Winning the race with inflation: The pricing opportunity for industrial companies

As inflation rises, industrial companies must take a new look at pricing.
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Many industrial companies face a complex new array of challenges today, including a global pandemic that has driven radical shifts in demand, buying patterns, cost to serve, and perceived value across sectors and value chains, which in turn have led to sharp spikes in commodity prices. Inflation in the cost of raw materials is forcing industrial companies to take swift action on pricing. The price increases required to offset inflation and maintain constant gross margin could greatly exceed the 2- to 3-percent hikes many industrial companies make at year-end. In our discussions with leaders across industries, many have voiced concern about this issue (see sidebar, “The response to inflation”).

Sidebar

As an example, a business with 30 percent gross margins and 40 percent of cost of goods sold (COGS) exposed to raw materials, assuming inflation of 20 percent, will need to implement and capture an 8 percent price increase just to keep gross margin unchanged. Even higher increases may be necessary with more exposure to raw materials or higher inflation (Exhibit 1).

Pricing increases can help offset inflation.
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Sidebar

In a highly volatile environment such as the one we are experiencing now, in which prices of raw materials can quickly swing by double digits, capturing pricing upside is more challenging than ever, especially if pricing and procurement organizations are not working hand in hand.

Indeed, nearly all pricing and procurement teams operate in silos with different calendars and operating rhythms, and they generally lack formal processes to communicate effectively and orchestrate decisions. As a result, margin leakage is common, and the volatility in prices of raw materials exacerbates the issue. A few examples follow:

  • Sales teams base discounting decisions on standard costs that they update only once a year, while actual sourcing costs could change as often as daily.
  • While they may update standard costs more frequently, lack of communication between pricing and procurement organizations often means that procurement savings are passed on to customers—for example, when a salesperson sets prices based on gross margin instead of value, granting customers hard-earned procurement savings.
  • Many pricing and procurement teams hedge risks independently and without coordination—for example, by using spot pricing on the purchasing side and fixed pricing on the commercial side, inadvertently raising the company’s exposure to inflation risk.

Now more than ever, procurement and pricing teams need to work together to understand pricing opportunities across products and agree on priorities to pass through cost increases and protect—or expand—margins.

While procurement teams should continue efforts to fight material-cost increases and creatively reduce sourcing costs (topics beyond the scope of this article), adjusting prices is essential in today’s inflationary environment to improve margin position and align the prices of a wide range of industrial goods to their value to customers (Exhibit 2).

A new approach can help industrials capture the full pricing opportunity.
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Industrial companies typically face several challenges in capturing the full pricing potential from their range of engineered products:

  • For standard and configured equipment, hundreds of product configurations and accessories make it extremely hard to link performance and capabilities to price. Having limited win–loss data and competitive insights is a typical blind spot that curtails value capture, and channel incentives are often out of sync with the true value brought to the table (for example, demand creation versus fulfillment).
  • For custom equipment, significant variations often arise between budgeted versus actual margin due to front-end gaps (for example, insufficient cross-functional review during budgeting, budgeting errors, or scope changes) and execution (for example, skill gaps or inefficient installation). In addition, pricing for change orders usually does not capture the complexity of postdesign spec changes—if change orders are charged at all.
  • For engineered components, including spare parts, poor segmentation or taxonomy data (for instance, insufficient detail on IP, part life cycle, cost to serve, or attributes or complexity of base units) often makes it impossible to adequately price thousands of SKUs, and discounting across customer segments, regions, or product segments is often unexplainable or inconsistent. The typical approach reverts to “one-size-fits-all” annual price increases of 3 percent, leading to poor price realization.
  • Across the board, a lack of clear price-performance mechanisms, such as tracking tools, process price realization, delegation of authority, and central quoting teams, can lead to additional margin leakage.

Proven tools to capture full pricing potential

Companies should take three main steps to make consistent price improvements: set the right price, optimize discounts and rebates, and manage leakage (Exhibit 3). We have honed these pricing levers through real-life application and back-testing across hundreds of industrial product families. Here, we briefly explore five of the ten levers.

Ten levers are proven to deliver more value from pricing.
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Setting the right price

Cost-plus may seem like an acceptable approach to pricing because it aims for a similar margin across offerings, but experience shows that certain customers are willing to pay much more for specific products and services with the attributes they value most.

Industrial clients can use a range of tools to align prices more closely to value, compared with the next-best alternative. For example, a manufacturer of air-driven liquid pumps built an attribute-based pricing system—the first lever—using a four-step process:

  1. segmenting the portfolio of standard products into groups with similar characteristics based on list price
  2. identifying key product characteristics for each segment, from size to power consumption, and performance attributes, such as pressure and area ratio
  3. using multivariable regression to build “price-setting equations” based on all key product characteristics and performance attributes
  4. calibrating recommendations based on the sales team’s experience and knowledge of the competitive landscape

Equipped with more granular insights, a sales team can price each product more accurately, provide customers and distributors with a detailed rationale for each price, and distinguish each product and its features from those of competitors. For example, if a pump has certain characteristics that the customer wants and that other pumps lack, it will be priced higher (Exhibit 4).

In attribute-based pricing (ABP), companies set prices based on performance attributes of the product.
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Different pricing levers apply to each product type based on how customers will compare competing products and services. For example, companies can use the fixed-ratio pricing lever to reset pricing architecture based on where parts will be used.

They begin by segmenting the product portfolio based on differentiation and attributes, such as proprietary versus nonproprietary technology. They then map parts to base units, determine appropriate benchmarks for prices as a share of the original unit (by segment), and adjust pricing in response to competitors’ pricing and customer expectations—often at considerably better margins.

The next lever, value-based pricing, is a powerful tool, especially in the realm of highly specialized and differentiated offerings that provide unique value to customers in comparison to competing products. In the metal-cutting machinery example shown in Exhibit 5, improvements along the two main axes of customer value—speeding setup and reducing downtime by minimizing maintenance requirements—boosted output by 3 percent per day.

Value-based pricing helps teams price highly engineered and custom products based on quantified customer benefits.
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The sales team calculated that this product would cut the customer’s labor costs and increase throughput worth more than $40,000 in additional lifetime value compared with a competing product. The team chose to share about a third of that incremental value with the customer, winning the deal and strengthening its longstanding relationship and reputation for thought partnership.

Optimizing discounts and rebates

While setting list prices, as described above, helps anchor pricing in ways that reflect full product value and differentiation, discounting is an essential tool to adjust to a customer’s specific willingness to pay, often transaction by transaction.

To maximize price realization, companies need rigorous discounting guidelines and implementation. For example, a company with a high volume of transactions across customer segments and product families can apply a lever that involves resetting the discount structure based on customer value and product competitiveness. The sales team ranked customers and channel partners based on their importance in terms of sales, part attach rates, market penetration, and so on, and they segmented units and parts based on competitive intensity. Based on these metrics, the company introduced a granular grid to provide guidelines for discounts for each customer and product segment (Exhibit 6). Discounting guidelines are provided to the sales team during the quoting process—often through dynamic deal-scoring models that compare quote characteristics with historical data—and use information about the customer to predict likely willingness to pay.

Moving to a tiered discount structure helped a company drive profitable growth.
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Managing leakage

For large projects, such as the design, manufacture, and installation of customized equipment, different sources of leakage may emerge: even before a deal is closed, costly errors can arise in budgeting, outdated pricing models, and poor translation of customer specifications. Leakage is also common in execution—for example, rushed purchasing and operational inefficiencies due to time pressure, overruns in engineering and manufacturing hours, warranty costs, and penalties for late deliveries.

Change orders can chew up margins, especially when teams do not carefully track the reasons for the orders and learn from their mistakes or because contracts lack clarity or detail about scope, responsibilities, or deliverables.

By identifying and fixing root causes, companies can apply the lever that involves turning customer change orders into profit centers to minimize cost increases that arise during execution (Exhibit 7).

Companies can protect margins by improving cost-order variance management.
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Driving consistent execution to sustain impact

Even the most powerful pricing analytics and supporting tools won’t deliver value unless teams use them consistently. The most successful pricing programs are not subscale, one-off efforts but are truly transformational—they typically require changes in mindsets and behaviors, along with new capabilities, such as value-based selling.

Industrial companies can significantly boost performance by building capabilities at scale, which we discuss in the next section, and by consistently using best practices in three main categories:

  • Pricing processes. These include quoting policies and processes, “delegation of authority,” and exception management.
  • Rigorous governance. Effective governance and performance tracking typically includes codifying every pocket of opportunity with a detailed “3W” plan: who, what, and when. Senior leaders can use standardized stage gating with clear definitions to track the maturity and progress of initiatives. With a plan of record, they can closely track performance by month and lever and maintain “radical transparency” each week about pricing performance at the product-family level. Senior leaders should convene regularly to review performance.
  • Data and analytics. These can be used to scout and quantify pricing opportunities already in hand and from public and private sources, along with digitized pricing processes to drive consistency. Sales teams can gain insights and boost efficiency by integrating lead sources in a single customized database, for example, and build artificial intelligence–driven deal quoting. Customized tools can provide teams with real-time pricing guidance based on analyses of transaction details: the value of the customer, historical purchases, product segments, historical transactions, and so on. The sales team can review, validate, and implement individual price targets and escalate requests for discounts beyond the target. Most sales teams will also need new capabilities and motivation to improve pricing performance.

Building capabilities at scale

Our research shows that organizations that build capabilities and have the right resources are more than three times more likely to succeed in a change effort. Capability building is a critical component of any pricing initiative because change must be consistent and at scale to deliver meaningful and sustainable improvements to the bottom line. For instance, a large company will need to engage thousands of busy salespeople around the globe.

To execute a pricing transformation, commercial teams need to build new skills to identify and capture pricing opportunities. Pricing and nonpricing specialists alike need foundational knowledge and a common pricing language, and they must also master practical approaches. As a result, commercial teams can work together better, develop and champion pricing initiatives, and create impact.

To build new knowledge and skills, shift mindsets in a real-world context, and reinforce new practices and habits to drive continuous improvement, companies should use a blend of delivery methods, such as workshops, digital learning, expert coaching, and performance support. In our experience, courses should cover five pricing topics: pricing foundations, setting prices, capturing prices, maintaining prices, and effective execution.

Pricing teams should also learn to use dashboards to gain real-time insights into a range of vital topics: customer-level performance and the largest sources of leakage; sales-rep performance to identify coaching opportunities; and the “margin maximizer,” which tracks current and historical key performance indicators by pricing lever—freight, small orders, price floor and target noncompliance, cost pass-through, and manual overrides—to find new ways to raise margins.

Next steps

We believe industrial companies can gain ground quickly in today’s industrial landscape if pricing and procurement teams learn to collaborate better using real-time data on tens of millions of transactions. With new tools and approaches, they can gain a deeper understanding of margin risk, translate it into clear pricing priorities, and incorporate details about commodity costs into conversations with customers.

As complexity mounts in the industrial marketplace, two certainties remain: pricing is still the most powerful profitability lever, and companies that continue to rely on outdated pricing approaches—disconnected from input costs or customers’ willingness to pay—will fall further behind as their margins shrink.

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