The AA, BB, CCs of Pricing Optimization
Variable pricing is gaining a lot of attention. Everyone wants a system that can crunch data and spit out a magic number. But chasing a magic number misses the real value of the process. Pricing optimization is not just a software function or calculation. It’s a powerful managerial tool. More specifically, it’s a strategy for improving profit by changing behavior. And when done correctly, it helps provide better service to your customers.
Learn Your AA, BB, CCs
Pricing optimization starts with customer stratification. Many businesses only use gross sales to rank accounts as A, B, C, or D. But not all “A”s are created equal. For instance, an A customer with a lot of returned items and late payments may not be very profitable. The stratification process accounts for these “hidden costs.” It provides a more comprehensive picture of your customers and their impact on your bottom line.
Stratification plots customers in a quadrant. (So instead of simply using A, B, C or D, rankings are AA, AB, AC, AD, BA, BB, etc.) The quadrant is based on two axes: buying behavior on the x-axis and profitability impact on the y-axis. The value for each area is based on a set of variables. For instance, profitability factors include delivery costs, will-call orders, returns, and days past due. Using the quadrant helps separate dependable A and B customers from those with sporadic buying behavior or chronically late payments.
Customer stratification doesn’t just show which accounts are most profitable; it shows how to make them more profitable. It’s similar to looking at a class’s test results. The overall grades don’t reveal much, but reviewing the test questions can pinpoint which students have problems with spelling and which have problems with grammar. Likewise, a customer’s AB or CD rating only tells you so much. The stratification process, however, breaks out specific factors. When you know what areas to target, you can respond more effectively. The goal of pricing optimization, after all, isn’t to charge the highest price, it’s to make the highest profit. To really improve profitability, you likely need to change the behavior of both customers and your sales reps.
Change #1: Account Management
Consider this (highly simplified) example. Acme Lumber has two customers: Jay Construction and Haas Builders. Both have a profitability ranking of “C.” But if we dig into the specific variables, we can see they have different issues.
Jay Construction usually has just a few items per each order. Haas Builders, on the other hand, makes a lot of returns. This information gives Acme’s sales reps a strategy beyond “sell more.” If the reps can help Jay’s Construction consolidate deliveries and Haas Builders improve order accuracy, it would reduce the cost to serve each company. Those accounts would become more profitable, even if their sales didn’t increase. This doesn’t just benefit Acme. If these customers improve their ranking and move into a higher quadrant (say from BC to BB), they may be eligible for better pricing. It’s a win all around.
Change #2: Policy Updates
If a particular variable causes problems across many customers, an account-by-account response may not be sufficient. It could suggest the need for company-wide changes. For instance, if “returns” are a problem for the majority of Acme’s customers, Acme may want to solve the underlying reasons for returns, add a service charge, or change its return policy.
Change #3: Resource Allocation
Stratification also provides insight about about employee performance. Identifying which reps are most profitable can help make decisions about assigning accounts. Instead of going by seniority or sales volume, assign your most profitable people to the most profitable customers. You can also evaluate “star” reps and look for behaviors that other team members can adopt.
Once a business stratifies their customers and performs a similar process with their items, they can calculate optimized prices. Exactly how a business uses optimized pricing is up to each organization. Some may decide to lock down prices, while others may allow reps a bit of flexibility on AA-BB accounts. A third possibility is to use optimized prices as a goal, and reward reps when they near their target.
While owners and managers are excited about the potential of pricing optimization, sales reps are less thrilled. The stratification process may reveal some A and B accounts aren’t very profitable and should be charged more. Reps aren’t going to be happy about raising prices on their “best” customers and may feel like they are gouging good accounts. Help reps understand that prices stem from both the products and services you provide. Extra attention and handholding represent real costs. It consumes time and money to constantly update orders, process returns, and wait for late payments. You shouldn’t gouge customers, but it’s OK to charge what you’re worth.
Some people see pricing optimization as the rise of the machines, with software poised to take the jobs of hapless sales reps. This scenario couldn’t be farther from the truth. Pricing optimization is an extremely hands-on process. It demands deeper conversations about pricing strategy. It prompts businesses to consider the “how” and “why” of their decisions.
Software is tremendously helpful. It processes huge amounts of data, runs complicated formulas, and delivers more precise answers. It’s a powerful tool, but it’s still just a tool. It doesn’t know customers, understand goals, or enforce policies. Without active participation, software can’t improve your profitability any more than a FitBit can improve your waistline. Instead of searching for magic numbers, businesses should use pricing optimization as a springboard for greater change.
Mike Limas is vice president of DMSi Software. He has over 25 years of experience as a CPA and CFO/COO of service, technology, and building products manufacturing operations.
This article originally appeared in the August 2015 edition of Building Products Digest.