What's in your pocket?

CFOs have long been confident in their ability to affect the cost side of the margin equation. But with multiple layers of overhead wrung out of the system and product costs rising unabated, unlocking the price side has taken on a certain sense of urgency.

Effectively implementing a pricing strategy, however, is more than simply viewing products on a cost-plus basis. It is also more than tracking pricing performance at the aggregate level. Instead, the promise of pricing is in the details: an effective strategy should rely on understanding economic profitability at the customer, product, and segment level—the so-called pocket margin—and using that information to inform overall decision-making.

To get to that level of detail, though, may require overcoming cultural, data, and compensation barriers to determine pocket costs. The effort is worth it, however: research has shown that pricing has up to four times more impact on profitability than other improvements. In this CFO Blog, we'll look at the power of understanding pricing at the customer level and discuss ways to install pricing disciplines that deliver consistent, positive results.

What are pocket margins?

Customer-level economic profitability can offer an untapped reservoir of information—and potential for improved margins for CFOs. For example, which customer segments are being given unwarranted volume discounts; which are unaffected by slight price increases; and where are delivery promises being made that materially increase transaction cost, but are not charged for?

To get at that level of information, however, may require moving past the aggregate view of pricing (gross margin, net margin) that finance typically demands to the "pocket" view that takes into account everything from payment terms to freight costs in order to identify the true profitability of a transaction (that is, gross margin less detailed allocations of fixed costs and SG&A).

And from that information, CFOs can extrapolate how profitable individual products, customers, and channels are and inform decisions better business decisions.

Identifying and leveraging pocket information

While the analytic tools exist to identify costs at a pocket level, the data is often widespread and incomplete, and frequently siloed. To fully assess pocket costs, finance should identify the components that add or subtract value from the business on a marginal basis. Those include factors that are not part of cost of goods sold (COGS), such as expedited shipping, fixed-asset or fixed-cost productivity, the cost of capital included in payment terms, and the various discounts and promotions offered.  

Working backwards from the list price, CFOs can use the tool to identify margin leakages and create visibility from a reference list price down to the pocket margin, including discounts, rebates, and other cost elements. While a product that earns 40% margin may look like the a winner in the product portfolio, if it turns out to be highly engineered and highly specialised, and requires extra sales support, it may not be. Instead, it may be the product that earns 20% margin and only has to be packed and shipped that you should be expanding.

Knowing what your costs are going forward may allow you to make the decisions that fit into the overall product strategy and build economic models that: 

  • Affect strategy - by making sure everyone involved in the pricing equation has a proper understanding of the economics of the business, CFOs can influence not just pricing policies, but overall business strategy.
  • Educate stakeholders - Having pocket-margin information can allow a CFO to educate his or her peers, CEO, and the board about pricing policies that work.
  • Institute controls - One outcome of pocket costing is often the exposure of "unwarranted discounting"—awarding discounts to customers whose volumes do not justify such action. One solution is to put limits on who can discount to what level and assign a finance person to authorize discounts that exceed that level.
  • Create a single version of the truth - A single version of the truth allows individual functions to make decisions about resource deployment, such as where distribution centres should be located, how much product should be kept in inventory, and how goods should be delivered. 

Out-of-pocket benefits

To adequately price in today's competitive marketplace, finance should build economic models that maximize sale-by-sale profit. Central to creating those models is a granular understanding of customer analytics on a product-by-product basis.

The company wide deployment of such information can help clear the way for informed decisions about everything from channels and products to sales and advertising. In addition, once a company has an understanding of the impact on individual products and customers, that information can offer a window into other areas of operations, such as the proper levels of safety stock and the cost-effective delivery methods.

Finally, gaining a handle on pocket margins can give CFOs another tool for growth and allows them to further drive the alignment of pricing approaches with corporate strategies. Pricing, after all, can expand earnings faster than cost cutting. What's in your pocket?

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.