Strategic Pricing using Activity Based Costing
Have you ever wondered how do companies set up their prices? The truth is that many rely on one of two methods:
· Added margin
· Match competitors
Of course there are myriads of permutation of these two methods, but most of them add certain margin, usually standardized across products or services range, and then reduce it based on the level of competition and relationship with particular customers. What we found is that often price setting is not backed up by any quantitative analysis which results in not achieving potential profitability, furthermore many sales managers have a very vague idea about how much they are not earning by relying on archaic heuristically based price setting methods.
In fact in many cases businesses are losing money due to ineffective pricing. Take for example a regional customer versus a metro customer. If both customers get free delivery there are significant differences in the cost of delivery, differences can be as large as $75/pallet vs. $15/ pallet. If the cost of delivery isn’t factored into this pricing the regional customer could be easily making a loss for the business.
Strategic pricing is based on setting pricing on the back of an Activity Based Costing exercise. Typically companies will run an Activity Based Costing Model to understand the true “Cost to Serve” of each customer account and product line. I.e. How much does it cost me to do business with customer X. Once the cost to serve is understood companies can better understand the margins which they need to set to make a profit.
Once the cost to serve has been calculated in the Activity Based Costing Model businesses should combine the non-numerical business information with the numbers before making any decisions. I.e. Is it possible to increase the price of regional Woolworths accounts? What’s the risk that Joe’s Grocery store will go to our competitors if we increase the price by 10%.
In my experience strategic pricing is an extremely effective way of increasing a companies overall performance. Many of our Bestrane clients have had great success from implementing a Activity Based Costing Model and then performing strategic pricing. One client increased their EBIT from 9% to 14.8% in 12 months from a strategic pricing exercise.
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