HBR / Digital Article / Precision Pricing When Inflation Is Rising

Precision Pricing When

Inflation Is Rising
by Jonathan Byrnes and John Wass
Published on HBR.org / February 04, 2022 / Reprint H06UAX

HBR Staff/Normform/NoDerog/Getty Images

Precision pricing is the key to pricing in today’s inflationary

environment and in the mixed-inflation markets we can expect in years
to come. It’s highly targeted and enables managers to base prices on
each product’s true, current costs and each customer’s true, current
profitability.

Traditional across-the-board price increases, which treat all costs and

customers the same, are much less effective.

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HBR / Digital Article / Precision Pricing When Inflation Is Rising

This is a problem for all companies, but particularly for manufacturers,

where standard costs for factor inputs (like raw materials, components,
and embedded services) are typically set annually. In an inflationary
environment, factor costs often increase within the year at various rates
on different inputs. Because it’s too burdensome to reset input standard
costs as the actual costs change over the course of the year, the
differences between actual and standard costs are recorded as purchase
variances (i.e., the difference between predicted and actual input
prices). Since accurate costs are essential in pricing products, managers
are forced to simply declare across-the-board price increases, which are
difficult to enforce and often cause widespread ill will.

Today’s inflation is caused by a unique mixture of shock waves

stemming from Covid-related surges in consumer demand and supply
shortages. These are disrupting the traditional supply-demand matches
that underlie stable pricing. As Covid persists and people make
alterations to their lifestyles and consumption, demand will continue to
be relatively erratic both from time to time and from product to product.
At the same time, supply disruptions caused by both near-term Covid
shutdowns and longer-term institutional problems like constraints in
port capacity and fragmented supply chains are likely to persist for
some time, and to recur periodically. Precision pricing is custom-
designed for this unstable environment. Here are four ways to
implement it.

Determine your actual costs and profits

Managers today have two critical pricing problems:

1. They’re forced to rely on their company’s standard costs, which are

often set annually. This prevents them from seeing the actual costs of
each product.

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HBR / Digital Article / Precision Pricing When Inflation Is Rising

2. They’re forced to rely on the aggregate profit metrics of revenue,

costs, and gross margins. This prevents them from seeing the actual
profits of each customer.

Enterprise profit management (EPM) remedies both of these problems

and enables managers to set precise, effective prices for every product
in every customer.

EPM brings digital precision to pricing. It’s a SaaS software process that
generates full, all-in P&Ls for every transaction in a company. Because
the costs are sourced directly from a company’s general ledger, they’re
precise, timely, and accurate. This enables managers to replace
traditional standard costs, which were created before today’s digital era,
with actual costs that reflect a company’s true cost picture and are
updated periodically (usually monthly).

Because each transaction has a set of identifiers like customer, product,

vendor, store, date, and so on, the EPM system can create an accurate,
current profile of customer profitability using actual, current costs. As
product input costs change, it shows the changes in product and
customer profitability that are essential to highly targeted pricing.
Companies that use EPM will find their customers fall into the following
broad profit segments:

• Profit peaks: Their high-revenue, high-profit customers (typically

about 20% of the customers that generate 150% of their profits)
• Profit drains: Their high-revenue, low-profit/loss customers
(typically about 30% of the customers that erode about 50% of these
profits)
• Profit deserts: Their low-revenue, low-profit customers that produce
minimal profit

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HBR / Digital Article / Precision Pricing When Inflation Is Rising

Consider these examples of four of a manufacturer’s customers. In each

scenario, the cost of trans-Pacific shipping has doubled.

Company A is a profit peak customer with high revenues and high

profits. If the cost of shipping doubles, it will affect only 10% of the
company’s purchases. If the products have relatively high value and low
weight/bulk, the shipping cost increase may only affect 5% of these
products’ cost. In this situation, the cost increase will have only a minor
impact on the company’s profitability in serving this customer. It would
be counterproductive to try to assess an across-the-board price increase
that would be zero-sum in nature and antagonize this customer.

Company B also is a large, profitable customer. The doubling of

shipping costs will affect about 60% of this company’s purchases.
Moreover, these products are commodities with low value but high
weight and bulk. In this situation, the profit impact would be very high.
It would warrant a serious consideration of how long the cost increase
would last and how long the customer would be ordering these
products. If it appears that this situation would last, it would be
necessary to have a meeting with the customer to discuss a
renegotiation of prices.

Company C is a high-revenue, money-losing profit drain customer. The

doubling of shipping costs would have little impact on the products they
purchase. In this situation, the customer sales team might approach the
company with the proposition that they could avoid a general price
increase if they cooperated on lowering the operating costs — for
example, by reducing the frequency of orders or eliminating expedited
deliveries — which could turn this losing customer into a high-profit
account.

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HBR / Digital Article / Precision Pricing When Inflation Is Rising

Customer D also is a large, money-losing customer. This customer has a

product mix in which the majority of products are subject to the
shipping cost increases. However, the company has a number of similar
substitute products that do not require trans-Pacific shipping. Here, the
customer sales team might offer a comprehensive product substitution
program that would create a more profitable product mix. The threat of
a large price increase on the current product mix may well be enough to
motivate the customer to make the change. If the customer doesn’t
accept this offer to change to the substitute products, the
manufacturing company would be justified in forcing a fully
compensatory price increase that covers both the additional cost of
shipping and the other excessive operational costs that were causing the
customer to be a money-loser in the first place.

Focus on your profit peak and profit drain customers

The EPM system can prioritize customers based on the magnitude of the
profit declines caused by the input cost changes. This reflects: 1) the
importance of the cost increases on product cost, 2) the impact of the
affected products on each customer’s profitability due to its product
mix, and 3) the customer’s profit segment based on the company’s
profitability in serving that account.

The sales team has to be the most careful with the profit peak customers
whose profitability will be significantly affected by cost increases. Even
if the sales team determines that a profit peak customer’s profitability
will not be strongly diminished by the cost increase, the team should
underline to the customer that they are foregoing a general price
increase even though their factor costs are rising.

Profit drain customers that will be significantly affected require

particular attention as well, because the cost increase may push the
account into deep enough losses to be unacceptable. In this case, the

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HBR / Digital Article / Precision Pricing When Inflation Is Rising

sales team has to be straightforward with the customer and explain

what the customer will have to do for the company to remain its
supplier.

The pricing action plan for low-revenue, low-profit customers depends

on whether the customer is a development prospect: a new customer, or
a large company with low share of wallet. If the customer is a
development prospect, the sales team can offer to forego the price
increase in return for profitable sales growth (unless the cost increase
makes this prospect untenable). For other small, marginal customers,
the sales team can create price-increase bands that reflect the impact of
the cost increases on the profitability of serving each customer. The
EPM system can produce this information.

Frame your customer contracts preemptively

In the contracting process, your deal desk should screen RFPs for major
products with potentially volatile inputs that would adversely affect
your profitability in serving those customers. Although many cost
increases are widespread, some commodities and services (e.g.,
petroleum feedstocks and ocean shipping costs) are both volatile and
very important to certain products.

If a prospective customer is likely or certain to buy a number of

products that would be affected by possible factor cost increases that
would make the customer unprofitable to serve, the deal desk team
should include escalators or guardrails that ensure that prices
automatically rise to reflect any significant cost increases.

Hunt for the right customers

While it’s important to incorporate provisions in contracts that protect

your company from significant cost increases, the ideal situation is to

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HBR / Digital Article / Precision Pricing When Inflation Is Rising

avoid customers who are clearly exposed to major cost increases that are
difficult to control and who have a history of refusing contracts with
escalators and guardrails.

Your EPM system will enable you to do a sensitivity analysis that

identifies the products and costs in an RFP that are likely to present
major profit risks, along with the likely profitability of serving the
prospective customer. This information should form an important
element in your hunter sales reps’ prospective customer roadmap.

•••

Precision pricing enables managers to laser-target the customers who

are appropriate candidates for price increases and to give their sales
teams precise cost information to justify specific price increases. They
can accomplish the needed price adjustments in a matter-of-fact
discussion that’s grounded in actual data.

In other situations, especially with money-losing customers who are not

majorly affected by a particular factor cost increase, the sales team can
offer to forego a general price increase in return for the customer’s
cooperation in reducing other operating costs. Similarly, the sales team
can engage new accounts with the prospect of significant growth with
an offer to forego price increases in return for substantial profitable
growth.

Compare this process to the traditional practice of across-the-board

price increases that set up a zero-sum relationship for all customers —
regardless of a customer’s profitability and product cost profile — and
eliminates the important opportunity to use the prospect of foregoing a
price increase as a lever to increase customer profitability.

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HBR / Digital Article / Precision Pricing When Inflation Is Rising

In this way, precision pricing generates profitable growth while

increasing your customers’ goodwill, turning a zero-sum situation into a
win-win.

Jonathan Byrnes is a senior lecturer at MIT and founder and

JB chairman of Profit Isle, a SaaS profit analytics software company.
Jonathan is coauthor of the recently published book, Choose Your
Customer: How to Compete Against the Digital Giants and Thrive.

John Wass is CEO of Profit Isle and former SVP of Staples. John is
JW coauthor of the recently published book, Choose Your Customer: How
to Compete Against the Digital Giants and Thrive.

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