Profit leakages can happen at every line of the profit and loss statement. Some are easier to identify than others and can easily be captured in a waterfall analysis to derive pocket price levels for a customer, a market segment or a product category. Others are well hidden in the P&L and require a lot more attention, analysis and proper allocation. Pricing specialists are champions of analytics and can use powerful tools to design and populate a waterfall analysis. They will be able to quickly identify the pure pricing-related elements of the price waterfall analysis. For other elements, these specialists might enter into discussions with their sales, supply chain and accounting peers in order to properly identify special service conditions and costs.
Many firms are able to conduct advanced ABC (activity-based costing) analysis, while others will run intense cost-to-serve analysis. Both methodologies should be able to provide a detailed, exhaustive and transparent waterfall analysis. Other firms, however, fall short of identifying proper profit leakages by focusing only on purely pricing-related elements. As firms strive to create differentiation and improve their customer experience, they are missing important pricing and value conditions that can significantly impact net pricing levels and profit levels. It is imperative, then, to monetize the cost of these conditions in order to evaluate their impact on both profitability and cash flow.
Let’s take a look at a few examples of hidden profit leaks that might not typically be included in a waterfall analysis or cost-to-serve analysis:
- Marketing Allowances: Sharing marketing costs offers an opportunity to learn more about customers’ customers at trade shows, in direct-mail campaigns and in digital programs. Sponsoring customer programs does impact the SG&A account, however. These shared expenses need to be included in the overall pricing offering and need to be contractual (SG&A expenses).
- Joint Development Projects: Customers may be sensitive to entering into joint development programs to identify value co-creation opportunities. These projects may include Six Sigma joint teams, lean value stream initiatives, joint product development and joint IP protection. Although these projects may be strategic, they do not come for free. IP, R&D and technical costs will be generated for these specific accounts (technical expenses).
- Depreciations: Partnering with customers in specific value co-creation opportunities might require capital expenditure (capex) investments both in fixed assets and in information systems. Although depreciations are below the EBITDA line, they have a strong impact on net profit and on free cash flow. Thorough payback and ROI analysis are required to evaluate these projects and to properly allocate their impact (depreciations & amortization expenses).
- System Customizations: Changes in document paperwork, EDI programming, and customized service conditions programming are examples of costly customer system requirements. Some of these requirements will be expensed, while others may be capitalized and depreciated. Although they are strategically embedded, it’s important that they’re captured, monetized and deducted from customer profitability analysis (technical and IT expenses).
- Free Products and Samples: Sticking to list prices and protecting margins remain key priorities of pricing teams. Free product programs and large-scale sampling activities have become an obvious choice for working around these priorities: BOGO (buy one-get one) programs, top-load promotions, special bundling designs, free trial periods, etc. The pricing team needs to monetize the cost of these programs and allocate them to the right waterfall analysis using the market value for the products rather than their internal costs (sales deductions).
- Consignment Stocks: During economic crises, many firms manage their business to protect cash flow and to stay “cash flow positive.” In doing so they request consignment stock at their locations from strategic suppliers. Consignment stock mainly impacts working capital and cash-flow management, but there may also be related administrative expenses buried in SG&A (SG&A expenses).
There are many more projects or conditions that could impact cost-to-serve analysis. Many of these come from the creation of special service conditions affecting supply chain activities and adding complexity inside the firm (SKU creation, made-to-order (MTO) products, freight conditions, Incoterms (international sales terms), etc.).
Implementing ABC analysis can be costly and requires a redesign of business processes. For firms seeking to obtain transparent profitability for an account, a segment or a product range, cost-to-serve analysis throughout the P&L can provide an excellent view into the common and hidden profit leaks. Cost-to-serve analysis can be complex to conduct and requires teamwork, collaboration and access to all available cost data. An important dimension of pricing realization and pricing discipline is to be able to control the creation of special conditions and special programs that are not just purely pricing-related, but are also a potential cost burden to the firm. These need to be challenged and evaluated carefully, as they may create complexity for little profit return. They also should be integrated into the waterfall analysis to ensure they are deducted from net pricing and net profit contribution for the appropriate customer, segment or product category.
Be bold! Join the pricing revolution and embark on the journey to pricing excellence!