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Loftier sales book does not necessarily hateful loftier income, as many companies have found to their sorrow. In fact, profits (as a percentage of sales) are often much higher on some orders than on others, for reasons managers sometimes do not well sympathize. If prices are advisable, why is there such striking variation? Let'due south look at 2 examples of selling and pricing anomalies:

  • A plumbing fixtures manufacturer raised prices to discourage the "worthless" small custom orders that were disrupting the manufacturing plant. But a serial of price hikes failed to reduce unit sales volume. A study of operations ii years afterward revealed that the most profitable orders were these custom orders. The new high prices more than compensated for costs; customers weren't irresolute suppliers considering of high switching expenses; and competitors had shied from short runs because of the conventional wisdom in the manufacture.
  • A prominent producer of majuscule equipment, realizing it was losing big sales potential in its largest accounts, started a national account plan. It included heavy sales support with experienced account managers; participation by high-level executives; special support similar applications engineering science, custom blueprint services, unusual maintenance work, and expedited delivery; and a national buy agreement with a hefty graduated volume discount.

Customers, however, viewed the programme as merely a dog-and-pony bear witness, having no substance. To convince the skeptics, summit executives personally offered greater sales and service support and even more generous discounts.

Sales finally turned upward, and this "success" justified even higher levels of support. But profit margins presently began to erode; the big national accounts, the company discovered, were generating losses that were big plenty to get-go the rise in book and the profitability of smaller, allegedly less bonny accounts.

Clearly these ii companies discovered that it costs more to fill some orders than others. The plumbing fixtures executives raised prices precisely because they knew information technology was costing them more to fill small-scale custom orders. The capital equipment company willingly took on actress costs in the hope of winning more sales. Management in both companies recognized that their toll tags would vary, the first from additional prices on custom orders, the other because of volume discounts. But executives in both companies failed to come across that the cost and price variations would cause profound differences in the profitability of individual accounts and orders.

Many companies make this mistake. Managers pay trivial attention to account profitability, selection, and management. They seldom consider the magnitude, origins, and managerial implications of profit dispersion. In this commodity we examine three central aspects of this important cistron: costs to suppliers, customer behavior, and management of customers.

Costs to Suppliers

Profit, of course, is the divergence betwixt the cyberspace price and the actual price to serve. In terms of private accounts and orders, there can be dramatic differences in both toll and toll.

Despite legal constraints that encourage uniformity in pricing, notably the Robinson-Patman Act, customers usually pay quite different prices in practice. Some buyers can negotiate or accept advantage of differential discounts because of their size or the functions they can perform themselves, like in-house maintenance or technical support. And some customers exploit deals and promotions more than others. Moreover, the costs of serving customers and filling orders can vary significantly.

Presale costs vary greatly from society to guild and account to business relationship. Geography matters: some customers and prospects are located far from the salesperson'southward home base of operations or normal route. Some customers require seemingly countless sales calls, while others place their orders over the telephone. Some must be courted with tiptop-level executives backed upwards by sophisticated business relationship direction techniques, while others demand piddling special endeavour. Such variations in cost reflect differences in customers' buying processes or the nature of their ownership teams. (Some teams are large and geographically and functionally dispersed; others are small and concentrated past location and/or function.) Finally, some customers demand intensive presale service, like applications engineering and custom blueprint support, while others accept standard designs.

Production costs also vary by client and by guild. Order size influences cost, as do setup time, flake charge per unit, custom designs, special features and functions, unusual packaging, and fifty-fifty gild timing. Off-peak orders price less than those made when need is heavy. Fast delivery costs more. Some orders phone call on more than resources than others. A visitor that inventories products in anticipation of orders, nonetheless, will take difficulty tracing production costs to item orders and customers. Accounting policies and conventions, furthermore, often cloud the distinctions in product costs.

Distribution costs naturally vary with the client's location. It also costs more to ship via a preferred transportation mode, to drop ship to a split receiving location, to find no dorsum-booty opportunity, or to extend special logistics support like a field inventory.

Postsale service costs also differ. Sometimes customer training, installation, technical support, and repair and maintenance are profit-making operations, but businesses oftentimes bundle such services into the production price, and the heir-apparent pays "nix extra" for them. For some items, including uppercase equipment, postsale costs are heavy.

Thus there are variations amid customers in each of the four components of cost: earlier-the-sale expenses, production, distribution, and later on-the-sale service. Moreover, if prices and costs practise not correlate, the distribution of gross income will have a dispersion that is the sum of the private price and cost dispersions and thus much greater than either. Of course, prices and costs are often viewed as correlated, but our research suggests that they ordinarily aren't—which produces a broad dispersion of account profitability.

With real cost-plus pricing, profitability could exist uniform beyond customers despite wide variations in both costs and prices. Simply there is evidence that prices seldom reflect the actual costs in serving customers (though they may be somewhat related to product costs). In many businesses, the departure between the highest and lowest prices realized in like transactions for the same production is every bit much every bit 30%, not including quantity discounts.one Consider, for case, the relationship betwixt prices and total costs in i month'southward orders for a manufacturer of pipe resin (come across Exhibit 1). The diagonal line indicates a price level equal to costs. If gross margin were the same on all orders, the orders would all lie along a line parallel to the diagonal line. Instead, they are widely dispersed. Near 13% of sales volume resulted in losses of nigh a nickel a pound, while about 4% of volume generated an eight-cent profit. The rest fell somewhere between.

Exhibit one Wide Gross Margin Dispersion for a Pipe Resin Manufacturer for One Month

This design is not unusual. In a wide diversity of situations, we take consistently observed a lack of correlation betwixt price and the cost to serve. Some orders and customers generate losses, and in general the dispersion of profitability is wide.

Customer Beliefs

It is useful to remember of customers in terms of two dimensions: net price realized and cost to serve. To show graphically the dynamics of the interplay between seller and buyer, we have devised a simple matrix (see Showroom 2). The vertical centrality is internet price, low to high, and the horizontal centrality is cost to serve, low to high. This categorization is useful for whatever marketer. The carriage trade costs a great bargain to serve but is willing to pay top dollar. (This category would include the customers of our introductory example, who placed pocket-size orders for high-cost custom fitting.) At the opposite farthermost are deal basement customers—sensitive to cost and relatively insensitive to service and quality. They tin be served more cheaply than the carriage trade.

Exhibit 2 Client Classification Matrix

Serving passive customers costs less as well, but they are willing to accept high prices. These accounts generate highly profitable orders. There are diverse reasons for their mental attitude. In some cases the production is too insignificant to warrant a tough negotiating stance over price. Other customers are insensitive to price because the production is crucial to their operation. Still others stay with their current supplier, more or less regardless of toll, considering of the prohibitive price of switching. As an case from another industry, many major aircraft components cannot be changed without recertifying the entire shipping. And in some cases vendor capability is so well matched to buyer needs that cost to serve is low though the customer is receiving (and paying for) fine service and quality.

Ambitious customers, on the other hand, demand (and often receive) the highest product quality, the all-time service, and low prices. Procter & Chance, boasting an efficient procurement function, has a reputation amid its suppliers for paying the least and getting the most. Aggressive buyers are usually powerful; their exercise of buying in large quantities gives them leverage with suppliers in seeking price deals and more service. The national accounts described in the second case at the beginning of this article collection difficult bargains with the capital equipment supplier.

Marketing managers often assume a potent correlation betwixt net price and toll to serve; they reason that price-sensitive customers volition accept lower quality and service, and enervating customers will pay more for better quality and service. Thinking in terms of service and quality demands unfortunately deflects attention from the critical issue of cost to serve. In addition, weak cost accounting practices that average costs over products, orders, and customers often back up the high-price, high-toll myth. But equally we have seen, costs and prices are non closely correlated.

A supplier of industrial packaging materials recently analyzed the profitability of its large national accounts. For each one it calculated estimate indicators of net price and price to serve, based on averages of the aggregate values of a year's transactions. Top officers expected to discover most of its customers in the carriage trade quadrant and the rest in the bargain basement. They were shocked when the results put well-nigh one-half of the 164 large customers in the passive and aggressive quadrants (run across Exhibit iii).

Exhibit 3 Customer Matrix of an Industrial Packaging Materials Supplier

We believe this pattern is more common than is by and large recognized. Among the various factors influencing buying beliefs, the most important are the customer's situation and migration patterns.

Customer's State of affairs

Four aspects of the customer's nature and position affect profitability: customer economics, power, the nature of the decision-making unit, and the institutional relationship between the buyer and seller.

As nosotros all know, fundamental economics helps decide a buyer'south price and service sensitivity. Customers are more than sensitive to price when the product is a big part of their purchases, more sensitive to service when information technology has a big affect on their operations. Contained of economic science, buying power, of grade, is a major determinant of the buyer's power to excerpt price concessions and service support from vendors. The power of large customers shows in their power to handle many aspects of service support in-firm—like breaking bulk—for which they need cost adjustments. Sometimes small customers also wield considerable ability. A technological innovator that influences industry standards commands the eyes and ears of suppliers. Thus the relationship of price to serve and customer size in this manufacture is non clear without careful measurement.

In respect to the decision-making unit, the purchase staff is more often than not sensitive to price, while applied science and production personnel are sensitive to service. These roles volition affect decisions, depending on who nigh influences vendor choice and direction.

Naturally, this element is bound upwards with whatever relationships that have congenital up between the heir-apparent and seller. Long-standing friendships, long histories of satisfactory performance, and appreciation for any special help or favors all tend to make customers reluctant to pressure suppliers for price and service concessions. Procter & Gamble rotates the responsibilities of its purchasing department members to discourage the evolution of potent personal relationships with vendors.

Migration Patterns

Changes in organizational ownership behavior and competitive activeness can produce predictable patterns of change in client profitability. Oftentimes a relationship begins in the carriage trade category. Customers need all-encompassing sales and service support, insist on loftier production quality, and do not worry much nearly price if the product is new to them. They demand the functionality and volition pay for it.

Over time, however, as the customers proceeds experience with the product, they grow confident in dealing with the vendor and operating with less sales and service support or even without any. The cost of serving them is likely to refuse, and they are likely to go more than price sensitive. In addition, the buying influence of the customer'southward procurement section frequently grows, while the role of engineering and operating personnel diminishes. This shift, of grade, reinforces the tendency toward price sensitivity and away from service concerns. Finally, through rival product offerings (often at lower prices), customers gain cognition that improves their competence with the product and thus their ability to demand price concessions and lessen their dependence on the vendor's support efforts.

If the customer perceives the product every bit trivial (as in the instance of office supplies) and therefore does not seek it avidly, price sensitivity will not necessarily increase equally service needs allay. In terms of the matrix in Exhibit 2, migration will be toward the passive and deal basement areas. If the buyer values the product and it is complex or service sensitive (like CAD/CAM equipment), the buyer may pressure the supplier for toll reductions even while service requirements remain high. The migration tends to be downward from the carriage merchandise toward the ambitious quadrant, every bit in the instance of electric generation equipment for utilities. In bolt similar pipage resin, a combination of customer experience, expanding influence of the purchasing staff, and increasing competitive imitation often leads customers into the bargain basement category.

Management of Customers

The shifts toward the bargain basement and aggressive quadrants are part of the full general trend of products to evolve from high-margin specialties to low-margin commodities. The dispersion of customer profitability nosotros have observed can exist managed. We suggest a five-step activity program: pinpoint your costs, know your profitability dispersion, focus your strategy, provide support systems, and clarify repeatedly.

Pinpoint your costs.

Manufacturers tin can ordinarily mensurate their mill costs better than costs incurred by the sales, applications engineering science, logistics, and service functions. For instance, few companies have a sense of the cost of unscheduled executive try to handle the demands of ambitious customers. And so information technology seems likely that customer profitability varies more than widely in businesses where a large percent of the total expenditure is incurred outside the manufactory. This would be the instance in many high-tech companies that have low manufacturing costs but spend a great deal on sales, design engineering, applications engineering, and systems integration.

Because many specialty products are custom designed and manufactured and behave heavy nonfactory costs, the cost dispersion for these products is greater than for bolt. But as we pointed out in our pipe resin example, profit dispersion can be high fifty-fifty in a commodity product.

Costs incurred at different times in the order wheel have different effects on the true cost to serve the customer or order. In major sales with long lodge cycles and long pb times, the presale endeavour may begin several years ahead, and service nether warranty may extend several years after installation and billing. If the price of upper-case letter is 15%, a dollar spent two years before the billing of the customer is worth $ane.32, and a dollar spent three years after billing is worth only 61 cents at the time of delivery. Companies with long lead times and guild cycles, such as sellers of ability generation equipment and commercial airliners, with long-term, substantial service liabilities, evidently take toll dispersions much larger than boilerplate, except where progress payments residuum out cost flows. These companies need specially good control systems and management judgment to measure costs and human activity accordingly.

Companies with poor toll accounting systems have no manner to determine gild, client, product, or market place segment profitability. Consequently, their cost control and management systems will be weak, and the upshot is likely to be to a higher place-average dispersion of costs. The sales manager of a large role equipment supplier who lacked adequate cost information described his situation thus: "It'due south management by anecdote. Salespeople regularly make passionate pleas for price relief on specific orders. When I press them for reasons, they say 'threat of competitive entry.' When I ask them if a curtailment in service would be acceptable to make upward for the price decrease, they give me a resounding no! What choice do y'all take in the absence of cost information, except to go by your judgment of the salesperson's credibility? I've wrongly accepted as many bad price relief requests as I've rejected."

An effective cost bookkeeping system records data by product, order, and business relationship, and records costs across the mill, including selling, transportation, applications or design engineering, and fifty-fifty unusual, unprogrammed activities like investments of blocks of corporate management time. Presale, production, distribution, and postsale service costs should all be recorded, analyzed, and related to orders and accounts.

Of grade, there are enormous difficulties in creating and maintaining such a system. But fifty-fifty a organisation that estimates such costs only approximately can assistance a great deal. Twice a year, for case, one industrial visitor calculates the cost of serving 3 sizes of customers (big, medium, and small) and 2 sizes of orders (truckload and less-than-truckload) for a representative sample of accounts and orders. During the following six months, sales managers utilize these numbers to guide their decisions on price-relief requests.

Know your profitability dispersion.

In one case costs are known, the company can plot them against realized prices to show the dispersion of account profitability, as in Exhibit ii. Clearly the framework must be adjusted to the characteristics of the business. Similarly, the price centrality should exist defined in a meaningful mode. Since list prices are oft misleading, use some sort of net toll. Notwithstanding, discounts should non be double-counted under costs every bit well. The ultimate objective is a measure of net profit by client and club. Tracking cost and toll information by order is an essential first step in building an account profitability matrix.

Companies that know their costs and utilise cost-plus pricing schemes volition notice near of their accounts in the bargain basement or carriage trade quadrants of the matrix. Though this design is perfectly reasonable, sales management should try to develop accounts in the passive quadrant. Many such customers will accept college prices because they like the product so much. The cost to them of negotiating a lower cost (or better service) outweighs the actress benefits they would get. The passive quadrant represents a region of maximum value for both the seller and the buyer.

A dispersion of profits is no bad thing; only not knowing information technology exists is. The best-managed companies know their costs well and ready prices on the ground of product value to customers rather than cost to serve. Then they accept some accounts in the passive categories. In fact, their profit dispersion volition be greater than that of companies pricing on a cost-plus basis. The worst managed companies, ignorant of their costs and setting prices mainly in response to client demands, are likely to have a large number of accounts in the ambitious category, with, obviously, pessimistic implications for profitability.

Focus your strategy.

The next step is to use your knowledge of cost, toll, and turn a profit dispersion to ascertain a strategy for managing your accounts. Hither the company defines its personality. The low-cost, low-service, low-price provider is in the lower left of a profitability matrix, while the company that offers differentiated and augmented products, intensive service, and customization—and, therefore, more value added—is in the upper right quadrant. Because any company's adequacy is necessarily limited, it cannot span the entire dimension. If it tries to, the poor focus will leave the company vulnerable to competition. This will allow rivals to jump into the aggressive quadrant with high service and depression prices, drawing customers abroad from both the bargain basement and carriage merchandise quadrants. The result for the stretched-out company is reduced profitability.

The visitor has two strategy decisions to brand. One is to locate the center of gravity or cadre of the visitor's business along the axis. The other is to define the range along the centrality it will encompass.

The central pick to exist made is the choice of customers, for companies that reside in a given quadrant will generally produce orders in that quadrant. Customers in each quadrant of the profitability matrix behave in a distinctive manner. The supplier has to make up one's mind which behavior is virtually consistent with its strengths. For instance, in an manufacture with high transport costs, like cement or sand, a customer located at the maximum practical distance from your plant is likely to be in one of the right-hand quadrants—for you. For a competitor whose plant is located about the customer, that account will probably be in a left-paw quadrant. Unless you lot can form a carriage-merchandise relationship with that client—realizing high prices because of the value of your services—you would do better to concede the business relationship to your competitor.

Provide back up systems.

Unless it wants to follow a policy of toll-plus pricing, the visitor needs to develop processes and systems that volition help information technology manage the profitability dispersion. The visitor's information system should produce reports based on lodge, customer, and segment profitability, not just on sales. Management must exist oriented toward lateral cooperation amid functions. A procedure that simply rewards salespeople for high unit sales and manufacturing personnel for low-cost production is unlikely to lead to the most assisting lodge mix.

Toll setting rates special attention. Companies that operate in the deal basement and aggressive quadrants of the profitability matrix must oftentimes gear up centralized offices to price large orders and screen customers' demands for services. A "special bids" group is often the only way to requite the quick replies and careful analyses such orders require. Such a group tin can all-time balance financial implications, production and operating capacity, and customer needs, without giving away the store. Since carriage trade customers value the supplier'due south actress services, a cost-plus pricing policy may be advisable for them. Finally, pricing for the trade in the passive quadrant has to exist based on the value the customer places on the product.

The assay, strategy, and customer negotiation functions must be kept separate. A men's and boys' coat manufacturer we know of is a good instance of what happens when this dominion is ignored. The owner's 3 sons headed divisions serving the department shop, discount store, and export markets, while the possessor himself managed the private-label business. He chosen on the three large full general trade chains (Sears, Ward, and Penney), one of which gave him virtually all of his business. The sons' divisions were very profitable, simply the private-label unit of measurement was a large money loser.

Why was this so? Before a son went out to negotiate an social club, the owner stressed the need to go high prices, go on costs reasonable, and secure orders that fit the company's abilities. The male parent analyzed large orders for profitability. But when the father went to talk to his biggest customer, no ane pressured him to keep profits up. He consistently caved in to demands for lower prices, higher service, and better quality. His sons felt powerless to analyze his orders for profitability. The lesson: the same person should not gear up profit goals and negotiate with customers.

The more services a company provides, the more coordination is necessary among the engineers, field-service staff, and other functionaries in delivering the product and service. Likewise, the more a company increases its price to serve, the more important inter-functional coordination becomes. Low-toll, depression-cost, low-service bargain basement operators don't need and can't afford elaborate logistics, field service, and other coordinating mechanisms. Carriage trade customers can't operate without them.

Deciding what strategic choices to make requires maintaining marketplace enquiry, pricing assay, and cost-accounting functions. While these are high-leverage operations in which modest investments tin can yield loftier returns, in hard times companies often view them as nonessential overhead expenses. This brusk-sighted attitude tin can be very damaging.

Repeat analysis regularly.

A ane-shot profit dispersion and strategy analysis is of little use. Buying behavior and migration patterns, similar markets and competitors, are dynamic. Migration patterns gradually dilute a company'due south account selection and management policies.

Cumberland Metals (a disguised name) made pollution control components for the Big Three car companies in the mid-1970s. Margins were very expert, reflecting the high value the auto companies placed on the product, their lack of experience with pollution command, and the absence of competition. The entry of competitors in the early 1980s and, on the customers' role, a shift in influence from engineering science to procurement staff signaled a key migration in their buying behavior, just Cumberland management ignored the warning signs. This inattention acquired long-standing customer relations problems and a prolonged earnings slump.

Cumberland Metals is unusual because it had only three big accounts. The loss of accounts and orders from the carriage trade quadrant is normally a matter of erosion.

How often a company should analyze profit dispersion and strategy depends on the rate of alter in the market and in technology. In many cases, a one time-a-year assay integrated with the almanac marketing plan makes sense. In high applied science or other rapidly changing industries, a more frequent review may be improve. In whatsoever case, the main difficulty lies in setting up good systems to track costs, prices, and profits; once the supporting information is bachelor, the analysis is non hard to perform.

Manage the Dispersion

A custom fabricator of industrial equipment, though operating at capacity, was losing money. The obvious trouble was low cost levels for the industry. Investigation, however, pointed to a mixture of poor pricing, poor price estimating, and a lack of cognition of profitability dispersion. Some bids were too aggressively priced: afterwards winning contracts, the visitor so lost coin on them. Executives had structured other bids to "make good money," basing them on inflated cost estimates. Acute competitors costed these bids better, handled the toll negotiations more skillfully, and won the contracts. So the fabricator was winning only unprofitable bids.

The electrical products partitioning of a large corporation, on the other hand, understood the importance of profitability assay. It advisedly analyzed its costs, developed a proactive pricing arroyo, and meticulously selected orders, products, and customers that fit its product competence and chapters. Afterwards a thorough earlier-and-after review, the financial analysis department at headquarters alleged that the division had gone from a five% loss to a 10% profit on sales in a glutted, static commodity market.

When meticulous analysis, a sensible strategy, and constructive implementation are combined, a company can manage its profitability dispersion to generate profits, not just sales.

i. See Elliot B. Ross, "Making Money with Proactive Pricing," Harvard Business Review (November–December 1984): 145.

A version of this article appeared in the September 1987 consequence of Harvard Business Review.