"Pocket-Price Waterfall"

In 2003, McKinsey & Co introduced a concept of "Pocket-Price Waterfall" (see: chart below). In the booming years of the 1990s, robust demand and different cost cutting programs drove up corporate earnings. Therefore, managers didn't pay any attention to pricing- they didn't have any reasons to worry about it then.

But now in these times of economic downturn - weaker demand and declining earnings - it has exposed shortfall in pricing capabilities. Many companies have already completed much needed cost-cutting and are struggling to sustain their earning-levels in these turbulent times.

In this post, I explain what it is the concept of "pocket price waterfall". And then how you can use these concepts to develop pricing strategy. Before reading this post, I recommend you to read my previous posts on "Power of Pricing" and "Pursuit of Premium Pricing".

Let's get started with concept definitions:

POCKET PRICE: The "pocket price" is a measure of the effective price paid by the customer in a particular transaction after accounting for all relevant discounts, promotions, rebates and allowances.

POCKET PRICE WATERFALL: The "pocket price waterfall" reveals how price erodes between a company's invoice figure and the actual amount paid by the customer--the transaction price. It tracks volume purchase discounts, early payment bonuses, and frequent customer incentives that squeeze a company's profits

Now why is it all that important? Right pricing is a more subtle game than setting list prices or even tracking invoice prices. Significant amounts of dollars can leak away from list or base prices as customers receive discounts, incentives and other giveaways to seal contracts and maintain volumes.

In the chart above, McKinsey studied a case of global lighting supplier who saw different customer discounts and promotions itemized on each invoice pushed average invoice price by 32.8% below standard base price (or list price). As if that wasn't enough - more revenue leaks beyond invoice prices are not detailed on invoices. These off-invoice leakes include cash discounts for prompt payments, cost of carrying account receivables, off-invoice promotional programs and freight expenses. In the end, company's average pocket price was half of its standard price - drop of 16.3% point in revenue deductions that did not appear in invoices!!

POCKET PRICE BAND: Pocket price waterfall is created as an average of all transactions. But in reality, amount and type of discounts vary on a customer to customer basis. It may even vary by order. Therefore pocket prices can vary a great deal. "Pocket price band" plots the range of pocket prices over which any given unit volume of a single product sells.

STRATEGY: Smart companies look at this band and identify "costly" and "unprofitable" customers. It is important to direct sales force to bring into line- or drop- these customers getting ungodly high discounts. At the same time, it is important to get more share of profitable customers. Launch intensive marketing programs to stimulate sales at customers generating higher pocket price for the company.

Remember a 1% increase in price will boost company's operating profits by more than 11%. (read Power of Pricing)

RECOMMENDED READING: Two great books on pricing and competition- "Pricing Strategy" by Morris Engelson and "Blue Ocean Strategy" by Kim and Mauborgne.