Transaction prices represent one of the most attractive - andoverlooked-opportunities to boost profits.

Managing Price,Gaining Profit

by Michael V. Marn and Robert L. Rosiello

The fastest and most effective way for a companyto realize its maximum profit is to get its pricingright. The right price can boost profit faster than in-creasing volume will; the wrong price can shrink itjust as quickly. Yet many otherwise tough-mindedmanagers shy away from initiatives to improveprice for fear that they will alienate or lose cus-tomers. The result of not managing price perfor-mance, however, is far more damaging. Getting theprice right is one of the most fundamental and im-portant management functions; it should be one ofa manager's first responsihilities, a nuts and boltskind of joh that determines the dollar and cents per-formance of the company.

The leverage and payoff of improved pricing arehigh. Compare, for example, the profit implicationsof a 1 % increase in volume and a 1 % increase in

price. For a company with average economics, im-proving unit volume by 1% yields a 3.3% increasein operating profit, assuming no decrease in price.But, as Exhibit 1 shows, a 1% improvement inprice, assuming no loss of volume, increases operat-ing profit by 11.1 %. Improvements in price typical-ly have three to four times the effect on profitabili-ty as proportionate increases in volume.

With such extreme profit leverage, pricing is onefunction that a company can always improve. Oneconsumer durable products company increased op-erating profit dollars hy nearly 30% with a mere2.5% improvement in average prices. An industrial

Michael V. Main is pricing consultant in the Cleveland,Ohio office of McKinsey &) Company, Inc. Robert L.Rosiello is principal in McKinsey Company's New YorkCity office.

84 DRAWINGS BY PAUL MEISEL

1 %Improvementin...

Price

VariableCost

Volume

Fixed Cost

equipment manufacturer boostedoperating profits by 35% by care-fully managing price levels up amodest 3%. According to our re-search, a wide variety of husiness-es, including those in consumerpackaged goods, energy, and bank-ing and financial services, haveachieved comparable results.

Even if a company's managersmake the right pricing decisions90% of the time, it's worthwhileto try for 92% - the payoff is thathigh. But the price lever is adouble-edged sword. The mes-sages of Exhibit 1 also apply in re-verse: a mere 1 % price decrease foran average company, for instance,would destroy 11.1 % of the com-pany's operating profit dollars.

Pricing issues are seldom simple and isolated;usually they are diverse, intricate, and linked tomany aspects of a husiness. But while most man-agers have a handle on the bulk of pricing issues,many overlook a key aspect of this most basic man-agement discipline: transaction price management.Without realizing it, many managers are leavingsignificant amounts of money-potential profit-onthe table at the transaction level, the point wherethe product meets the consumer. Most companiesuse invoice price as a reporting measure, hut thedifferences between invoice and actual transactionprice can mean significant reductions to bottom-line profit.

Some companies that have identified this prob-lem are handling it by applying two basic concepts:the pocket price waterfall and the pocket priceband. Reduced to their essentials, these conceptsshow companies where their products' prices erodebetween invoice price and aetual transaction price,and they help companies capture untapped oppor-tunities at that level.

The Three Levels of Price Management

The pricing puzzle is more manageable whentaken in pieces. Price management issues, opportu-nities, and threats fall into three distinct but close-ly related levels:

1. Industry supply and demand. At this highestlevel of price management, the basic laws of eco-nomics come into play. Changes in supply (plantclosings, new competitors), demand (demographic

1 . Comparison of Profif Levers*

...Creates Operating Profit improvement ot

n.1%

7.8

3.3

2.3

*Bassd on overage economics ot 2,463 companies In Compustat aggregate

shifts, emerging substitute products), and costs(new technologies) have very real effects on indus-try price levels.

Managers examining pricing in this contextshould understand the pricing "tone" of their niar-kets-that is, the overall direction of price pressure(up or down) and the critical marketplace variahlesfueling that pressure. This knowledge allows man-agers not only to predict and exploit broad pricetrends but also to foresee the likely impact of theiraetions on industry price levels.

2. Product market strategy. The eentral issuehere is how customers perceive the benefits of prod-ucts and related services across available suppliers.If a product delivers more benefit to customers,then the company can usually charge a higher priceversus its competition. The trick is to understandjust what factors of the product and service packagecustomers perceive as important, how a companyand its competitors stack up against those factors,and how much customers are willing to pay for su-periority in those factors.

Market research tools, like conjoint analysis andfocus groups, can help managers understand cus-tomer perception of benefits. And understanding atthis second level of price management helps guideboth the product's price positioning and the fine-tuning of product and service offerings.

3. Transactions. At this last level of price man-agement, the critical issue is how to manage the ex-act price charged for each transaction - that is,what base price to use, and what terms, discounts,allowances, rebates, incentives, and bonuses to ap-ply. Where concern at other price management lev-els is directed more toward the hroad, strategic po-sitioning of products in the marketplace, focus at

HARVARD BUSINESS REVIEW September-October 1992 8S

TRANSACTION PRICING

2. In the Pocket Price Waterfall, each Element Represents a Revenue Leak[dollars per square yarO}

$6.00

DealerListPflco

0.10Order SizeDiscount

0.12CompetiveDiscount

S5.78

InvoicePrice

0.30PaymentTermsDiscount

22.7%ofl invoice

0.37Annual\toiumeBonus

0.35Off-Invoice 0.20Promotions Co-op

Advertising

0.9Freight

$4.47

PocketPrice

the transaction level of price management is micro-scopic-customer by customer, transaction hytransaction, deal hy deal.

The three discrete levels of price managementare clearly related. If, for example, a company fore-sees an industrywide supply shortage of its product,repositioning the product hy lowering the pricewould he a mistake. In the same way, the product'smarket strategy should set the context for transac-tion-level pricing decisions: a move hy Toyota todiscount its Lexus luxury sedan at the transactionlevel would conflict with the market positioning ofthat model as a high-benefit, fair-priced alternativeto competitors like Mercedes Benz, BMW, or Jaguar.

Unfortunately, many top managers perceivetransaction pricing decisions as unimportant andoften relegate them to low-ranking managers oreven entry-level clerks, with some flexihility at thesales force level. By doing so, companies may beforegoing one of the most substantial profit oppor-tunities available.

The Transaction Pricing Opportunity

The ohjective of transaction price management isto achieve the best net realized price for each orderor transaction. Transaction pricing is a game ofinches where tens, hundreds, or even thousands ofcustomer- and order-specific pricing decisions dailycomprise success or failure-where companies cap-ture or lose percentage points of margin one trans-action at a time. But top management neglect, hightransaction volume and complexity, and manage-ment reporting shortfalls all contribute to missedtransaction pricing opportunities.

The complexity and volume of transactions tendto create a smoke screen that makes it nearly im-possible for even the rare senior managers whoshow an interest to understand what is actuallyhappening at the transaction level. Management in-formation systems most often do not report ontransaction price performance, or report only aver-age prices and thus shed no real light on pricing op-portunities lost transaction by transaction.

The pocket price waterfall and the pocket pricehand have proven valuable in lifting this smokescreen and providing a foundation to capture oppor-tunity at the transaction level.

The Pocket Piice Waterfall. Many companies failto manage the full range of components that con-tribute to the final transaction price. Exhibit 2shows the price components for a typical sale bya manufacturer of linoleum flooring to a retailer.The starting point is the dealer list price fromwhich an order-size discount (hased on the dollarvolume of that order) and a "competitive discount"(a discretionary discount negotiated before the or-der is taken) are subtracted to get to invoice price.For companies that monitor price performance, in-voice price is the measure most commonly used.

But in most businesses, particularly those sellingthrough trade intermediaries, invoice price doesnot reflect tbe true transaction amount. A host ofpricing factors come into play between the set in-voice price and the final transaction cost. Amongthem: prompt payment discounts, volume buyingincentives, and cooperative advertising allowances.When you subtract the income lost through thesetransaction-specific elements from invoice price,what is left is called the pocket price-the revenuesthat are truly left in a company's pocket as a result

86 HARVARD BUSINESS REVIEW September-October 1992

of the transaction. Pocket price, not invoice price,is the right measure of the pricing attractiveness ofa transaction.

The manufacturer offered a series of discountsand incentives that affected its product's pocketprice. The company gave dealers a 2% paymentterms discount if they paid an invoice within 30days. It offered an annual volume bonus of up to 5%based on a dealer's total purchases. Retailers re-ceived cooperative advertising allowances of up to4% if they featured the manufacturer's products intheir advertising. And the company paid freight fortransporting goods to the retailer on all orders ex-ceeding a certain dollar value. Taken individually,none of these offerings significantly affected profit.Together, however, they amounted to a 22.7% dif-ference between the invoice and pocket prices.

Otherwise competent senior managers often failto focus on pocket price because accounting sys-tems do not collect many of the off-invoice dis-counts on a customer or transaction basis. For ex-ample, payment terms discounts get buried ininterest expense accounts, cooperative advertisingis included in companywide promotions and adver-tising line items, and customer-specific freight getslumped in with all the other business transporta-tion expenses. Since these items are collected andaccounted for on a companywide basis, it is diffi-cult for most managers to think about them - letalone tally them - on a customer-by-customer ortransaction-by-transaction basis.

Exhibit 2, which shows revenues cascading downfrom list price to invoice price to pocket price,is called the pocket price waterfall. Each elementof price structure represents a revenue "leak."The 22.7% drop from invoice price down to pocketprice is not at all uncommon. The average decline

from invoice down to pocket price was 16.7% forone consumer packaged goods company, 17.7%for a commodity chemical company, 18.6% for acomputer company, 20.3% for a footwear company.

Pocket price, net invoiceprice, is the right measureot the pricing attractivenessOta transaction.

21.9% for an automobile manufacturer, and 28.9%for one lighting products supplier.

Companies that do not actively manage the en-tire pocket priee waterfall, with its multiple andhighly variable revenue leaks, miss all kinds of op-portunities to enhance price performance.

The Pocket Price Band. At any given point intime, no item sells at exactly the same pocket priceto all customers. Rather, items sell over a range ofprices. This range, given a set unit volume of a spe-cific product, is called the pocket price band.'' Ex-hibit 3 shows the flooring manufacturer's pocketprice band on a dollars per yard basis for a singleproduct. Note that there is a 35% difference be-tween the highest and lowest priced transactions.Although the width of tbis pocket price hand mayappear large, price bands that are much wider arecommonplace. Pocket price hands that we exam-ined ranged up to 60% for a lighting fixtures manu-facturer, 70% for a computer peripherals supplier,200% for a specialty chemicals company, and 500%for a fastener supplier.

Understanding the variations in pocket pricebands is critical to realizing a company's best trans-

3. The Elements of a Pocket Price Band Reveal Profit Opportunities[P&cent ot Volume!

15.0

14,2

13.4

5.0

2.7

10.7

6.6

13.110.1

6.1

3.1

S5.80 5.60 5.40 5.20 5.00 4.80 4.60Pockel Price [m doilan per squore yaraj

4.40 4.20 4.00 3.80

HARVARD BUSINESS REVIEW September-October 1992 87

TRANSACTION PRICING

action pricing opportunities. If a manager ean iden-tify a wide pocket price band and comprehend theunderlying causes of the band's width, then he orshe can manipulate that band to the company'sbenefit. Recall from Exhibit 1 the huge operatingprofit payoff from a 1 % increase in average price.When, as in the case of the linoleum flooring manu-facturer, poeket prices vary over a 33% range, it'snot hard to imagine how more deliberate manage-ment of such wide price variations might yield sev-eral percentage points of price improvement - andthe rich profit rewards that would accompany thatimprovement.

The width and shape of a pocket price band tell afruitful story. Managers are invariably surprised notonly by the width of their pocket price bands but al-so by the identity of customers at the extremes of

If a company doesn'tnnanage its pricing policieson all levels, custonners maywork those policies to theirown advantage.

the band. Customers perceived by managers as veryprofitable often end up at the low end of the band,and those perceived as unprofitable at the high end.The shape of the pocket price band provides the as-tute manager with a graphic profile of a business -depicting, among other things, what percentage ofvolume sells at deep discounts, whether there existgroups of customers who are willing to pay higherprices, and how appropriately field discounting au-thority is being exercised.

The Castle Battery Company Case. The follow-ing, somewhat disguised, case shows how one com-pany used the pocket price waterfall and band toidentify profit leaks and regain control of its pricingsystem. It illustrates one way in which the water-fall and band concepts can be applied, and showshow, if a company doesn't manage its pricing poli-cies on all levels, experienced customers may beworking those policies to their own advantage.

The Castle Battery Company is a manufacturerof replacement lead-acid batteries for automobiles.Castle's direct customers are auto parts distribu-tors, auto parts retailers, and some general massmerchandisers. With return on sales averaging inthe 7% range. Castle's profitability is very sensitiveto even small improvements in price: a 1 % increasein price with no volume loss, for instance, wouldincrease operating profit dollars by 14%.

Extreme overcapacity in the battery industry andgradual commoditization made it increasingly dif-ficult for Castle to distinguish its products fromcompetitors. So Castle senior management wasskeptical that there was much, if any, potential forprice improvement. But Castle managers had en-tirely overlooked lucrative pricing opportunities atthe transaction level.

Exhihit 4 shows the typical pocket price waterfallfor one of Castle's common battery models, thePower-Lite, sold to an auto parts retailer. From abase price of $28.40, Castle deducted standard deal-er/distributor and order-size discounts. The compa-ny also subtracted an on-invoice exception dis-count, negotiated on a eustomer-by-customer basisto "meet competition." With these discounts, theinvoice price to the retailer totaled $21.16. Whatlittle transaction price monitoring that Castle didfocused exclusively on invoice.

4. Off-Invoice Discounts: a Big Part of the Pricing Picture

$28.40

BasePrice

4.26StandardDealefDistributorDiscount

$21.16

InvoicePrice

0.22 L I - I ,Receivabies o 85 [Carrying C(M)p 060 'Cost Advertising Mer- 0.74

chantJising AnriuaiAiiowance Volume

PocketDiscountSlO.22(36%)

032i=reight

$ie.is

PockatPrice

88 HARVARD BUSINESS REVIEW September-October 1992

5. A Single Product Can Have a Wide Pocket Price Band,15.8

(P&centot^lumej

12,4

4,5

1.9

6,1

4,6

13.2

12,21 , 11,6

7,9

2,7

1,6

S14 20Pocket Price

22 23 24 25

That focus ignored a big part of the pricing pic-ture-off-invoice discounting. Castle allowed cashdiscounts of 1.2% for timely payments hy ac-counts. Additionally, the compatiy granted extend-ed terms (payment not required until 60 or 90 daysafter receipt of a shipment) as part of promotionalprograms or on an exception hasis. For this transac-tion, the extra cost of carrying these extended re-ceivahles totaled 22 cents. Cooperative advertising,where Castle contributed to its accounts' local ad-vertising of Castle products, cost 85 cents. A ,specialmerchandising program in effect at the time of thistransaction discounted another 60 cents. An annualvolutne rebate, based on total volume and paid atyear end, decreased revenues by yet another 74cents; and freight paid hy Castle for shipping thebattery to the retailer cost 32 cents.

The invoice price minus this long list of off-in-voice items resulted in a pocket price of only$18.18, a full 14% less than invoice. The total rev-enue drop from base price down to pocket price isthe "pocket discount"- in this ease, $10.22, ofwhich $2.98 was off-invoice.

Of course, not all transactions for this particulartnodel of battery had the same pocket price. As Ex-hihit 5 shows, each element of the pocket price wa-terfall varied widely by customer and transaction,resulting in a very broad pocket price band. Whilethe average pocket price was $20, units sold for ashigh as $25 and as low as $ 14 - plus or minus greaterthan 25% around the average. Aprice band like thisshould trigger immediate questions: What are theunderlying drivers of the band's shape and width?Why are poeket prices so vai(iable, and can that vari-ability be positively managed?

Castle managers were quite surprised at thewidth of the price band for their Power-Lite model,

hut on reflection, concluded that it was due to dif-ferences in account sizes. The company had a clearstrategy of rewarding account volume with lowerprice, rationalizing that cost to serve would de-crease with account volume.

But when tnanagement examined the Power-Litepocket prices against total account sizes for a sam-ple of 50 accounts, it found tio correlation-it was avirtual shotgun blast. A numher of relatively smallaccounts were buying at very low pocket priceswhile some very large accounts were buying at veryhigh pocket price levels.

Castle managers, perplexed hy the seatter ofpocket prices by account size, launched an immedi-ate investigation. In most cases, they found no le-gitimate reason why certain low-volume accounts

Castle's Power-Lite pocketprices showed no correlatiorito the account sizes - it wasa virtuol shotgun blast.

were paying such discounted prices. Often, theydiscovered that these accounts were unusually ex-perienced and clever accounts-customers who hadbeen dealing with Castle for 20 years or more andwho knew just whom to call at Castle headquartersto get that extra exception discount, that percent-age point of additional co-op advertising, that extra30 or 60 days to pay. These favorite old accountswere granted extra discounts based on familiarityand relationships rather than on economic justifi-cation. These experienced clients understood Cas-tle's pocket price waterfall and were working itagainst the company.

HARVARD BUSINESS REVIEW September-Octohcr 1992 89

TRANSACTION PRICING

Castle senior management realized that its trans-action pricing process was out of control, that deci-sion making up and down the waterfall laeked dis-cipline, and that no one was focusing on thecomprehensive total of those decisions. The end re-sult was a pricing reality that didn't square withCastle's strategy of rewarding account size withlower prices, and that was costing Castle millions.

To correct its transaction pricing situation, Cas-tle mounted a three-part program. First, it took veryaggressive corrective actions to bring the overdis-counted, "old favorite" accounts back in line. Man-agement identified the prohlem accounts and ex-plained the situation and its impact on overallcompany profits to the sales force. Then the compa-ny gave the sales force nine months to fix or dropthose outliers. Fixing meant decreasing the exces-sive discounting across the waterfall so that outheraccounts' pocket prices were more in line withthose of accounts of similar size. Salespeople whocouldn't negotiate their outlier pocket prices up toan appropriate level were to find other accounts intheir territory to replace them.

Within the time allotted, the sales force fixed90% of the trouble accounts. Sales' newfound real-

WELCOME.VOtUf^E

Companics can assimilate pricing policy information toinfluence retailers.

ization that every element of the waterfall repre-sented a viable negotiating lever contributed to thissuccess. And, in most cases, the salespeople easilyfound profitable replacements for the other 10%.

Second, Castle launched a program to stimulatevohime in larger accounts that had higher than av-erage pocket prices compared with accounts of sim-ilar size. Management singled out the attractive"target" accounts for special treatment. Sales andmarketing personnel investigated them carefully todetermine the nonprice benefits to which each wasmost sensitive. The company increased volume inthese accounts not by lowering price but by deliver-ing the specific benefits that were most importantto each; higher service levels for some, shortenedorder lead times for others, more frequent salescalls for still others.

Finally, Castle embarked on a crash program toget the transaction pricing process back under con-trol. This program included, among other compo-nents, setting clear decision rules for each discre-tionary item in the waterfall. For example, thecompany capped exception discounts at 5% andgranted them only after a specific volume and mar-gin impact evaluation. Management also set upnew information systems to guide and monitortransaction pricing decisions. And Castle estab-lished pocket price as the universal measure ofprice performance in all of these systems. It beganto track and assign, transaction-by-transaction, allof the significant off-invoice waterfall elementsthat were previously collected and reported only ona companywide basis. Further, pocket price realiza-tion became a major component of the incentivecompensation of salespeople, sales managers, andproduct managers.

Castle reaped rich and sustained rewards fromthese three transaction pricing initiatives. In thefirst year, average pocket price levels increased 3%and, even though volume remained flat, operatingprofits swelled 42%. The company realized addi-tional pocket price gains in each of the two subse-quent years.

Castle also received some unexpected strategicbenefits from its newfound transaction pricing ca-pability. Account-specific pocket price reporting re-vealed a small but growing distribution channelwhere Castle pocket prices were consistently high-er than average. Increasing volume and penetrationin this emerging channel became one of Castle'skey strategic initiatives this past year. The freshand more detailed business perspective that Castlesenior managers gained from their transaction pric-ing involvement became the catalyst for an ongoingstream of similar strategic insights.

90 HARVARD BUSINESS REVIEW September-October 1992

6. Tech-Craft Gave a Pocket Discount of 39 .1% After Waterfall Elements^Dealer List Pricej

100%

DBoterUstPrfca

2.03,9 ' —Nationol 2.7PromotionDiscount Discount

83.3

InvoicePlica

4-1 i LCo-op 3,5Advertising Promo-

tional

n%VolumeIncreose

PocketDiscount39.1%

5,6AnnualVolumeBonus

1.9g

Allowance

2.1Freight

60,9

PDCMPrice

The Tech-Craft Company Case. Consider anoth-er case - one that takes an even finer cut than theCastle example. Here, top management used boththe pocket price waterfall and the pocket price bandas broader tools. The company not only assimilatedvaluable information about its pricing policies butalso used that knowledge to manipulate its pricingsystem and influence its retailers. The Tech-CraftCompany took the waterfall and band and extendedthe concept, successfully applying the lessons of afinancial tool to benefit its marketing strategy.

Tech-Craft is a manufacturer of home appliances,with microwave ovens as its primary line. Tecb-Craft sells its microwave ovens directly to appli-ance retailers and a variety of mass merchandisersand department stores. With dozens of major andminor brands available, the microwave market ishighly competitive and most retail outlets carrymultiple brands.

Very complex price structures had evolved overthe years in this competitive market. Exhibit 6shows tbe average pocket price waterfall (on a per-centage of dealer list price basis) for a Tech-Crafttransaction to an appliance retailer. The companygave a total pocket discount of 39.1 % over 11 differ-ent waterfall elements.

Research into competitors' pricing practices re-vealed that most competitors' price structures werejust as complex as Tech-Craft's hut varied in form-particularly off the invoice. For example, tbey var-ied by cash discount terms, co-op advertising rates,volume bonus discounts, volume break points, andfreight payment policies. Tbe variety and complex-ity of price structures made it somewhat difficultfor appliance retailers to compare microwave pricesamong competitors. Further research showed thatmost retailers used just invoice price minus cash

discount as their yardstick for comparing prices,taking for granted most of the off-invoice items. Soa dollar discount on the invoice had much more im-pact on the retailer's buying decision than a dollaroff the invoice.

With this knowledge, Tech-Craft managers madea simple price structure change to one product line.They took their largest off-invoice discount - theannual volume bonus-and shifted it to on-in voice.To do this, they estimated each account's annualpurchases at the beginning of the year, paid the vol-ume bonus on the invoice hased on tbat estimate,and tben made an end-of-tbe-year adjustment ifnecessary. Tbe result was an 11 % increase in same-store volume, not by deeper discounting but ratherby tailoring the pocket price waterfall so tbat Tech-Craft's price reflected the criterion that retailersused in comparing prices.

The result so intrigued Tech-Craft managers thatthey researched their pocket price waterfall evenfurther, discovering evidence that retailers werenot equally sensitive to price changes across all ele-ments of the waterfall. For example, they foundthat retailers were much more sensitive to a $1change in the national promotion discount tban toa $1 change in the order-size discount, despite tbefact tbat they affected Tcch-Craft's pocket priceequally. Tech-Craft managers used such insightsregarding dealers' unequal sensitivity to differentpieces of the waterfall to alter their pricing ap-proach in several areas.

First, when tbey wanted to lower price to stimu-late volume, Tech-Craft managers adjusted the wa-terfall elements to which their retailers were mostsensitive-thus engendering the maximum volumegrowth. Conversely, when tbey wanted to raiseprice to increase margins, they adjusted tbe ele-

HARVARD BUSINESS REVIEW September-October 1992 91

TRANSACTION PRICING

7. A Quarterly Report Monitorsthe Watertall for Major Product

[Doliars per unit}

Base price

Standard dealer-distributar discount

Order size discount

Exception discount

Invoice price

Cosh discount

Receivables carrying cost

Co-op advertising

Merchandising ailowance

Annuai volume rebate

Freight

Pocket price

198904

S27.83

4.05

0.68

2.98

20.12

0.23

0.26

0.83

0.71

0.74

0.39

16.96

1990HA

$28.40

4.26

0.71

2.27

21.16

0.25

0.22

0.85

0.60

0.74

0.32

18.18

LinesChange fin do/teN^J

1 . - .

! so.57

-0.21

-0.03

0.71

1.04

-0.02

\ 0,04

-0.02

0.11

0

1 0.07

!i.2:

merits to which their retailers were least sensitive-thus minimizing loss of volume.

Second, over time they decreased the amount ofdiscounting in the waterfall elements that justdidn't matter to retailers, shifting part of that dis-counting to those elements that really influencedretailer huying decisions. By doing so, Tech-Craftmade sure it was getting the most retailer buyingpreference for its discount dollars.

Tech-Craft management became quite skillful inthe fine art of "waterfall engineering"-that is, fine-tuning the components of its pocket price waterfallto optimize the effect on buyer behavior. Not un-like Castle, Tech-Craft reaped rich rewards from itsnewfound skills and initiatives in transaction pric-ing. Within a year, the company had not only grownits unit volume by over 11% but also had increasedaverage pocket price levels by 3.5%, resulting in a60% operating profit improvement.

Capturing Untapped TransactionPricing Opportunity

while the specific moves required to capture un-tapped transaction pricing opportunity can varywidely from company to company, the most usefulimprovement actions fall into three general areas:

1. Manage the pocket price band. An understand-ing of pocket price and its variability across cus-tomers and transactions provides the bedrock ofsuccessful transaction price management. The en-tire pricing process should be managed toward

poeket price realization ratherthan invoice price or list price.Pocket price should be the soleyardstick for determining thepricing attractiveness of products,customers, and individual deals.All price measurement and per-formance gauges should he recastwith pocket price used as the basefor calculating revenues. As theCastle Battery Company casedemonstrates, considering busi-ness from this pocket price view-point can drastically change acompany's perspective on the rel-ative attractiveness of segments,customers, and transactions.

Creating information systemstbat correctly measure and reportpocket price is problematic formany companies. Elements of thewaterfall often reside on different

systems or do not exist in data systems at all. Thesedifficulties notwithstanding, companies shouldmake the investment to produce a correct and com-prehensive pocket priee calculation. Managersmust resist the temptation to leave elements out ofthe waterfall because they are difficult to calculateor inconvenient to include from an informationsystems standpoint. Effective transaction pricemanagement often requires tough customer initia-tives, but incorrect or incomplete pocket price re-porting gives managers an excuse not to initiatenecessary pricing policies.

Once a company establishes a pocket price mea-sure, it should drive explicit sales and marketingsteps off the "tails" of the poeket price band. Excel-lent transaction pricers look to the pocket priceband and target specific actions for the best andworst 10% to 20% of transactions and customers.Marketing and sales should target customers withtransactions at the high end of the price band forincreased volume. These departments should alsoidentify clients at the low price end, marking themfor actions that will either result in improved pricelevels or their termination as customers.

Management should not exclude any low-pricecustomers, regardless of their history or relation-ship with the company, from such corrective ac-tions. The hard pocket price numbers must deter-mine which customers require remedial priceaction. Price band management initiatives quicklylose credibility and momentum if exceptions aremade that allow favored customers to languish atthe low end of a pocket price band.

92 HARVARD BUSINESS REVIEW September-October 1992

2. Engineer the pocket pricewaterfall. The best transactionpricers understand the leverage ofwaterfall engineering. Despite thefact that a dollar anywhere alongthe waterfall affects a company'spocket price and profit equally, theTech-Craft case demonstrates thatnot all waterfall elements equallyinfluence customer buying. Aknowledge of which pieces of thewaterfall matter to custom,ers canguide not only how a companychanges overall price and pricestructure but also how it negoti-ates with individual customers.Managers shouldn't be at all sur-prised if different sets of waterfallelements are important to differ-ent customer segments or differ-ent channels of distribution. Salesrepresentative input can furtherenrich understanding of specific Salespeople carry the company's benefit and value

customer sensitivity to waterfall elements.Each component of a company's pocket price

waterfall deserves careful and explicit manage-ment. Top managers should set a quantifiable ob-jective for each element of the pocket price water-fall, and if that goal is not achieved, they mustchange or even discontinue that element. Tootnany companies put in place a waterfall elementlike annual volume bonuses and leave it there un-changed, regardless of its effectiveness in influenc-ing customer behavior. The sales and marketingorganization should set hard objectives for each wa-terfall element. For example, the objective for anannual volume bonus might be to cause sales vol-ume to grow at an average of 8% annually in exist-ing accounts.

A company should take an annual snapshot ofthe results of its efforts. If it fails to meet its objec-tive for a waterfall element, it should either adjustor eliminate that element. Excellent transactionpricing companies, like Tech-Craft, routinelyreengineer their pocket price waterfalls and makeeach piece of the waterfall work for them.

3. Get organizational involvement and incen-tives right. With percentage points of return onsales in the balance, transaction pricing meritsbroad organizational involvetnent; it is too impor-tant for even the president and CEO of a business toignore. Companies that are best at transaction pricemanagement have general managers who under-stand its importance, set specific goals for transac-tion price improvement, and monitor those goals

through regular and concise transaction price per-formance reports.

Exhibit 7 shows a quarterly "Pocket Price Sourceof Change" report that the president of Castle nowuses to monitor the waterfall for major productlines. From it he can quickly see changes in averagepocket price and understand the key sources ofthose changes along the price waterfall. He can rec-ognize and reward pocket price improvement, ques-tion price performance shortfalls, and communi-cate to his organization that transaction pricing isimportant to him.

Deeper in the organization, superior transactionprice performance seldom occurs unless top man-agement offers appropriate incentives to key pric-ing influencers and decision makers like pricingmanagers, salespeople, sales managers, and market-ing managers. Individuals incur an unavoidable riskwhen they strive for higher prices from customers-the risk of alienating the customer or losing thebusiness altogether. It's always easier and less riskyto price low. To offset the risk of pushing for higherprice, tie incentives like compensation to pocketprice realization.

Sales force incentives based on total sales rev-enue are not enough of an inducement for salespeo-ple to push for higher prices. The pricing leveragefor sales revenue-based compensation is always outof balance-a 5% decrease in price, for instance, willcause only a 5% decrease in a salesperson's com-pensation. But assuming average company eco-nomics, it will engender a 60% operating profit de-

HARVARD BUSINESS RE'VIEW September-October 1992 93

TRANSACTION PRICING

crease for that transaction. Only sales incentiveplans that abundantly reward above-average pricerealization and deeply penalize below average pricelevels will draw smart and profitable transactionprice management from a sales force.

Even if salespeople have no explicit pricing au-thority, some sales force incentive for transactionprice realization may still be prudent. Salespeopleare usually the frontline negotiators and the carri-ers of a company's benefit and value message. Theyknow the discounting limits their company will ap-prove and will drop to those limits unless adequate-ly compensated to do otherwise. The sales forcerole in transaction price management is simply tooimportant for much progress to he made withouttheir committed buy-in and support. In both theCastle and Tech-Craft cases, pocket price-based in-centives for all pricing decision makers, includingthe sales force, fueled ongoing improvement intransaetion pricing performance.

The transaction pricing opportunity is real andachievable for most companies today. The invest-ment and risk of capturing this opportunity are low;the keys to success are mostly executional - doinga numher of small things right. What is more, ad-vances in information technology tend to makemany of these small things easier than ever to do.And, as the Castle and Tech-Craft cases show, thepayoff is extremely high, hoth in near-term and sus-tainable profit improvement and in valuahle stra-tegic insights. With its extremely favorable risk-effort-reward profile, improving transaction pricemanagement may be one of the most attractive andoverlooked profit enhancement opportunitiesavailahle to most managers.

References1. Arleigh W. Walker, "How to Price Industrial Products," HBR Septem-ber-October 1967, p. 125.2. Elliot B. Ross, "Making Money with Proactive Pricing," HBR Novem-ber-December 1984, p. 145.

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