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Pareto Pricing & True Profitability

Updated: Feb 13

A SOLID PRICING STRATEGY IS KEY TO MAXIMIZE PROFITS AND CREATE VALUE


Pricing is the most effective (and the fastest) tool to increase profits. Improving price by 1% yields substantial gains, compared to other tools.[1] [2]





Yet, most companies find extremely difficult to execute an effective pricing strategy. Here are the top five mistakes that companies make when trying to impact profits through pricing:


1. Treating all customers and solutions (products or services) the same:

Not making the distinction between vital and trivial customers and solutions. When pressed for results, companies tend to use mostly a “shotgun” approach to increase prices, when they should be using both “precision rifles” and “shotguns”, depending on the value of the customer and the nature of the low-margin problem.


2. Using inaccurate and incomplete margin information to make decisions:

Conventional accounting, such as cost absorption systems, are not designed to provide detailed and accurate P&L by each customer and solution. They do not account for variable or complexity costs, in a timely and precise manner. At the same time, companies don’t have the time or resources to perform detailed cost mapping or ABC (Activity-Based Costing) for every product or service in their portfolios. The result is a dangerous approximation that can lead to pricing targets that are either too aggressive or not impactful enough, for a given customer.


3. Missing simple and yet effective portfolio analytics:

The lack of accurate margin information and the absence of an effective method to visualize the portfolio, according to value and complexity, can lead to unnecessary customer battles and competitive threats. Managers can easily fall into the trap that pricing is the only solution when there can be other causes, such as unfavorable mix, logistical costs, and sourcing issues, to mention a few.


4. Lacking visibility into the opportunity:

Having a quantitative portfolio management model, based on Pareto-Analytics, helps the company “size the prize” and align the entire organization around the mission. Sales and marketing alone can not increase prices sustainably without help from the core of the organization, including purchasing, engineering, production, finance and IT.


5. Having limited commercial capabilities to execute the pricing strategy:

Sales, marketing and product management are typically ill-equipped to govern the solutions’ portfolio when it comes to complexity cost and true profitability. At the battlefront, sales managers struggle to negotiate and provide customers with a clear rationale to justify price increases. The reasons why a customer is profitable or unprofitable are never completely clear under conventional cost accounting. This gap forces many sales managers to retain the business based primarily on the relationship they have with buyers. Although relationship selling is very important, it is not completely sustainable on its own.


TRUE PROFITABILITY IS THE BETTER LENS TO FOCUS ON PRICING TARGETS


True Profitability is a simple and proven method to organize the portfolio according to value and complexity, using Pareto-Analytics. It also measures the profit level of an individual customer or solution, stripped of all bias created by arbitrary allocations from conventional accounting systems. True Profitability is the income statement or P&L for each solution offered to the market through the lens of complexity.


  • Profits come from customers, not from cost containment and cutting! An organization that is agile, well connected to the customer, understands its true cost to deliver at both customer and solution levels.

  • Identify the good and not-so-good areas with greater precision and granularity.

  • Enhance the focus on money-making areas and deemphasize the money-losing ones.

  • Single-out and quantify the best market segments to grow.

  • Connect your core (organizational heart) to the customer. Use practical tools to improve profits, focused on organizational behavior change.

  • Develop your people’s capabilities to maximize profits and to operationalize solutions.



COMPANIES NEED TO LEARN HOW TO USE TRUE PROFITABILITY TO SUCCESSFULLY EXECUTE PRICING STRATEGIES AND MAXIMIZE PROFITS


The mission is to develop the capability of the organization to use Pareto-Analytics, apply True Profitability thinking and execute on profit maximization strategies, such as pricing. The method consists of simple and cost-effective steps to coach organizations, allowing them to adapt and continue to use the tools going forward. The steps to learning True Profitability are as follows.


1. Gather sales data and feed a simple Pareto-Analytics model, based on Microsoft Excel:

We start by helping teams load a flat-file, containing the equivalent of one year’s sales and margin data, by customer and solution, onto a simple Pareto-based Excel model. We also load other costs below the variable contribution line, such as engineering, sales, and general administrative expenses into the model. The outcome of this work will allow us to answer a few key questions, as follows.


Classifying Customers and Solutions according to Value and Complexity.



  • The vital few customers and solutions that create 70%+ of the value.

  • The long tail, responsible for the greatest amount of complexity cost.

  • Supporting customers and how they help or hurt your business.

  • Ancillary products and services and their impact on profits or losses.


  • How much does each segment of the portfolio impact Operating Profit?





  • How does your True Profitability curve look like?

  • Where are the largest opportunities for rationalization and pricing?


  • How big is the pricing and rationalization opportunity?


  • Sizing the prize by customer.



  • P&L and pricing strategy by Customer and SKU.


2. Train a core group of people on True Profitability thinking, analysis and negotiation methods to succeed.

We need to convey the methodology and different approaches to maximize profits, including negotiation strategies with different customer segments. At the end of the session, the team will be able to apply Pareto-thinking, develop specific plans by segment, customer, and solution, and use the model to measure progress and govern complexity.


3. Facilitate insight gathering and plan development.

A half-day session based on the Pareto model using company data. Working with visualization techniques and data analysis, coupled with the expertise from the people in the room, we will facilitate the development of targeted plans based on True Profitability. The outcome of the session is a set of detailed, data-based action plans, to maximize profits via targeted pricing, portfolio simplification, and complexity reduction.


If you would like to learn more about True Profitability, there is a book available at Amazon.com (https://www.amazon.com/True-Profitability-complexity-Complexity-Management/dp/1724922793/ref=sr_1_1?keywords=true+profitability&qid=1581544897&sr=8-1)



  1. [1] McKinsey & Co. Article – Pricing: The next frontier of value creation in private equity: Walter Baker, Manish Chopra, Alexandra Nee and Shivanand Sinha (October 5th, 2019) [2]Economic sensitivity analysis for ~1,000 midsize ($100 million - $1 billion) US public companies, 2017

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