Pricing in a Downturn Economy

In the current environment, costs are rising as price sensitivity increases. 

Six tactics can help companies get pricing right.

By Cheri N. Eyink, Michael V. Marn, and Stephen C. Moss, The McKinsey Quarterly, September 2008

Getting pricing right is always a challenge in an economic downturn, as decreasing demand, excess capacity, and greater price sensitivity all conspire to drive down prices. In most downturns, the cost of raw materials, feedstocks, and other upstream supplies—as well as the cost to serve customers (for delivering goods, for example)—tends to stabilize and even decrease as business activity slows.

As a result, decreases in downstream prices are at least partially offset by lower upstream costs. But in the current environment, not only is weaker demand from the end user making it harder to maintain prices, but significantly higher and more volatile input costs mean that companies caught in the middle are getting hit from both sides.

What’s a business to do? In this unusual downturn, companies need to manage the profitability of individual customers and transactions with greater precision, develop richer insights into their customers’ changing needs and price sensitivities, and understand more clearly the microeconomics that shape their own industries and those of their suppliers. We’ve assembled six tactics aimed at maintaining the best balance possible between sales volume and profit margins in the current challenging environment. 

Watch for sudden shifts in price structure
Companies should be vigilant in monitoring pricing policies that reduce revenue—such as volume discounts, rebates, and cash discounts—as well as cost-to-serve, including freight and sales support. In the current downturn, rising costs and declining demand can cause these elements to change more dramatically and quickly than they have in the past. Rapidly increasing fuel prices, for example, are putting intense pressure on delivery costs. Declining demand means that some customers may be collecting volume discounts they no longer deserve. Best-practice companies are reviewing much more frequently their pocket margin waterfalls,¹ which show how much revenue companies really keep from each of their transactions, and adjusting their pricing policies accordingly—for example, by adding delivery fuel surcharges to every order. Without the extra attention and quick action, erosion at all points of a transaction can quickly destroy profits in times like these. 

Monitor customer-level profitability
Companies should use transaction-level data to measure precisely the profitability of each customer. By doing so, companies can detect if the cost to serve particular customers or declining order volumes are nudging those customers below target profitability levels. In this downturn, for example, many customer groups are becoming simultaneously smaller and more costly to serve. One industrial company found that more than 20 percent of its customers had fallen below breakeven profitability, forcing it to raise prices selectively and, where possible, lower cost-to-serve by decreasing delivery frequency, reducing sales support, or fulfilling orders through alternate channels. 

Adjust to changing customer needs
Downturns always prompt changes in customer needs and in the benefits they value when choosing a supplier. The dynamics of the current downturn mean that such swings can occur even more rapidly. In this environment, the best companies are constantly assessing—through market research and direct contact—how economics are changing for their customers. Even more important, they are reacting quickly by retooling their price and benefit offerings accordingly. For example, one plastic resins supplier that had developed a fast-curing resin (to enhance capacity of injection molders when the economy was strong) has now developed a less costly resin that doesn’t cure as quickly. The new resin helps the supplier’s customers decrease costs, because molders are not running at full capacity during the downturn. With other supplies raising their prices, many molders see the slow-curing resin as an attractive alternative. As a result, the supplier can maintain its profit margins even while selling the alternative resin at a lower price. The combination of lower demand and higher input costs in the current downturn makes it critical to get these kinds of adjustments to the cost/benefit balance correct. 

Update price sensitivity research
Dramatic increases in energy and food prices have made consumers much more sensitive to prices across a wide range of product categories. Each price increase for necessities such as food and fuel has cut a little more from discretionary budgets, sharply increasing price sensitivity. Market price tests become obsolete after just a few months. To get price points right, pricing sensitivity research and market price tests should be rerun immediately to track these changes. 

Monitor your industry’s microeconomics
Radical shifts in costs and demand have thrown previously predictable market pricing mechanisms into chaos. Responding correctly requires a keen understanding of the microeconomic forces at play at the industry level. In one example, a building materials company found itself in a precarious position as the downturn deepened: a precipitous decline in US housing starts meant diminishing demand, while the costs for raw materials, energy, and transportation were increasing rapidly. In response, the company reassessed the industry’s microeconomics, looking in particular at the latest supply, demand, and cost dynamics. With this new information, managers cut capacity at a plant in an area where the decreased supply would not cause a local shortage. The capacity reduction, which would have had little if any effect on market prices a year earlier, brought about a better balance between supply and demand and kept market prices an estimated 10 percent higher than they would have been without the change. 

Study your suppliers
The extreme volatility in this downturn demands that companies reexamine not only the microeconomics of their own industries but also the microeconomics of their suppliers’ industries. Recently, a specialty chemicals company invested in modeling the current industry supply, demand, and cost dynamics for one of its primary raw materials. By doing so, the company predicted an industry-wide, 15 percent price increase for that raw material three months before it happened—a feat of some significance because there hadn’t been an annual price increase of more than 5 percent for that material within the past six years. Suspecting an imminent and unusually large price increase, the chemicals company began adding clauses covering raw-material price increases to its customer contracts, a move that would have met extreme resistance if made after the price increases were announced. Instead, the move established an industry precedent for passing cost increases through to customers. 

About the Authors


Cheri Eyink is a consultant and Mike Marn is a principal in McKinsey’s Cleveland office; Stephen Moss is an associate principal in the Stamford office

The Do's and Don'ts of Cash Management

By: Bronwen Roberts

Working capital is a highly effective barometer of a company's operational and financial efficiency and effectiveness. The better its condition, the better placed the company is to focus on developing its core business.

The early, primitive attempts at maximizing cash management can be traced back to the late 1970s. Unbelievably, there are still some companies who haven't yet understood that putting cash trapped in the balance sheet to better use can give them a competitive edge over their rivals.

A most recent report shows a further reduction of working capital in companies in the US and Europe compared with the previous year, of between 3 per cent and 5 per cent. This demonstrates the continuing increase in the importance of working capital management to help companies achieve their strategic objectives.


How to do It
There is more to working capital management than simply telling a company to collect its debtors as quickly as possible, to delay paying its suppliers as long as possible, and to keep stock levels as low as possible. A properly conceived and executed improvement program will certainly focus on optimizing each of these components, but will deliver additional benefits that extend far beyond the merely operational. It will demonstrate the need for ambitious corporates to integrate working capital management into their strategic and tactical thinking, rather than view it as an optional bolt-on extra.

There are a number of dos and don'ts to help guide corporate thinking. Firstly, do think of working capital management as a strategic objective that can enable your corporation's goals. We cannot over-emphasize this opening point. The same factors that drive a company's working capital also drive its operating costs and customer service performance. Therefore, by addressing the drivers of working capital a company will also experience significant improvement in operating costs and customer service.
 
For example, a company's working capital is deteriorating due to an increase in past due accounts receivable (AR). A review of the overdue AR illustrates a high level of customer disputes. The disputes are taking on average 30 days to resolve and consuming significant amounts of sales, order entry, and cash collectors' time. By tackling the root cause of the disputes, in this case poor adherence to pricing policies, the company can eliminate the disputes, thereby improving customer service.

This will free up the time of staff in sales, order entry and cash collections, enabling them to be more effective at their designated roles. This in turn increases productivity, reduces operating costs, and potentially increases sales. Working capital will improve, as customers will have fewer reasons to hold payment. This example illustrates how working capital is one of the best indicators of underlying inefficiency within an organization.

Consider Another Perspective
Don't think of things only from your own company's perspective. If you can help your own customers plan their inventory requirements more efficiently, for instance, you can match your production to their consumption, efficiently and cost-effectively, and do the same with your own suppliers. The potential implications for inventory levels are huge. By aligning ordering production and distribution processes, you increase inherent efficiency and achieve direct cost savings almost instantly, as a by-product. And then you discuss the best way to bill or to pay.

Do educate your organization to consider the trade-offs between different working capital assets when negotiating with customers and suppliers. Depending on the usage pattern of a raw material, there may be more to gain from negotiating consignment stock with a supplier versus pushing for extended terms. This could apply particularly in cases of long lead-time items, or those that require high minimum order quantities.

Agree Formal Terms
Do agree formal terms with suppliers and customers and document those terms carefully. Keep them up to date, and communicate those payment terms to employees throughout your business, particularly those involved in the customer to cash and purchase to pay processes, including your sales organization.

Don't allow prolific new product introduction without a clear product range management strategy. Poor product range management creates inefficiency in the supply chain, as companies are required to support old products with inventory and manufacturing capability. This increases operating costs and exposes the company to an obsolete inventory that may have to be disposed of.

Collect your Cash
Don't forget to collect your cash. Many businesses fail to implement effective ongoing collection procedures to prevent excess overdue funds or build-up of old debtors. Ask customers if invoices have been received and are clear to pay. If not, identify the problems that are preventing timely payment.

Confirm and reconfirm the credit terms agreed upon with the customer. Often, credit terms get lost in the translation of general payment terms and what's on the payables ledger in front of the payables clerk. Do devote the requisite amount of time and attention to the critical issue of dispute management.

Don't set top-down targets uniformly across the business. For instance, too many companies impose a 10 per cent reduction in working capital for each division. This fails to take into account the potential opportunity within a division and can result in setting an impossible target that acts to de-motivate. Instead, balance top-down with bottom-up intelligence when setting targets.

Targets Drive Behaviour
Do set targets that drive the desired behaviour. Many companies will incentivise collections staff to minimize the aged AR over 60 days. Does this mean that customers who pay one to 60 days late are good payers? No, aged AR over 60 days will result in increased costs and time it takes to collect the debt. By incentivising staff to lower the amount over 60 days, you keep your costs down. Do educate staff, customers and suppliers that cash and cash management are important, and are an integral part of a successful business relationship.

Look Within Yourself
Don't assume that all the answers are to be found externally. Before approaching existing customers and suppliers to discuss cash management goals, fully understand your own process gaps so you can credibly discuss poor payment processes.

Do treat suppliers as you would like your customers to treat you. Far greater cash flow benefits can be realized by strategically leveraging the relationship you have with suppliers and customers. In addition, a supplier is more likely to support you in an emergency if you have treated them fairly.

Don't however, treat everyone the same. Use segmentation tactics to split your customer supplier into similar groups. This may be based on a basket of criteria including profitability, sales, AR size, past due debt, average order size and frequency. Define strategies for each segment based around the criteria and your strategic goals.

Do celebrate success in hitting targets. Emphasise the actions that helped you get there.

Conclusion
To summarise briefly, following the dos and don'ts will enable you to optimize cash and to highlight inefficiencies in your processes that must be remedied to better serve customers. It will enable you to build stronger partnerships with your suppliers across the total working capital value chain. This translates ultimately into improvement in bottom-line results, often a good deal quicker than you might expect, and helps clarify the senior management focus on strategic imperatives. 

Author Bio
REL Consultancy Group www.relconsult.com are global specialists in generating cash improvements, cost reductions and service enhancements by optimizing working capital. They are the only international corporate financial consulting firm that focuses exclusively on increasing operational efficiency from working capital and operations. They work with people to transform your organization, your customer's and your suppliers in more than 60 countries around the world.