The Role of Finance in Pricing Decisions

One of the key financial metrics constantly measured and monitored by the business is the level of profitability growth.

For any company, profit and positive cash flow, are both critical and with a company that does not initially have investors or financing, real and not paper profit may only be its capital. Without sufficient capital or the financial resources used to sustain and run a company, business failure is imminent.

The bottom line is that no business can survive for a significant amount of time without making a profit. That being the case, the measurement of a company’s profitability, both current and future, is critical in the evaluation of the company.

In an environment where competition is intense, customer loyalty is diminishing and business growth is not a guarantee, the scramble for the profit pie is far from over.

Faced with these mounting challenges, businesses embark on cost transformation initiatives to boost profit margins. Normally, the exercise starts by looking at the company’s Profit and Loss historical spend, analyze the cost drivers, justify the spending and then make the decision to wield the axe or not.

Sometimes an across the board approach is pursued whereby an equal percentage cut is applied to all business areas. The drawback of such approaches is that they only allow you to extract limited savings that are not sustainable in the long term.

Also, business areas that have future potential for growth and require continual attention and investment are sacrificed for short term gains.

In other cases, the focus is more on increasing revenues, either through new business development, growing the existing product line, up-selling or cross-selling. Provided there is demand for your new offerings and recurring costs are not significantly high, the results could be different.

However, there is another focus area, in my experience, I have noticed is often not granted adequate resources and effort despite its massive potential to grow both revenues and profitability.

Effective Pricing

Pricing has a substantial and immediate effect on company profitability and any significant price changes in either direction can have unexpected effects on the bottom line. Managing pricing is therefore a vitally important lever to increase profitability and generate funds for investment.

With margins increasingly getting squeezed due to costs escalations, using the wrong pricing model for your business increases the risk of losing money on some customers or contracts by applying the same pricing approach and margin across the board.

Although companies differ noticeably in their approach to price setting, the goal should always be to get the price right across all customers, channels, segments, products and service lines. The challenge today, especially for B2C businesses, is meeting the constantly evolving needs of consumers at a reasonable profit.

Consumers are increasingly demanding quality, immediate availability and superior after-sales service at a much lower cost than before. On the other hand, input costs are not declining. In such an environment, the effectiveness of traditional cost-based and competition-based pricing approaches is challenged.

Since these approaches are reactive in nature, perhaps the competition has raised prices or perhaps the COGS has increased, can you afford to raise prices without losing business to a competitor?

Finance and Sales & Marketing Collaboration

In a number of organizations, pricing decisions are the remit of sales personnel in the field. The absence of robust pricing processes in these organizations often result in sales personnel basing pricing decisions on gut feel.

Additionally, because of the pressure to bring in new deals and reach the sales quota, heavy discounting is widespread and chaotic.

Working hand in hand with sales and marketing teams, finance can help fix the broken system and bring transparency and discipline to pricing decisions.

1. Clarity on customer sensitivity to price variations: With so many factors affecting a company’s profitability, it can be difficult to determine the best way to price your products and achieve the desired profit levels and customer loyalty. However, disciplined pricing execution is highly dependent on the specific products’ price sensitivity, or customers’ willingness to pay a different price for a product without affecting demand. Leveraging their commercial acumen and analytical strengths, finance personnel can help develop business rules and sophisticated tools that quantify customer price sensitiveness and willingness to pay and improve price levels.
2. Document and implement new processes: In the absence of robust processes to ensure discipline in price setting and prize realization, the organizational consequences of not following pricing guidelines are too big to ignore. As process improvement specialists, finance can help put into practice processes and tools to document, monitor and communicate incentive systems, acceptable discount levels and price variances to sales and marketing teams and other decision makers. As a well-run business, you want to ensure that the price the company gets is a close as possible to the price the company wants. Thus, any price changes have to be justified and documented for approval.
3. Define pricing boundaries: Companies usually use historical heuristics, such as cost information, to set prices. At the anniversary of each contract and during pricing review, very rare do most of them calculate the customers’ costs-to-serve. A standard increase is applied to previous pricing rates with the objective of getting a certain ROI or a certain markup on costs. This simplistic approach ignores the customer’s perceived value of the product as a critical factor for determining the final price. Finance can look to see whether or not the price points are too low, too many, or are at least profitable and value-based enough to be implemented. Through scenario planning practices, finance can run test-and-learn plans that help define pricing boundaries. New approaches are piloted, and prices are then optimized based on what works and what doesn’t.
4. Drive change throughout the company: Evolving from pricing based on cost or competition (me too) to pricing based on customer value is a continuous learning process that requires a shift in culture. The process requires top management buy-in, sponsors and change agents who are committed to improving the organization’s pricing capabilities and overall system effectiveness. Finance business partners are well positioned to act as change agents, internalize value-based pricing and motivate the organizational changes required to support it. They are able to help colleagues understand the value reflected in prices. In turn, sales teams are empowered to address customer or client questions related to price variances and walk away from unprofitable deals.

Customer Experience and Customer Perceptions

It is vital for businesses to develop a deep understanding of their customers’ needs, perceptions of value for money and how any shifts in prices alters their willingness to pay. At the core of value-based pricing is having the ability to balance costs and the benefits attributed to your product or service.

One of the grave mistake you could make as a business is falsely assume that customers will immediately recognize and pay for your innovative and superior product. Today, rather than base their purchase decision solely on price, customers first want assurance that your product is the right one to fulfill their Jobs-to-be-done.

Instead of asking, “How can we achieve higher prices in spite of strong competition?” you need to start asking, “How can we generate additional customer value and increase customer willingness to pay, in spite of strong competition?”