Inflation is back. Following decades of limited cost volatility, dealing with rising inflation is now a key topic in the boardrooms of advanced-industry companies worldwide. Many organizations are struggling to adjust to this new environment because their sales teams have never had to negotiate price increases of this magnitude with their customers. They often have limited transparency into the impact of individual cost drivers on prices, making it difficult to calculate the price increases required. Moreover, today’s pricing processes and tools were not designed to handle the scope and granularity of the price increases now needed.
Volatility is here to stay
Today’s inflationary environment results from several specific trends, including strong demand growth in the postpandemic world as global industrial activity quickly rebounded. Supply chain constraints have resulted in the limited availability of certain materials and products and ensuing cost volatility. For example, steel prices jumped 3.6 times between the second quarters of 2020 and 2021, only to drop somewhat in the first quarter of 2022. Supply chain disruptions such as rising freight costs, lockdowns in China, and Russian supplier sanctions have also contributed to the scarcities. All these factors are boosting cost inflation for industrial players, requiring them to react.
While these trends show no signs of abating, economic concerns are growing, and companies are wondering how they should adjust their pricing to offset constant inflation without jeopardizing future revenues.
Industrial companies have done well so far
Notwithstanding this difficult environment, the past year has produced profitable growth for many business-to-business (B2B) companies in the industrial space. Our research suggests they have experienced both rising revenues and profitability.
McKinsey recently analyzed a set of 55 European B2B companies active in advanced industries, gathering quarterly financial performance data for the past two years and reviewing all quarterly reports from the past 15 months. The goal was to assess the degree to which these companies actively discussed price, cost, and sales management practices as profitability drivers.
The analysis revealed that 60 percent of advanced-industry B2B companies have mentioned using active pricing management techniques when discussing their quarterly results. That’s more than the 40 percent that have actively discussed the implications of cost inflation in the same situations. Among companies that improved their profitability the most, a high share mentioned their pricing activities. When discussing pricing activities, these companies use determined language, such as taking “bold pricing action” or “swift product pricing in response to increased commodity prices and inflation.”
In fact, the top 25 percent of companies under review improved their profitability in terms of average earnings before interest and taxes (EBIT) by over ten percentage points. That compares with an average (weighted by revenue) of about four percentage points for all the companies we analyzed. These top companies also increased their revenues by 27 percent and tended to engage seriously in active price management (Exhibit 1).
Active pricing management has been the predominant margin management approach discussed by advanced-industry companies in their quarterly reports. Companies have recently discussed it far more often than approaches such as driving cost savings or other profitability improvement techniques.
Active pricing remains difficult to implement
Not all active pricing initiatives in advanced industries work out. Some have less impact than expected in improving an organization’s profitability position. This happens not only because successful pricing projects can be difficult to execute but also because of the wide range of business models used in the industry. For example, some organizations focus on standard and configured products, while others build completely custom equipment. Still others offer engineered components, including parts, while some provide installation and maintenance services. Consequently, no one-size-fits-all answer exists for handling inflation in advanced industries.
One result of this lack of a universal pricing template is that companies often end up losing value related to pricing opportunities on the table. This happens for three main reasons. First, some companies do not sufficiently understand their cost breakdown, so they cannot offset price increases fast enough when facing cost disruptions. Second, they issue messy contracts that often fail to mention specific inflation-related remedies to derisk the business. Third, they have a general lack of capabilities to manage their pricing execution. In fact, McKinsey’s analysis shows that up to two-thirds of price improvement leaks result from inadequate strategies and a lack of policy and process support, including undefined strategies for negotiating cost increases. That’s a problem, because the longer a business endures increased cost levels without successfully passing through the increases, the harder it will be to recover margins in a competitive environment.
Taking action across three horizons
Companies could benefit from defining three time horizons for their pricing initiatives. Today, we observe companies focusing heavily on short-term measures as they act in emergency modes to prevent profitability erosion. However, now is the time to also elevate the company’s focus on advancing pricing capabilities to the next level.
Full order books and long delivery times can constrain a company’s ability to act in the short term. There are, however, several steps organizations can take, such as acting on the inflation clauses already included in their supplier contracts or allocating remaining capacity and stocks to the highest margin geographies when possible. They can introduce surcharges for specific cost items such as energy and transport and set value-based target prices using advanced-analytics models. Companies can also introduce “win rooms” to review quotes and manage performance.
Midterm—recast pricing processes
While companies have more latitude in the midterm, some hurdles remain. For example, IT systems can take a long time to replace or upgrade, and strong pricing talent is scarce. Nonetheless, companies can work to modernize pricing processes by using advanced analytics. For example, they can use them to identify microclusters in historic transaction data to locate the more relevant pricing factors (Exhibit 2). One industrial OEM’s spare-parts division used this approach to identify and implement a 10 percent pricing opportunity (on top of inflation adjustments).
Companies can also redesign approval workflows to ensure that deal reviews take place at appropriate levels and introduce dynamic pricing that will automatically factor in changes in the core business drivers. In addition, some companies create greater transparency about costs by looking at both past developments and potential future trends. They do so at the SKU level, or more pragmatically by product cluster, and assess the impact of cost increases in the near future. A closer collaboration between procurement and sales—involving data exchange, organizational connections, and processes—allows companies to create forward-looking views on particularly sensitive cost drivers. It also helps companies make more sophisticated pricing decisions based on a common understanding of the input factor cost breakdown (for example, freight or energy). Such fact-based insights allow sales teams to be more effective during customer negotiations. Other pricing processes that may help include renegotiating contracts to ensure that they include appropriate inflation clauses and developing capabilities among pricing and sales teams, especially concerning value pricing.
Long term—lock in new pricing methods
Even in the long term, advanced-industry players can feel some constraints due to extremely long product innovation pipelines with extended lead times. Companies should review their product ranges to ensure that they meet various customer needs, ensure that their innovation pricing is fully value based, and regularly refresh the capabilities of the pricing and sales teams.
Few managers today have experience dealing with inflation of the kind they now face. While perhaps unprepared, they do have a toolbox of proven analyses available to conduct a quick fact-based assessment of their organization’s pricing potential. Simple analyses, such as a pocket margin waterfall analysis, a margin variability analysis, or a product profitability comparison, are great ways to get a sense of the addressable potential and prioritize opportunities.
Most industrial companies recognize the need to address inflation, but many lack the capabilities and talent they need to do so effectively. To face and embrace the challenge, managers should build their plans across three time horizons—short term, midterm, and long term—and adjust their strategies with specific tools and techniques to accommodate each horizon.