[Note: This post is a chapter of our Growth Handbook, a guide on organic growth for search funds and mid-market operating executives.]
Warren Buffett has said the single most important decision in evaluating a business is pricing power. Search-CEOs naturally target companies with meaningful market power, and the opportunity for EBITDA growth through pricing optimization is widely-appreciated in the search community. Pricing optimization is a common initial lever for driving profitable growth because if done right, it can translate into a nearly-immediate increase in free cash flow. Plus, if a company’s pricing strategy is flawed, increasing lead generation or sales outreach will anchor customers to a model that may become more difficult to shift later, so the order of operations matters.
The difficulty, however, is in unpacking a generalized desire to “optimize pricing” into the specific components of a pricing program to isolate what needs to be done. We offer the below framework for attacking the problem:
The basic goal is to align your prices with customer willingness-to-pay (i.e., shift to value-based pricing)
Often that requires segmenting your customers into different buckets and charging them different amounts (perhaps indirectly) based on that willingness-to-pay and value created
These segments can be based on static customer company features like size and industry or situational factors like lead time, size of order and other properties
Thus, pricing connects back to having a clear understanding of personas and pain points solved
Many pricing optimization efforts fail at the “last mile” of execution—getting sales people to follow the pricing plan
The fear of losing an order entirely often outweighs the perceived personal benefit of extracting an extra few points of price
For instance, if a hypothetical sales person is paid based on a commission of ~5% of revenue, getting a 2% increase in price translates to an immaterial increase in pay for her, which can cause excessive conservativism in pricing (from the standpoint of the company)
For most businesses, focusing on incentives, training and psychology (of both customers and your sales people) is more important to a pricing program’s success than raw quantitative analysis
Pricing Optimization Project Plan
Each pricing optimization initiative will vary, but the steps below broadly apply to anyone running a pricing project at a mid-market company–particularly a B2B service company.
Align internally on goals with leadership team
Assemble working group: it’s very helpful to have representation across departments if possible because internal buy-in is critical and these people will be your champions
Internal Pricing and Margin Analysis
Review your offerings at a product/service level to see margin by category
Shows if any offerings are not profitable (low-hanging fruit)
Shows where you have room to cut price, if appropriate, though in most cases lower mid-market companies should be increasing prices
Look at changes in prices over time
Have they kept up with inflation?
Compare versus COGS
Unfavorable shifts in revenue mix?
Consider utilization, staffing and other ops factors
Example 1: Consistent shortages in key roles? May need to bring supply/demand of labor into balance with price change or nudge revenue mix toward offerings that don’t require those roles
Example 2: Peak demand on certain days causing warehouse capacity issues? Charge more for those days
Customer Economics and Willingness-to-Pay
What are (a) customer objectives and (b) the price of their perceived Next Best Competitive Alternative (NBCA)?
Differentiation value: what value do we add beyond NBCA? (quantify this; consider cost, revenue, risk and psychological value)
Segment customers and quantify potential pricing factors: what specific factors influence customer willingness-to-pay? These could be attributes of the company or the individual decision maker or the job/offering itself; possible factors include:
Company: size, industry, geography
Decision-maker: role, years of experience, has solicited multiple bids?
Job/Offering: lead time, day of week, total size
Cost of failure and alternatives
Decision-making process; threshold where another person approves?
Representative buyers (expert interviews)
Internet / desk research
New Model Development
Revise base rates
Revise/implement dynamic pricing factors
Socialize internally and get feedback
Create quoting tool: ideally integrated into CRM
Monitoring dashboard: show both sales rep pricing policy adherence (i.e., are we following the plan) and impact (sales conversion rate and gross profit won per quote)
Cascade communication down from sales leads to frontline reps
Leverage the members of your working group to communicate key points (i.e., create peer validation)
Show sensitivity of how the business can lose volume and still gain EBITDA
If sold via custom quotes, may not be necessary to announce price change
Bundle announcement of rate increase with new value-add or at least announcement of quality/reliability milestone (i.e., error-free rate, safety rating achieved, etc.)
Expect pushback and don’t lose nerve if a few customers balk
Testing, Monitoring & Refinement
Clarify how much volume you can lose (or need to gain) while still achieving positive outcome from price changes
“Gross profit won per quote” is a good metric to follow that considers price captured and impact on sales conversion rate, while normalizing for variance in quote volume
Hold regular calls with sales leads and project team; review dashboard and solicit qualitative feedback from reps
Adjust pricing model where needed
Schedule minimum of once/year review of prices
Note: in some cases it will be necessary to revisit the sales incentive plan and make adjustments as part of a pricing optimization initiative, emphasizing gross margin, pricing policy adherence or other goals