Price Waterfall Analysis
A Key To Understanding and Plugging Profit Leaks
- by
- Ryan Maley
The business world is becoming more and more competitive. Even with the pandemic affecting the way companies run their usual operations, there is still no stopping business owners from finding 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 the 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 of oversight can greatly affect your profit margins and cause you profit leaks. This is where price waterfall can come in handy.
What is the Price Waterfall?
Price waterfall is an analysis method used by 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?
Some companies do not have a good understanding of how profits are affected by the many types of discounts, rebates, and other incentives offered to customers.
Over time, more incentives may be offered and they may seem relatively minor, but the implications for profitability can be huge. Many of 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 obscured costs are called “profit leaks” because it is not immediately obvious where the profits are going. Price waterfalls can identify what is leaking and how much.
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.
- Define commercial policies defining levers and how they are to be used by salespeople to achieve company sales and profitability goals.
What is in the Price Waterfall?
There can be many ways to develop a price waterfall and waterfalls may vary industry to industry. However, there are usually common components across all companies and industries.
List Price
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 mulltiple 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
On-invoice deductions are those items that are generally visible to the customer such as product discounts, promotional credits, and rebates. 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
Off-invoice deductions are a frequent source of profit leak. These deductions can include a wide variety of things reated 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 actually considered.
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 difficulty 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, and information technology is valuable. Get individual stakeholders input to the problem. 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 usually a challenge not necessarily because the analysis is difficult, but actually collecting the data and understanding it can be difficult.
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 the key is identifying 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 communicating where profits are leaking and to understanding how you can plug the leaks.
Making the Most of Your Price Waterfall
Price waterfall analysis has proven itself useful to many businesses in a wide variety of industries. While simply analyzing the data is useful in understanding profitability, the real benefit of waterfalls come from how you use them to help transform pricing and better achieve your company goals.
The most common reason for a journey of pricing transformation is the quest for more profits. Price waterfalls can provide a map for that journey by identifying the source of profit leaks. However, they are just one step on the journey.
Use your price waterfall to systematically review strategies and commercial polices to help your entire company achieve its goals.
Ryan Maley is a management consultant with Stratence Partners, a specialized consulting firm that helps companies get the most from pricing by helping optimize strategies, implement pricing excellence, and increase commercial effectiveness. Stratence has helped companies in many diverse industries develop price waterfalls to drive transformation to pricing excellence.
© 2021 by Ryan Maley. All rights reserved.