One of the most instructive and entertaining business management books you can read was published in 1883. Emile Zola’s “The Ladies’ Paradise”.The_Ladies_Paradise (Au Bonheur des Dames), has recently been adapted and serialised on British television. Whilst the TV series understandably focusses on character relationships, Zola’s story is a more cynical critique of retail power and innovation in marketing. The store’s owner Octave Mouret has an intense commercial drive. His aim to drive out smaller competitors by compelling his – principally female – clientele to continually return and spend by using an overwhelming selection of inducements; fabulous goods and attractive novelties, advertising displays, home deliveries, no-obligation refunds and massive sales. Mouret ran ‘The Ladies’ Paradise’ as a high velocity business operating lengthy payment terms with suppliers and selling large volumes at extremely thin margins. The entire venture was dependent on recycling cash to effectively purchase volume growth and as such, actual profit was illusory.
The dangerous illusion of discounting for the sake of volume growth was very effectively demonstrated by Michael Marn and Robert Rosiello in 1992.They presented a price waterfall to make pricing transactions transparent. The pricing waterfall, which broke down al the potential impacts on profit of a pricing transaction, powerfully illustrated the negative impact of minor price reduction decisions on the final take-away or “pocket” profit margin. A similar price waterfall model created by Pennog illustrates how relatively small changes in the negotiated price can sometimes wipe out the pocket margin. Marn et al., 2003 used data from typical of S&P 1500 companies in a price waterfall to show why it would be necessary to increase volumes by 18.7% to off-set the pocket margin impact of a 5% price decrease.
Managers’ reluctance to gain such transparency is often down to a concern that allocation of fixed costs at the product level is not worth the effort, or that cost of goods sold provides sufficient information for day-to-day decision making. However, as Milani et al 2013 explain, whilst accurate allocation on costs is necessary for financial reporting, a less specific cost allocation (e.g. on a volume share basis) can be acceptable for day-to-day product pricing and discounting decisions. Further, as the graphic shows, making pricing decisions based on the margin contribution after variable product costs (cost of goods sold) only, masks the real impact on the bottom line. Often discount values are set at list or target prices rather than at the negotiated price at which they are later applied.
The simple price waterfall model prepared by Pennog, has been used to compare a 5% price discount applied to a negotiated price and a target price scenario at a volume-break (2,500 lbs, Kg or tonnes in the example). The graph illustrates how a volume discount designed at the target or list price can severely damage profitability when it is later applied to the negotiated price – requiring the sale of half as much volume again just to recover the profit lost.
Transparency and the rules for discounting are therefore equally important. Tony Romito 2011 explains the importance of capturing the timing of discounts and rebates in a single repository (something which is rarely done), which helps to consider all off-invoice discounting elements; annual rebates, price discounts based on volume breaks, commissions and fees, which may together impact profitability with a single customer.
Margin erosion is often due to a lack of transparency and profitable growth is more often achieved through pricing transparency and careful margin management rather than big impact price increases or volume-based price discounts. In Zola’s “The Ladies Paradise” the conquest of Mouret was as much to do with his confusing of volume growth for profit as his infatuation with Denise.
If you would like to discuss implementing Pricing Transparency and evaluate the Pennog pricing model contact Pennog by calling +44 1484 443001 or by selecting “Capturing Value Through Pricing” in the easy contacts form and providing some details of your interest.