Maintaining Profitability During Inflation

It's no secret that the world is dealing with the worst inflation in four decades. Globally, inflation is cutting into the profits of companies in every industry. Businesses across the world are scrambling to deal with the dramatic increases in costs along with supply chain problems and labor shortages arising from the global COVID-19 pandemic.

Inflation makes sellers feel that it upends every aspect to defending their value proposition. The good news is that businesses can flourish even during inflation. Yes, it's inevitable that companies will have to raise prices. But increasing prices should be thoughtful and products should be chosen with surgical precision.

Customers are unique. Instead of instituting across-the-board price increases, deploy fine-tuned increases informed by the value received by the customer, cost to serve, and historical performance. Don't be afraid to walk away from low-value customers who resist the price increase. In this case it's critical to support your sales professionals when walking away is the right choice. Your efforts should be to replace the loss of a low-value customers with a customer more attractive to your bottom line.

• Consider charging for indirect increases. Besides direct price increases tied to inflation indexes, B2B companies can pass on surcharges for fuel, expedited shipping, inventory holding, and longer payment terms. Challenge low-value customers that leak profits with such practices as rush orders, partial truck deliveries, delayed terms, etc. If they won't pay the fees, let them go elsewhere.
• Swap price for other valuable features. Prepare for customers resisting a straight increase, by offering other benefits. These range from supply volume guarantees to bundled products or adjusted service levels.
• Take care to enforce terms that are already in the customer contract. Review and enforce the contingencies for price increases that may exist. Equip sales professionals with the data and scripts to have any expected difficult conversations with backbone. The average industrial company loses over 6% of revenue through off-invoice discounts and leakage, according to a global sample analyzed by Bain and Price. That's a nice bucket of profits to grab back.
• Adjust the product mix. During a period of inflation and supply shocks, it's critical to have an up-to-the-minute SKU-level view of profitability. Just as it sometimes makes sense to walk away from low-value customers, companies may be obliged to drop marginally profitable products and services.

Hedge Now

Prepare your organization now to hedge against a medium or long-term inflation scenario. Most corporate leaders have not dealt with macro inflation during their careers, leaving them unsure of how to proceed. Organizations dedicated to taking pricing steps grounded with Selling Backbone need to assess their inflation exposure. Typically, the finance team leads an exercise that reveals baseline details of how profits would shift under different inflation scenarios. In granular detail, the analysis considers which products and services contribute to profitability and which customers can be served at a profit.

Such a baseline establishes the organization and sets it on a path with strong footing to undertake the optimal pricing actions. Rather than trying to solve the entire problem at once, it pays to sequence which customers and distribution channels to tackle first. Set priorities based on customer profitability or contract renewal dates. Using a customized pricing plan and ensuring salespeople are confident leadership will support them making the tough decisions needed with different customers. This will allow organizations to improve their competitive position during a heavy inflation market, plus build the capability to adjust prices quickly whenever it's warranted.

It's understandable that B2B companies may be reluctant to do what's necessary to protect profits during inflationary times. Many companies granted their customers pricing relief due to the pandemic, and now they are sunk into a pricing hole and inflation is devouring profits. Fixing this problem requires having difficult conversations. It might involve breaking informal arrangements with channel partners and customers. It's difficult to tell good customers that they are facing longer waits for products and higher prices. Yet inflationary conditions favor organizations that act swiftly to implement responsive price strategies.

The good news, if there is any, is that if customer leaders think it's fair, even if painful, they will absorb or pass on price increases due to inflation. These customers will not, however, give their suppliers much credit for delaying price increases only to push them through 6 or 12 months from now. For supply-constrained industries, customers have limited alternatives with which to negotiate. Price could very well be less important than supply and inventory availability.

Here's an example of how one company dealt with inflation.

For a regional car service company, the pandemic years had been tough on their company's business. Many of the company's best customers had stopped business travel in favor of conducting business via videoconferencing. The company ended up selling some of its vehicles. When that wasn't enough, it was forced to furlough drivers. As the pandemic gave way to more travel, the company was further shocked by inflation in the form of dramatically rising fuel costs. The owner had no choice but to raise fares. We listened sympathetically as the owner talked about how he had so many loyal customers and that he was reluctant to see a price increase damage the personal relationships he had with them.

Here's what we told him. Pricing in inflationary times is a lot like playing musical chairs. When the first competitor raises prices, they might lose a little business, but most competitors will follow quickly. If you wait too long to increase prices, worrying about your loyal customers, you are soon going to be inundated by new customers who are price buyers. These customers will be glad to take advantage of your cheaper car service. The results are predictable. These marginally profitable and fickle customers will overload and impact the quality of service expected by loyal, existing customers. No one wins in that scenario.

Honest reflection during inflationary times will allow business leaders to recognize that costs are going up, and therefore prices must rise as well. Realize that your loyal customers already know this. The value buyers will probably stick around. The price buyers might leave for a while, but they are the most likely to be unprofitable, so it might be a blessing in disguise to see them go.

Business is about earning a reasonable return for the value your company delivers. Profitability becomes the lifeblood of companies if they can address these three practices.

Fairness Is Critical

The concept of fairness is critical. Both sides must agree to the essential fairness of the price. Everyone understands fair pricing. The procurement people may not want to admit it, but they know their vendors need a fair profit or the relationship they often come to depend on will be unsustainable. It's never in a customer's interest to bankrupt a vendor they depend on. A fair price is one that, given your costs, similar competitive products, and a reasonable share of the incremental value the products generate, the stakeholders agree is fair.

Some analysts argue that a price that captures 25% of incremental value is fair. We disagree. Sometimes the fair number is just 5%. There are times when fairness is capturing 50%. It's all based on the situation, the competition, the nature of the current relationship, and the relationship you desire for the future.

Fairness may be more art than science. We recently did some work in financial services where the product was priced at $22. The primary research showed that customers would not resist a 7 to 8% price increase. That's not bad, but a look at the value the product generated revealed that the client benefited to the tune of $60 per sale. The sales team decided to lead with a price increase of $50. After some internal back and forth, the parties agreed to a price increase of $48. A satisfied customer and certainly more profitable for the financial services firm was the result.

Here's another example of value-based pricing using the UVPF (Understand Value, Price Fairly) formula.

We collaborated with a company whose sales team was convinced their product was a commodity. The assumption reinforced that there was no choice but to reduce price to remain competitive. We went to work to surface reasons why the product was a trade good with unique value. Interviews with customers and decision makers supported our view. Further analysis demonstrated that while the product indeed functioned as a commodity, our client was the preferred vendor in most cases. This was because among the competitors, there were wide variations in product quality, reliability of supply, and customer service.

The company's products were really a staple rather than a commodity and were essential for their customers. The company decided there was over-supply and announced it was taking one of its manufacturing plants off-line. That step alarmed the customers because they knew that when supply goes down and demand stays the same, prices go up. In fact, the sales team announced that prices were, indeed, to be raised. The sales team said they would honor existing prices for customers who put in orders immediately. Some customers thought it a bluff and that prices would be maintained. We acknowledge even some of the client's own salespeople didn't believe the strategy would work and customers would rebel.

In fact, when the company followed through with the announced price increase, customers left in droves. It was a tense situation for a few weeks. Some customers tried a competitor but found that it could not reliably satisfy demand. Other competitors took the opportunity to match our client's price increase. In the following weeks, one customer after another decided it was in their interest to accept the price increase for the more reliable supply and superior customer service. This company discovered that all their customers were poker players. That's why UVPF is so important.

Three Differentiated Pricing Plans

To make such value pricing work, managers need to adopt three differentiated pricing plans to manage capacity as shown in Figure 10.1. Each one is based on the utilization of the resources of the company. It is useful to think of each approach as being in a zone of utilization.

Zone 1 in Figure 10.1 represents the period when there is ample capacity. What many companies do during these periods is reduce the price of their high-value products. By doing so, they undermine the value structure of the company and their credibility with customers when the business cycle improves. Instead, the company should introduce low-value products or reduce service levels from the high-value package in order to protect the prices of the high-value offering.

Zone 2 is the transition period. When there are signs that the business is beginning to get busy, let the low-value customers know they might not get their products when they expected them. Make sure the expectation is set with these customers ahead of time. These customers believed they could get some products and services for low prices and are now disappointed that they can't. Remind them that they have choices: pay for the premium product that comes with premium delivery, pay for expedited delivery on an ad hoc basis, or accept a delay.

In Zone 3, the company is running at or above capacity. Don't waste a lot of time on most RFPs. Your main goal should be meeting existing customer demand. In fact, don't even bid on the low-priced opportunities because now there is a need to reserve capacity to satisfy high-value customers. Think about how airlines reserve some first-class seats for last-minute travelers. Always have a little extra capacity to take on the real high-value business, whether it be through an extra shift or weekend work. Costs will be a little higher, but the company should be charging a premium for customers to get capacity access during these times.

Companies can price based on capacity in any industry that has cycles of constraints and cost structures that are or can contribute to the capacity dynamic. Many industries, from professional services to steel and pulp and paper industries do this in a reactive manner by reducing prices on high-value products and services. They leave significant amounts of money on the table by not being initiative-taking about managing the capacity process and introducing low-value services and products with long lead times.

One industry segment that should use opportunity costing to control utilization is the professional services. Leaders here tend to look at their labor as a high variable cost when, in many cases, their costs are actually fixed. That is, the core group of people who are protected from any layoffs are a fixed cost and should therefore be viewed that way in both the costing and the pricing process.

Service firms tend to drop prices on high-value services and lose money. The Give-Get is to offer lower prices but to make sure some level of service and support is taken out of the offering.

By focusing on the value that professional resources bring to clients and learning to continually improve value, professional services companies are able to move out of the cost-based meat grinder of customer negotiations and into the value-based discussion with client executives that results in more benefit to everyone involved.

More Effective Give-Gets

Here's one more possibility that some of our clients find intriguing because it leads to better capacity utilization and higher profits. It calls for you to insert a clause in your sales contracts that gives you the right to “bump” certain customers when it becomes clear that you are at full capacity. The airlines do this kind of bumping all the time. While federal law gives them that right, we are all aware of how much passengers resent it. For you, that “magic clause” becomes a bargaining chip to use in price negotiations with procurement people. It becomes perhaps the most effective Give-Get to use in contract negotiations, and exercise it based on the three phases of capacity utilization shown in Figure 10.1.

Rather than having your salespeople always negotiating with price, they negotiate with the clause. When a procurement person asks for a lower price, the salesperson says, “No problem, but we have to have the right to bump you for our higher paying customers.” To that, what will a typical poker-playing purchasing agent do? They'll pretend to get upset, which is a tell that they were playing poker all along.

The magic clause is another way the airlines stay profitable. It has application in a wide range of industries. Note the brute force method that UPS recently used during a recent peak holiday period. They charged Amazon $2 to $8 per package for the extra handling. UPS well understood that Amazon is trying to ramp up its own delivery infrastructure and that it was using UPS services to manage the packages they couldn't manage themselves. This understanding gave UPS enormous pricing leverage.

The current supply problems in the semiconductor industry have led to production problems in a wide range of industries, but none have been hurt worse than automobile producers. These hard-charging price buyers are suddenly faced with a shortage of computer chips. The shortage of these chips, which often cost less than $10 per unit, are holding up the production and sales of $40,000 automobiles. The procurement teams at the car makers have transitioned to poker playing in order to get supply at lower costs. Smart suppliers will invoke this clause in order to charge dramatically higher prices for their chips. We told the story of the chip maker that had a customer show up at the local airport in their corporate jet to take possession. The car maker was happy to pay a surcharge of 60% above to take reliable supply.