their bottom lines.

 

BETTER NEGOTIATIONs

With the sales force having a better understanding of different elements causing price leakage, as well as the pocket price, they would have more confidence in the company’s price structure and be more willing to negotiate for a better price. They also use the information obtained from price waterfall to their advantage. For example, they can show a customer how good the deal is by accumulating all of the on-invoice and off-invoice discounts that the customer receives. Or, realising the impact of each discount on the company’s bottom line, they might be able to formulate a better combination of discounts that can satisfy both the buyer’s interest and the company’s interest.

 

BETTER OPERATIONS

Price waterfall can be used as an effective way to measure a company’s performance. By setting a benchmark for each element of the price waterfall and consistently monitoring them, the company can identify areas of operation that can be improved. For example, by keeping track of each source of price leakage, companies can identify if they are losing money due to rush orders, poor delivery, or freights.

 

Conclusion

Price waterfall is a simple concept, but it requires a long-term commitment and co-operation between different departments to realise the benefits.

In order to implement an efficient price waterfall, it is recommended that companies adopt a dedicated price management system alongside price training for their employees. While this was very costly in the past, thanks to the rise of SaaS technology, acquiring a pricing system that allows companies to keep track of different types of discounts and incentives, as well as to set complex pricing rules and benchmarks, is no longer exclusive to large enterprises.

 

Further Reading

You may also find an earlier article entitled Make discounting work for you, NOT against you of interest.

 

References

Statistics in the article are provided by McKinsey in The Power of Pricing.

 

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