While pricing is a critical component of any business, many manufacturers have inadvertently started executing before the right price has been set. Why is this? Prices are generally set to maximize margins, given supply and demand, as well as competition in the market. However, maximizing margins does not maximize profitability. If you execute a pricing strategy before having a completely accurate picture of profitability, you will be managing and enforcing prices that are not optimal, and this can have a huge impact on your bottom line. In the $2 trillion sector of complex, asset-intensive manufacturers that includes chemicals, steel, semiconductors, electronic components, paper, packaging, plastics and several others, this lack of insight into profitability represents $100 billion in annual revenue losses.
In order to truly get the most out of your pricing management and enforcement initiatives, it is critical to use granular product and deal profitability information to target the right prices. It is not until the best strategic pricing levels are known that you can execute a set of prices that will optimize profitability. Using strategic pricing as the foundation for price setting ensures that pricing solution initiatives to manage and enforce prices, will maximize corporate profit and return on asset (ROA) goals.
Maximizing Margins Does Not Maximize Profits
Pricing is obviously a key element in a company's efforts to maximize profitability. It is a strategic lever that can be used to affect the demand for products. However, if target prices are not set based on an in-depth knowledge of profitability (such as by product, customer or deal), they will not maximize overall company profits. Setting prices based on margin alone yields the "wrong" price.
Although margin is an important metric, profits cannot be optimized using margin alone. This can only be done by taking production speeds into account. Combining margin and production speed yields a time-based metric of profitability called "profit per minute." And since companies report profits based on time periods such as a year or quarter and there are only a given number of minutes in a year (525,600 to be precise), profit-per-minute is a more accurate measurement of product profitability.
To demonstrate the impact that margin-only approaches can have, let's take an example of how a company might emphasize one product over another. (See Figure 1.)
Figure 1: Margin-Only and Profit-per-Minute Approaches Yield Dramatically Different Profitability Rankings
Based on margin alone, Product A is more profitable than Product B. However, if we incorporate the rate at which each product is made, we come up with a different metric.
Rather than margin, we have a metric that production speed to yield profit-per-minute for each product. Since Product B is made much faster than Product A, Product B has a higher profit-per-minute than Product A. Using profit-per-minute as the criterion for profitability rather than margin alone we get a very different picture. In this particular example, choosing to make Product A instead of Product B would cost the company $1.58 million in profit over the course of a year.
Why Has Profit-per-minute Not Been Used?
If profit-per-minute is a much better guide than margin alone to ensure optimal profitability, why have companies not used it? Actually they have long known the importance of a production speed's contribution to profitability. But they had no way to combine production run data with margin information. With the two-product example above, the calculation is very simple. However, when a company makes hundreds or thousands of products and sells them to hundreds of customers, the problem becomes overwhelming. It becomes nearly impossible to know profit-per-minute at a granular level — by product, by customer, by market, by region or by production facility. So companies have settled for margin alone as the best possible metric to maximize profitability.