By Ryan Maley
The business world is becoming more and more competitive. Even with the pandemic affecting the way companies run their usual operations, business owners continue to find ways to compete. But it’s not always just about knowing the market and your competition. To make the most of your earning opportunities, setting the right price for your products is key.
But knowing how to choose the right price is easier said than done. To make sure that you identify the right price for your products, you should first learn how to properly analyze your business operations and expenses. Understanding every aspect of your business is something you will have to prioritize, otherwise even the slightest oversight can greatly affect your profit margins and cause you profit leaks. This is where price waterfall analysis can help.
What is a Price Waterfall?
A price waterfall is a key first step in achieving pricing excellence. It is an analysis method used to find any hidden costs or expenses that may be causing profit leakage. It is considered one of the most effective methods for businesses to understand how much they are actually earning from the products they are offering. If done properly, a price waterfall analysis can help a company make the most of their earning opportunities and set the best price that will both work for the market and benefit the business.
Why is a Price Waterfall important?
In our pricing consulting projects, we discover that many companies do not have a good understanding of how their profits are affected by the many types of discounts, rebates, and other incentives offered to customers.
Over time, more incentives may be offered and even if they seem relatively minor, their implications for profitability can be huge. Many types of incentives are not closely monitored or appear on the budgets of different departments. For instance, customers may be offered “free design services” for customizing products. The designers may actually work in non-sales departments. Seemingly overnight, the “free” designs are costing tens of thousands of dollars and draining profits.
Often, these types of hidden costs are called “profit leaks” because it is not immediately obvious where the profits are going. Price waterfalls can identify where there are leakages and their amount.
Price waterfalls can help you:
Improve understanding of prices and profitability.
Know the levers (discounts, rebates, incentives, etc.) offered to customers and their effect on profitability.
Understand internal selling and service costs that affect profitability.
Set commercial policies defining levers and how they are to be used by salespeople to achieve company sales and profitability goals.
Achieve pricing excellence!
What is in the Price Waterfall?
Price waterfalls can be developed in many ways and waterfalls may vary industry to industry. However, there are usually common components across all companies and industries.
Sample Waterfall Analysis Chart
List Price (Gross Sales)
The waterfall usually starts with a list price or manufacturer suggested retail price. This is usually an ideal price as defined by the company’s costs and profit margin goals.
In the case of multinational companies, the list price might actually be multiple items including a global list price that is adjusted based on currency exchange rates or market and regulatory specifics resulting in a local list price.
On-Invoice Deductions: Discounts
On-invoice deductions are those items that are generally visible to the customer such as product discounts and promotional credits. When developing your waterfall, each type of reduction should be defined separately. For instance, you may offer a volume purchase discount and a seasonal discount.
Reducing the list price by on-invoice deductions results in the invoice price. This invoice price is, confusingly, referred to as a gross price or a net price in different contexts.
Off-Invoice Deductions: Rebates
Off-invoice deductions are a frequent source of profit leak. These deductions can include a wide variety of items related to the cost of selling or servicing the customer. Off-invoice deductions typically include periodic rebates (cash and product rebates), consignment costs, free product samples, free shipping (or unrecovered shipping costs), etc.
After off-invoice deductions are accounted for, we have a net or net net price. This is often referred to as the pocket price by pricing professionals because it is what companies actually “pocket” after all deductions are taken into account.
COGS
Your pricing waterfall can be extended to include other items that affect your margin.
Cost of Goods Sold (COGS), the cost of actually producing a product or service, should be included. Understanding your per unit manufacturing costs is important. In some cases, companies are reluctant to include the COGS for fear of disclosing sensitive cost data, but COGS data can be used in aggregate and only shared with appropriate people.
Cost to Sell & Cost to Serve
Cost to sell and cost to serve are important areas for profitability analysis and are often hidden sources of profit leak.
Cost to sell are those costs related to completing sales to customers and can include salesperson-related costs and free samples for evaluation. It should include things like free design services when companies provide free engineering or modification to products in order to win sales.
Cost to serve is any non-COGS costs that benefit the customer. Typical examples include warehousing, non-invoiced freight, and even warranties.
Developing Your Price Waterfall
Developing your own price waterfall may require a lot of work.
In many companies, the various deductions, particularly off-invoice deductions, are not tracked well. Even list prices may prove difficult to determine as various adjustments and deductions are made to prices. Sometimes buyers prefer not to see discounts on invoices. Some sales systems do not permit this, so salespeople adjust the list prices and show zero discounts. All this leads to difficulties in performing price waterfall analysis.
If you have these types of issues, preparing the waterfall may require some work and a specific plan of action.
Build Your Team
A cross-functional approach to developing your waterfall is a good start. Having representation from pricing, sales, marketing, finance, engineering, information technology, and even your pricing consultant is valuable. Get input and new perspectives on the problem from individual stakeholders. Someone from outside your function may be able to identify some of these on and off-invoice deductions that contribute to profit loss.
Analyze the Data
Analyzing data is often a challenge, not necessarily because the analysis is difficult, but because actually collecting the data and understanding it can be.
Because some data is not tracked well or recorded properly, as discussed above, it may be a challenge to actually “reverse-engineer” things like the list price. However, data analytics are a key to building the price waterfall model and, of course, understanding the amount of profit leak and the potential return on investment for plugging the leaks.
Assemble Your Waterfall
This may be the simplest step, but it is crucial to identify every type of deduction in order to measure the effect of pricing and commercial policies on profits. Showing every type and size of deduction is key to identifying where profits are leaking and understanding how you can plug the leaks.
How Much Detail Should Be Included?
It is easy to get carried away and include lots of levers and costs in your waterfall. The key is to be pragmatic. What information and level of detail is needed to help understand your profitability and plug leaks?
Your waterfall should be granular enough to understand the biggest issues. Sometimes, just realizing that your rebates are above a n percentage threshold can lead to more analysis and an understanding of how different rebates are being used by different salespeople. Your rebate policy can then be updated to get them under control. Enough granularity is required to gain complete understanding of the issue and to inform decisions.
Larger organizations may have different business units, multiple sales forces, different productions plants or costs, etc. A single waterfall may not be appropriate for large, complex organizations. You can understand this complexity by using multiple waterfalls or make your waterfall an interactive analysis tool. Data collection and analytics automation allow many analyses to be performed at very low cost. You may even be able to analyze each SKU for each customer.
Making the Most of Your Price Waterfall
The waterfall is a key element in understanding prices and translating an organization’s pricing strategy into a pragmatic price setting tool. Indeed, it is the first step to world-class pricing execution and a powerful tool for ongoing pricing monitoring.
Stratence Partners uses pricing waterfall analysis as one of its first pricing analytics during our pricing consulting. It is a standard, off-the-shelf analytic tool in our SPIE pricing systems and tools.
While simply analyzing data is useful for understanding pricing and profitability, the real benefit of waterfalls comes from how you use them to help transform pricing.
Use your price waterfall to systematically review strategies and commercial polices to help your entire company achieve its goals.
About Ryan Maley
Ryan Maley is a pricing consultant with Stratence Partners, a specialized consulting firm that advises companies on how to get the most from pricing by helping optimize strategies, implement pricing excellence, and increase commercial effectiveness.
Stratence Partners’ pricing consulting has worked with companies in many diverse industries to develop price waterfalls to drive transformation to pricing excellence. We help companies structure a full pricing framework including:
• Pricing Strategy, Products, Services, Solutions and Go-To-Market Optimization
• Pricing Setting for Smart Cost+, Competitive Premium and Value-Solutions Pricing
• Commercial & Sales Pricing Execution, Win-Loss Effectiveness
• Pricing KPI’s and Performance Monitoring
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