Friday, December 12, 2008

Pricing in Economic Downturn

These are tough times. In an economic downturn like this, decreasing demand combined with excess capacity and greater price sensitivity continue to drive down prices.

In most downturns, it is seen that the cost of raw materials, feedstocks, and other upstream supplies tends to stabilize and even decrease as the overall business activity slows. As a result,decreases in downstream prices are at least partially offset by lower upstream costs.

But in this unusual donwturn, not only is weaker demand from the end user making it harder to maintain prices, but significantly higher and more volatile input costs mean that companies are getting hit from both sides. What’s a business to do?

According to McKinsey research, in the current downturn, companies need to manage the profitability of individual customers and transactions with greater precision (read: "Concept of Pocket Price Waterfall"),develop richer insights into their customers’ changing needs and price sensitivities, and understand more clearly the microeconomics that shape their own industries and those of their suppliers.

McKinsey & Co assembled five tactics to find the best balance possible between sales volume and profit margins in the current challenging environment

1) Watch for sudden shifts in price structure: Companies should be vigilant in monitoring pricing policing that reduces revenues - such as volume discounts, rebates and cashbacks- as well as cost to serve their customers. Good companies are reviewing their pocket margin waterfalls closely and more frequently - to understand how much revenue company is really keeping from each of their transaction and adjusting pricing policy accordingly. Read my previous blog on pocket margin for more specifics.

2) Monitor customer-level profitability: By analyzing transaction-level data, companies can measure customer profitability. By doing so, companies can detect if cost to serve particular customers and/or declining volume (or sales) are nudging those customers below desired profitability levels. Based on this insight, companies should selectively raise prices, where possible, and reduce cost to serve by finding alternate and cost-effective channels

3) Adjust to changing customer needs: Customer needs and buying patters change during economic downturns. And, say, if your company operates in B2B environment and your customers are businesses, it is crucial to understand how the downturn has affected them. It is likely that their business is as slow and struggling as yours - orders will likely fall and cost of serve could increase if you do not find better ways to do inventory management.

4) Analyze price sensitivity models: Update price sensitivity research by re-running your costing and pricing models for all products and services. Inflationary downturn has made consumer more price sensitive than before - dramatic increase in food prices and gas has cut a little more from discretionary budgets, sharply increasing price sensitivity

5) Industry microeconomics: Extreme volatility in a downturn demands that companies reexamine not only the microeconomics of their own industries but also the microeconomics of their suppliers' industries.

Get your company's pricing right !

RECOMMENDED READING: Beating the Business Cycle (Lakshman) & Pricing With Confidence(Reed)

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