Without transaction pricing a company may be flying blind.
Regular customers receive discounts to list price. From the size of these discounts, managers can identify which customers are most profitable, right? Well, not really. The actual cost of sales - even for a commodity product - varies from customer to customer, with differentials determined by a range of factors from transport costs to packaging, to costs of sales visits. At the same time, the payment received may differ from the invoice to reflect factors such as additional volume discounts or prompt payment refunds.
In even the most straightforward business, more than a glance at the invoice is needed to understand the 'pocket price' which is achieved on each transaction. And profit sensitivity is at its highest in this area: a 1% price difference typically equates to a 4% difference in sales - more for a low-margin business.
Michael Marn, pricing consultant at McKinsey & Co, believes that many companies would benefit by conducting the detailed analysis needed to establish the precise pocket price. 'Most companies use invoice price as a reporting measure, but the differences between invoice and transaction price can mean significant reductions to bottom-line profit.' Marn cites the example of a tyre company which was hugely surprised at the effects of off-invoice items. 'In particular, several of their largest customers bought heavily when price promotions were on - dramatically reducing the overall profitability of those accounts.' Most companies prefer to use a balance of common sense and analysis. 'We look at profitability by individual accounts in all of our operations,' says Stuart Moberley, finance director at engineering group McKechnie. 'This analysis will include things like distribution costs, but we don't break it down into areas like payment times.' John Curry, chairman of electronics group Acal has a similar approach. 'There is no formal structure, but we look at the overall costs of our major customers on a regular basis, and are continually checking that some of the smaller accounts are viable. The principle of calculating transaction prices is fine, and we could probably do more in the middle of the spectrum.' For SIG, the high-volume building products distributor, the focus is firmly on gross margins, reports finance director Frank Prust. 'With our number of customers, we have to look at the gross profits and then look at overall costs as a percentage of sales. For us, understanding the exact gross margins on individual product lines and individual customers is a key to the business.' Transaction pricing may be even more important for strategic reasons than for maximising profit, believes Neil Monnery at Boston Consulting Group. 'Average costing (dividing non-specific costs among all products and customers) can be highly dangerous. Without proper analysis of transaction prices, the risk is that competitors can pick off your most lucrative business, because you don't fully understand who your best customers really are.' Monnery quotes a branded consumer goods company that was consistently losing market share to own-label products. 'Its systems were over-allocating sales and distribution costs to major customers, which meant it could be convincingly undercut on those strategically crucial accounts.' Transaction pricing analysis may be too unwieldy for some, but it should be becoming easier, partly due to the improving quality of management information systems. Further, the process favours cross-functional teams, since input is needed from different disciplines within the organisation. Next time the board is rueing the continuing pressure on its sales prices - or complaining that many of its competitors are 'buying' business - it is probably worth checking that as much as possible has been done to understand which of its customers are paying the best price.