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Accenture

A precision pricing methodology — which formulates pricing decisions based on what themarket is willing to pay and focuses on an integrated approach across a product’s pricinglife cycle — can help companies maximize profits and outperform the competition.

In their pursuit of high performance, one of the most powerful – and least leveraged – tools that companies have is price. The reason is simple: price increases usually reach the bottom line “in one piece,” while the advantages of lower unit costs or higher sales are diluted. Thus, for a company with 10 percent margins, a 10 percent price increase could produce a 100 percent increase in profit!

Of course, when prices go up, buyers go down. This is why pricing has always been viewed as a delicate art of finding the balance between the two. Nevertheless, larger profits would be possible if more companies treated pricing as a science, complete with driving principles; a sustainable process; and standard, provable metrics. This paper presents some ideas for developing such an approach to original equipment manufacturer (OEM) parts-pricing activities: a precision pricing methodology.

Today’s Pricing Mantras

Successful pricing is often the result of several important business behaviors. The first of these is to formulate pricing decisions based on what the market is willing to pay, rather than by only calculating the relationship between incurred costs and desired profits (a costplus approach). Consider that most customers’ purchase decisions (overt or intuitive) spring from their conclusions about whether an item’s quality, availability and desirability make its price acceptable. Marketplace characteristics, assortment and acuteness of need also affect this decision. However, none of these criteria speak to a cost-plus approach to pricing. In fact, they imply quite the opposite: the development of an external, customer-focused approach to strategy, planning, managing, executing and analyzing.

Precision pricing also requires that companies develop an interlocking strategy, with regular, promotional and clearance prices that mirror the stages of each product’s unique life cycle. This kind of integrated treatment makes it easier to identify which pricing approaches are working, and to take appropriate steps to improve total financial return. In effect, looking at a product’s pricing life cycle engenders better, more proactive pricing actions (e.g., positioning) and better reactive pricing actions (e.g., competitive match). Nowhere is this more obvious than in the consumer electronics market, where new, differentiated products often command price premiums that are largely independent of cost. Remember a few years ago when PDAs averaged about $300? Since that time, they’ve essentially become commodities, and now sell for as little as $30.

Many companies could extract greater value (i.e., increased sales and profits) if they applied straightforward pricing concepts, tools and techniques. Generally, the more sophisticated companies are at pricing, the more successful they tend to be in the marketplace. The reigning authority is Dell, whose handle on supply and demand conditions is exceptional, and whose pricing is about as close to real time as any company gets. Dell’s approach is far more market-driven than it is cost-driven. Within a short time period, Dell might goose the market with low prices to reduce overstocks and/or raise prices on products when a spike in demand is anticipated. Thus, customers who want a specific product willingly pay more, while those who are ambivalent are gently steered toward another product. This is not as complex as it seems. It’s just taking rapid advantage of routine shifts in the relationship between supply and demand, and using elasticity curves to map the effect of price increases/decreases on buyer behavior.

Lastly, OEMs need to work harder to match pricing techniques with the appropriate business situation. Precision pricing is not a one-size-fits-all paradigm. In fact, Dell’s price optimization approaches would be overkill for many companies and products. It’s important to carefully evaluate the governing rules and philosophies that help define pricing for a specific marketspace. Take Southwest Airlines, whose executives decided that everyday low pricing is more appropriate to their business model than the elastic pricing approaches used by most carriers. Southwest’s customers voted with their pocketbooks for what is essentially a commodity product, while the complex pricing theories used by the airline’s competitors alienated many consumers. Furthermore, the legacy carriers are now in a situation where they generally have to match the discounters on price anyway.

Pricing Parts and Accessories: A Unique Challenge

So do the above rules also cover the precision pricing of OEM parts and accessories? Generally, yes. However, there are a great many ways that aftermarket environments – and thus parts-pricing procedures – are special. Consider, for example, that although most companies approach parts pricing on a cost-plus basis, very few actually know the total landed cost of those items. Not knowing their exact cost, they end up spreading a loosely calculated average markup across an entire product line.

Complicating the problem, some OEMs sell through intermediaries, and thus have little chance to acquire the knowledge they need to improve their parts-pricing performance. Even when this is not the case, parts pricing is often treated as an afterthought (another unfortunate example of aftermarket equals afterthought). This laissez-faire attitude is why there is so much room for improvement. Basically, the more opportunities you identify, the more ground you gain.

Another example of the price-related uniqueness of service parts is the murky relationship between the cost of a part and the cost of downtime. This dynamic can create extreme (and justified) sensitivity to pricing. Consider that an expensive fighter jet can be put out of action for lack of a $3 part. For a more consumer-oriented example, note that customers often pay up to half the value of a new dryer just to get their old dryer fixed. The repairman may only replace a $5 part, but he’ll likely charge a heart-stopping service fee. Why so much? Because his customer needs the dryer now. Compared to many companies, Mr. Repairman has a better understanding of demand-driven pricing!

The nature of competition in parts and accessories (P&A) is also somewhat different. Oftentimes, the company that makes a particular product is the only source of that product’s replacement parts. Other times – in automotive, for example – independent companies manufacture tons of aftermarket products, often reducing those parts to commodity status. Thus a deep understanding of the competitive playing field is particularly essential in pricing parts and accessories.

Pricing of P&A is also atypical because of their sheer number. In many capital goods industries, spare parts inventories require up to 20 times more SKUs than what are needed for current-product manufacturing. Compounding the problem, product-model life cycles are becoming shorter in virtually every industry. Computer manufacturers, for example, unveil a new generation of products about three times a year. The resulting challenges – supporting multiple generations, tracking parts types, ensuring parts and service availability and calculating high-profit price points – are considerable (see Figure 1). For all these reasons, demand for aftermarket items is also more unpredictable than for OEM products, so it’s harder to factor the cost of inventory into the pricing of parts.

Compared to the OEM equipment they populate, most parts and accessories have a very long sales life span. And during that life span, pricing criteria shift frequently – higher at the beginning, lower in the middle and often very high near the end of (or after) a product’s life – when parts become harder to find, but often just as essential to maintaining uptime.

Lastly, parts often have widely varying levels of elasticity. On the one hand, low price simply won’t sway a buyer if he has no need for the item. Such is the case with auto replacement parts. Alternatively, some items – computer-upgrade components, for example – are often a price-based temptation for buyers. They buy if the price is right. For these items, price often drives demand.

All of the above characteristics make parts and accessories a unique pricing challenge – one that requires pricing approaches that are frequently different from those associated with finished goods. So how can OEMs address that challenge, and potentially raise profits with more creative and aggressive P&A pricing?

Profiting From Price

Earlier in this piece, we mentioned a pricing life cycle. This is the key to driving increased profits through pricing: integrating regular promotion and exit pricing across the five stages of a pricing life cycle (see Figure 2).

Strategy

The first pricing life cycle stage asks OEMs to balance a variety of influencers. The mission, however, is singular: create one overall pricing strategy – everyday low price, transitional, premium, etc. – that focuses on maximizing profits. Strategic considerations include the following:

• Proactivity: Do we wish to lead the market in terms of pricing (first mover) or do we prefer to be reactive (wait and see what our competitors do)? These considerations have a great deal to do with investigating and understanding competitors’ pricing strategies. The next step is to determine if the right course is to go head-to-head with a similar strategy, or formulate a dissimilar one and thus compete on your own playing field.
• Competitiveness: How aggressive do we want to be about pricing? If we are not aggressive enough, margins suffer. But if we are too aggressive, that encourages new competitors to target our markets. The latter is happening right now in the printer business, where OEMs have priced their replacement ink cartridges so high that consumers often buy a new printer just to get the cartridge (recognizing this, printer manufacturers have started putting “half-tanks” in many of their new printers). However, exorbitant ink pricing has also prompted numerous low-cost ink-tank manufacturers and refill services to enter the market. The message is clear: OEMs must balance the nice margin premiums enjoyed in the near term with the profit implications across the full product life cycle.
• Inclusiveness: Does our prospective price include everything – like a replacement tire whose cost covers mounting, balancing, warranty, disposal of the old tire and so forth? Or is it better to separate price into its item and service components? This is an area where alternating strategies often go head-to-head. For example, Tire Dealer A might brag that his one low price includes everything. Tire Dealer B might counter by saying that his component pricing saves customers money by not “forcing” them to buy add-ons that they don’t want (e.g., extended warranties).
• Brand: Companies such as Harley-Davidson often charge more for replacement parts because the power of their brand permits them to do so. Customers willingly pay a bit more because it’s made by Harley.

Planning

After strategy development comes the need to devise tactics for regular, promotion and exit-stage pricing. To make this happen, basic segmentation approaches are often taken, such as, good-better-best distinctions; loss leaders to draw in customers; or perhaps variable pricing based on geographical divisions or customer-value assessments.

High-performance businesses segment parts and pricing based on their role within or across parts categories. For example, a business may price tires aggressively low (loss leader) to drive floor traffic into the service department. But once a customer’s car is up on the rack for tire replacement, the service technician may notice that new brakes or shock absorbers are needed. And these items will likely be priced much differently.

Some parts retailers institute a pricing floor for their products (e.g., no part priced below $1) regardless of cost. End users ultimately pay $1 for a 5-cent part, but since the part’s price point is so low and because the part is likely bundled within a larger service event, consumers are willing to pay.

Management

This is the first stage that directly considers the individual stages (regular, promotion, exit) that comprise the pricing life cycle. First, companies must identify (on an item or category basis) a regular price for the product – one that can be maintained over a reasonable period of time. To decide on a promotional price, they then must determine what each promotional program’s objective will be: increase profit? relieve overstocks? generate foot traffic? Lastly, there are decisions about the product’s exit price. This could involve an exit strategy for emerging from a specific selling season such as Christmas or spring, or it could be for the end of a product’s market life. The latter, of course, is when big discounts usually kick in to ensure that inventory doesn’t linger and/or that sales of newer (replacement) versions are not compromised.

One unique aspect of the service parts paradigm is extreme end-of-life pricing. Many dealers maintain that their very old parts (often 20 or more years) are gold – their retirement fund. That’s because someone will eventually need that part, and only that one dealer will have it. However, considering the carrying costs associated with such a long holding period, most businesses would be advised to think in terms of multiples of the original price.

Execution

Leading companies do several things well when it comes to optimizing price. For commodity parts, they maintain a competitive, updated database of competitor prices. To gauge their best overall prices, they may consider like or similar products that aren’t directly competitive. Those companies also are likely to maintain extensive databases that record their own pricing moves and the impact of pricing changes on unit sales volume. This enables them to assess the impact of pricing decisions on volume and demand. This traditional elasticity analysis often is not performed in service parts environments.

High-performance businesses also may base pricing on the relative value gleaned by the end user. Recall the previous example of an expensive aircraft grounded for want of a $3 part, or the value of a small part to a contractor operating a skid steer on a project billing at more than $100+ per hour.

It’s still essential to calculate each product’s pocket price or the net revenue that ends up in the seller’s pocket. This is important because, in our experience, pocket price may only be a fraction of list price in many service parts environments. Without pocket-price information, margins can’t be assessed, marketing strategies can’t be formulated and profit targets can neither be set nor reached. Thus, most leaders know the pocket price to the end user – taking into account discounts, allowances and consumer-specific costs. To understand what ends up in the seller’s pocket, it’s also important to understand the full landed costs of the part in terms of material costs plus fixed costs that have been decomposed into appropriate activity-based components.

Leading companies also excel at applying the best people and superior technology to the optimization of pricing. For example, leading-edge technology is needed to maintain pricing databases and run elasticity analyses. Companies also require pricing execution systems that enable flexible pricing where appropriate (e.g., for bundling and promotions). Such systems also must provide control and visibility over issues associated with pocket-pricing discrepancies.

Unfortunately, the lack of off-the-shelf tools means that many organizations have been forced to build customized applications to perform these tasks. Leaders also may leverage technology to help get the right data from the right parties. As mentioned earlier, parts OEMs tend to sell through independent channels. As a result, there often is a great deal of price-sharing sensitivity and/or minimal visibility with respect to final or end-user pricing. Nevertheless, capturing price data is a necessary exercise.

From an organizational perspective, companies establish pricing responsibilities in a wide variety of ways. Some pricing professionals report up through the aftermarket marketing organization, while others go through the aftermarket supply chain, finished goods manufacturing or even finance. Although some companies have considered installing a chief pricing officer, this probably is not necessary. What is required, however, is sufficient authority within the pricing organization. Success is dependent on skills, guidance and leadership.

Assessment

The last major piece of the pricing life cycle is evaluating results – measuring the impact of pricing decisions. Leading companies compare expected financial impacts with real-life results, often using exceptionbased capabilities to flag problems or anomalies. These assessments become part of a feedback loop into the company’s overall pricing strategy and plans. However, surprisingly few organizations leverage this procedure to create continuous learning and improvement processes.

A key component of the assessment stage is gauging the impact of pricing decisions on end users – their price perceptions. Pricing decisions that deliver superior short-term profitability at the cost of customer satisfaction are sure to experience negative long-term repercussions.

Lastly, an often overlooked area is compliance. Even organizations that work hard to establish strategic, life cycle-adherent pricing structures can still be beset by renegade pricing. Sometimes the culprit is revenue-incented sales or the pressure to meet end-of-quarter projections. Regardless of the pressures working against compliance, companies must emphasize full-pocket pricing.

Are Price Optimization Initiatives Worth Pursuing?

Most companies are in a constant state of debate over which improvement initiatives have the most potential to help them reach and maintain high performance. Precision pricing is not one of those initiatives. This is because virtually any manufacturer with substantial parts inventories should be evaluating its P&A pricing regularly and routinely. The playing field changes too fast for this not to happen. Simply put, pricing strategies need to evolve whenever:

• A new product is introduced;
• A similar competitive offering hits the market;
• A new market, geography or customer segment is identified;
• A merger or acquisition occurs;
• A competitor enters or leaves the market;
• A major technology implementation or breakthrough occurs;
• A key business process (e.g., supply chain) is outsourced; or
• A recall or safety warning is launched.

In addition, the basic contributors to a product’s cost also change frequently. Although a cost-plus pricing strategy is seldom optimal, it is still necessary to balance market-focused pricing strategies for parts and accessories against fact-based assessments of their total net landed cost. And a part’s net landed cost is likely to shift every time:

• A demand swing occurs (necessitating higher or lower production runs);
• A part enters a new stage in its life cycle (promotion, end of life, etc.);
• A new manufacturing or supply chain technology is introduced (potentially lowering the cost to produce or store goods);
• A key business process (e.g., production) is outsourced; or
• A companion or updated product is brought on line (potentially increasing manufacturing lot sizes).

At the end of the day, precision pricing is about maximizing profit, not revenue. This is why cost-plus pricing is generally inappropriate. Cost-plus pricing may help ensure profit, but it is not concerned with maximizing profit – particularly across the product’s complete life cycle. Companies can no longer afford to overlook the value in a precision pricing methodology, which can help them maximize their profits to gain competitive advantage and ultimately enhance their overall performance.