Leading-edge Pricing: Harnessing the Power of the Waterfall

By Anthony Milani, Ray Florio, Tiago Salvador and Hyun Suk Oh

Customers will always want more for less. In an effort to provide the most compelling value proposition, companies in a wide range of industriesconsumer packaged goods, resources, professional services, hospitality, oilfield services, manufacturing and moreface continuous pressure to provide fresh offerings, extend existing services and find new partners with which to collaborate. Recent economic turmoil has greatly accelerated this process, as companies merge, consolidate and expand to provide the best, most comprehensive deal to more ROI-focused business-to-business customers. Unfortunately, this had led to such diverse and multi-faceted offerings that most companies cannot hope to peg the underlying costs of deals to determine if they are pricing and negotiating profitably. More importantly, these companies are limited in understanding whether they are pricing and negotiating the right products to the right customers. The processes and systems that identified and tracked their cost data, designed for creating financial statements, were never intended to provide sales organizations with the inputs required for sophisticated deal and contract management. While a fully allocated price and cost waterfall can address this issue, many companies struggle in its creation, value realization and industrializationa comprehensive approach that is necessary for success. Fortunately, there are some key steps high performance businesses can take to avoid the typical pitfalls.

Introduction: Doing more for less

While businesses are locked in challenges to enhance value propositions that attract and retain customers, the recent economic turmoil has greatly accelerated the process. Just think of all the mergers, acquisitions, joint ventures and consolidation activity that happened during the height of the recession in 2009. Even as the recovery takes hold, the trend appears to continue in 2013 based upon a recent study that shows 76 percent of respondents anticipated their company would be involved in merger activities this year.1 All of this activity has resulted in the majority of companies expanding their product and service catalogs, as well as their cost base and resources much more quickly. Moreover, once these new offerings are available, they begin permeating the majority of contracts, as sales representatives look for any advantage over the competition, with little visibility into the true cost of that extra edge. Employees and facilities that become idle when services are underutilized also remain an ongoing cost that are not typically assigned or tracked. Unfortunately, if calculating the profitability of each deal, customer or product was difficult five to 10 years ago, a true measure of profitability is even more problematic today. No one would advocate pricing solely based on cost. For the vast majority of companies, such a fundamental basis for pricing became obsolete decades ago. However, understanding true cost to serve is a critical component of decision making, and is a necessary first step to employing more sophisticated pricing. Of course, for many corporations, this key input is sorely lacking.

1.Mergers and Acquisitions on the Rise for 2013, Proformative, Jan. 23, 2013, http://www.proformative.com/news/1497051/mergers-acquisitions-rise-2013

Fortunately, companies can gain the necessary insights and act upon them by developing a full price and cost waterfall for each deal. This practice provides insight into true profitabilityafter all costs are taken into accountbeyond just cost of goods sold (COGS). The waterfall might include customer-specific costs, such as specialized sales personnel or marketing events; nuisance costs like restocking from returns; and even costs that may not be in the profit and loss statements, such as late payment costs (see Figure 1). Figure 1: Most companies look at contribution margin to determine profitability by deal; however, they should be looking at pocket margin
Basic Product/Service Add-ons and Extras List Price Regional Adjustments Regional Price Contracted Discount Contracted Price Additional Negotiated Discount Negotiated Price Allowances/Returns Rebates/Chargebacks Promotions Volume Discount Payment Terms Discount Surcharges Expedited Freight Pocket Price Cost of Goods Sold Freight Third Party Charges Other Variable Costs Contribution Margin Brokerage Fees/Commissions Marketing and Advertising Sales Compensation and Benefits Proposal and Relationship Building After-Sales Incentives Product Development Customer Service Disputes Bad Debt Expense Inventory Carrying Costs Standard Terms Non-Standard Terms Cost of Late Payments Technical Services Dedicated Fixed Assets Other Indirect Costs Pocket Margin

$K

$0

$20

$40

$60

$80

$100

$120

$140

(Source: Example waterfall of costs to take into account using figurative data.)

But were not structured to do that

One of the first reactions to a waterfall is the ever common, We dont keep track of all those costs at a deal level. Typically, companies do not. Instead they build their financial tracking systems and processes for the purposes of generating financial reports. In fact, for some complex businesses, fully tracking all of these components could seem insurmountable, but some simple logic can quickly and fairly accurately assign the appropriate costs to each deal. If done properly, it will provide actionable information that is a close approximation to reality. The tradeoff in precision will be worthwhile. Some executives in the organization may still hesitate because they do not see the benefits of this level of information, or they believe COGS and other direct costs is enough information for decision making. Despite this common belief, companies that do develop a waterfall often find the decisions based on direct costs alone were not right. As a matter of fact, customers previously considered to be highly profitable may actually have large indirect costs, leading to losses on most sales. Understanding true profitability will impact far more than pricing decisions. Incorporating this information into customer, product and sales strategies can make a difference for companies. Imagine being able to direct the right products to the customers who will actually provide the highest bottom line profits for the company, instead of those who will simply pay the most. On top of that, consider the benefit in negotiations if the sales organization can leverage past information to quantify the impact on margin for each individual addon service or contract term on margin, and make the appropriate tradeoffs. If that is not compelling enough, think how much

As an example, meatpackers or other food and beverage companies have often found that some of their large distributors actually eroded profits due to strict packaging requirements. These requirements demanded more labor and equipment in facilities than were needed to service other customers. In addition, frequent returns necessitated extra sales and support staff, along with associated costs for restocking and waste. Looking only at direct costs, these types of customers previously may have been considered the first choice for any sales; however bringing all factors into view provides a different perspective for the customer strategy.
better cost-cutting decisions will be now knowing how much the company leverages a particular resource and the value it adds, along with understanding the degree necessary to cut costs in order to maintain proper margins on market-relevant prices. In reality, though there can be major benefits, most companies quickly realize that achieving full visibility into the true profitability of each and every deal, and then getting the benefits from that knowledge, is neither a simple nor a short process. Many companies attempt it numerous times before finally achieving success. Fortunately, the pitfalls they encounter tend to be the same. The companies that understand the key barriers can greatly simplify the process and shorten the time to realizing the benefits, and eventually adopt this new way of doing business throughout their organization.

Guiding principles for the journey

The journey towards understanding and leveraging true profitability in a companys decision making can be broken down into three distinct phases: waterfall creation or model building, value realization or acting upon newfound opportunities, and industrialization or making the entire process sustainable in the organization (see Figure 2). Figure 2: The three-phase journey to achieving visibility into true profitability

Waterfall Creation

Value Realization

Industrialization

Before delving into the details, there are a few guiding principles to keep in mind:

Make it an ongoing journey

This is not a one-time effort to achieve shortterm goals. The true advantages from a deallevel profitability effort come from ongoing benefits realization year over year. Putting in place a waterfall is a cultural shift; getting the most out of it requires that it become part of day-to-day life in the company. If the initiative is viewed only for short-term margin gains, the company will get only a small share of the potential benefits.

Start small
Trying to implement deal-level profitability across the entire business all at once is daunting. Some functions will be less open to this change until its value is proven, and there will be a large number of differences in the cost base across business lines and geographies. Begin with a segment of the business that is receptive, demonstrate success and then expand from there.

Have the right sponsor

Since the journey affects so many areas across the company, the appropriate sponsor should be a well-respected influencer at a high enough level to bring together the necessary stakeholders. By being engaged throughout the journey, the sponsor will actively serve as an advisor providing guidance and ensuring forward progression.

Let the business lead

Do not make this a finance or IT initiative. All of the decisions, outcomes and success relies on the entire business. A waterfall approach needs the business to fully embrace and drive it from the beginning. Sales, operations and leadership need to understand and accept responsibility for the quality of the outputs and improvements. Getting these functions onboard and engaged at the onset will more likely lead to success.

Focus on outcomes
A good profitability model is extremely helpful, but it is how an organization leverages it that counts. The entire effort is only worthwhile if it results in tangible benefits for the business, and those benefits need to cover the spectrumfrom simply plugging data gaps to make way for future improvements to the model, to identifying major profit opportunities for the company.

A detailed look at the three phases

As companies embark on the journey depicted in Figure 2, there are important details for each phase, as well as methods to avoid typical pitfalls during each:

A critical element to the waterfall is ensuring the base list price is current and market relevant. Get Ready: Address issues in the base list price.

Get Set: A base list price aligned to strategies and segment goals enables the discount analysis required by the sales force to effectively negotiate with customers and it minimizes risk for erroneous conclusions when comparing The first step to gaining and acting on a full understanding of deal-level profitability is the discount bar of the waterfall.

Waterfall creation

to calculate that profitability. The resulting waterfall model will serve as the basis for the remainder of the effort. Unfortunately, many companies find themselves halted by barriers at this early stage, trying numerous methods to develop a waterfall but falling short. Companies can use this situation to their advantage, though. Analyze previous attempts and understand why they failed. Was the model growing too complex? Did it require too much effort to sustain? Did it grow outdated too quickly? Did the necessary stakeholders not understand it? Whatever the cause, the learning experience helps to avoid making the same mistake again. After identifying what caused the company to stall, or if attempting this for the first time, begin with the philosophy that the end product is not a financial report or an accounting tool. It is a decision-making aid meaning if it is off by $57 dollars on $3 billion in revenues, it is unlikely that the resulting actions will change significantly. Efforts to reconcile small discrepancies across multiple financial systems usually do not add much value, so avoid tracking every penny. Provided that the results align reasonably well with a widely accepted external standard, such as the companys profit and loss statement, then the results are close to accurate for decision making and will build confidence in the underlying numbers.

Now Go: Begin the journey of true profitability through Waterfall Creation

Allocating costs down to individual deals is likely to be the next sticking point, and one that generally generates debate over how to properly assign costs. Take an approach that balances thoughtful vs. thorough in the methods. It is likely that each business line and geography has only a small number of significant costs. Rather than attempting complex allocations or even developing difficult-to-maintain activity rates for all costs, focus where it really matters. Spend time with a broad group of influential stakeholders to find acceptable, more sophisticated methods to allocate costs as accurately as possible. The less substantial costs can rely on simple logic. It will be far easier to gain stakeholder agreement through this approach, and it will prove an effective means of balancing collaboration with top-down direction. Most stakeholders will appreciate inclusion and will feel valued by bringing their insights into the process. As a result, the waterfall will not be seen as complex calculations and they are more likely to champion the initiative, leading it towards success.

Once the company has the numbers, begin an iterative process of validating them with the stakeholder group. Not only will they help identify potential flaws in allocation logic, but also they can pinpoint some underlying inconsistencies in billing or invoicing processes that result in inaccurate inputs into the models. These inconsistencies will either need to be addressed or worked around to ensure the model represents the true state of the business.

Value realization
A waterfall is useful only if it results in actual improvements. The model may tell where to focus attention, but once the company knows that, it is time to act on the most promising opportunities. Typically, the common barriers to realizing the benefits are lack of direction, doubts about the ability to actually produce outcomes, and a general lack of time to pursue new opportunities. However, some simple practices can help companies achieve more significant and sustainable benefits, and in a manner that builds support for the new profitability view across the business. Moreover, with these best practices in place, companies can make value realization a permanent feature of doing business, one which everyone actively takes accountability. Rather than setting an ambiguous goal of simply improving profitability, the first step to generating benefits is establishing firm, attainable improvement targets based on both benchmarks and internal analysis of potential opportunities. In addition, these end-goals need to be well known across the organization and incorporated into the overall business agenda. It is paramount that leadership engages in regular communications on the progress the company makes toward its goals, with clear visibility to executive sponsors and functional leads. Building a value realization review into monthly leadership meetings, or even establishing specific value realization touchpoints, can help the business keep moving toward objectives. It is advised that those objectives are continually reviewed and updated as the business improves and the market changes. Without this attention to goals, employees tend to fall into their normal routines and may not reach for the potential opportunities.

A leading oilfield services provider recently put this approach into practice for their final and successful attempt at developing a waterfall. From previous attempts, the company learned that overly complex or manually intensive cost allocations eventually met with failure. By adapting the approach to use simplified assumptions as the basis for the logic, their waterfall effort then allowed them to effectively focus on getting the more significant costs correct as well as the ability to turn their insights into actions. Working with key representatives from sales, operations and finance, the provider was able to develop reasonable, understandable cost allocation methods that everyone could support. After reconciling to the overall profit and loss statements, an iterative review process of the resulting models further enhanced the organizations comfort levels with where costs were being pushed down, leaving the critical decision makers open to acting upon the insights gained. In fact, many of those involved early in the process became outspoken champions of the profitability initiative as it deployed to other business lines and geographies.

The second step is to set up a team who is responsible for achieving these goals. This team will be much more successful if it has in-depth knowledge and support from all the major functional areas likely impacted including marketing, sales, corporate strategy, operations, logistics, supply chain, finance and IT. This broad base of expertise will not only foster a better understanding of how to act on opportunities, but will facilitate the identification of significantly more. If opportunities emerge that involve an underrepresented or even unrepresented business function, the team should involve that function in the opportunity identification process. Gaining this kind of internal support removes potential barriers to realizing value. Also, to support making this effort an ongoing component of the companys culture and operations, as well as bringing in fresh perspectives, companies should cycle new members from the business into the value realization team every few months.

In recent years, several leading clients have followed these guidelines to jumpstart adoption of, and benefits generation from, their waterfall. Accenture has often helped drive this process, with leadership setting the stage, being involved from the very beginning and setting up value realization teams from all functional areas, including off-site plant As this team and the remainder of the operations and sales offices. For a typical client, those selected for these business are acclimating to the value realization effort and overall changes in teams are expected to spend at least five to 10 hours a week focused on how they view profitability, some pushback value realization, and their normal responsibilities are adjusted accordingly. will naturally occur. At this critical adoption Once these teams identify a number of opportunities, the business leads help point, initiatives that require extensive effort select those with the best trade-off between benefit and effort, and then or prolonged time-to-value are not going shift implementation to the appropriate groups. to win support. On the other hand, if the value realization team prioritizes quick wins When putting this approach in action, the companies involved soon start that achieve significant benefits rapidly, realizing benefits, but this tends to work best if the value realization teams stakeholders will be inclined to champion are suitably rewarded. Continuing the process, Accenture will help lay the profitability efforts earlier. groundwork for our clients to cycle new team members at regular intervals. Likewise, prior to starting any initiatives, the In many cases, the clients we have guided along this journey not only met team must work with each functional area to estimate the benefits for each area as well as but exceeded the initial goals they established. Some even exceeded initial profit improvement targets by as much as 50 percent, building considerable the efforts required. This approach will help support for the profitability initiative among key stakeholders. the team to best understand ways to build
support upfront, before delving into more involved and longer-term efforts. This will also help with broadening the overall profitability effort to other areas of the business.

Industrialization
Once the company has its models, and has begun leveraging them to generate actual benefits, many employees may wonder how they can sustain the initiative. At the same time, fears may be high that the entire process may need repeating every quarter or month, depending on refresh needs. A company also may have a list of changes that stakeholders want to incorporate after using the waterfall, or there may be new data sources to enhance the allocation logic. How can executives be sure that all of this is incorporated without introducing errors that may compromise confidence, or result in a cumbersome update process? Start with the basics. Throughout the entire process, maintain and update clear, concise documentation. This will allow the company to understand the goal and function of each part of the model, and provide for an easier transition to resources who may take on responsibility for it. Moreover, clear documentation will allow a more streamlined and efficient validation process, allowing the right resources to easily confirm or find errors in the model prior to its widespread dissemination. Once documentation and validation are established, a change management process will prove necessary. Similar to the way software developers address multiple changes in a single patch, schedule and prioritize alterations to the model, providing ample time to fully test and prepare the organization for the new or different features. It is best to not reactively address every change request as it comes up since these actions may serve as an incubating ground for introducing errors. Similarly, investigate new data sources thoroughly, and resist incorporating if requirements involve high manual maintenance, or introduce a wide disparity of approaches across business lines and geographies. Often companies ask whether this type of effort should result in a technology solution for true sustainability. This will depend on specific needs and the complexity of the models. While a company may have begun 9

the journey with a proof-of-concept based in a simple spreadsheet, as the model grows to encompass more of the complexities of the entire business, it is unlikely this will remain sufficient. However, it may not require the biggest and best solution out there. Some companies even find success outsourcing the process to a third party. The key to making the right decision is to embark on this path prior to selecting the

way forward. To find what works for the company, assess the design with existing tools and capabilities. Once the full scope is understood, think about making a technology investment. This will help the company be better positioned to understand the true value each solution provides.

Recently a global beverage company embarked on creating a new and consolidated waterfall following a large merger. While the waterfall was able to address and support key initiatives for the company, the after effects of the merger resulted in allocation logic having to bridge multiple systems and account for a myriad of processes. In addition to sustainably weaving together these varied data sources and inputs, the brand needed help streamlining disparate pricing management, approval processes and field communications, leading it to leverage a major packaged technology solution for pricing. Through this transition, the documentation the company provided allowed for much faster speed-to-value, and limited the costs of the industrialized solution.

Conclusion
Companies across multiple industries are being driven to negotiate much more complex and intricate deals, causing them to lose touch with the ability to quickly and easily measure true profitability. Some companies have made numerous attempts to regain the appropriate levels of visibility only to stumble into the typical barriers and pitfalls. The high performing businesses that learn from these obstacles, establish broad support, validate the results continuously, focus on objectives, support outcomes, and make intelligent choices to sustain the process realize their achievements and overwhelming levels of success. The benefits from reconnecting with this key metric are both broad and substantial, spanning customer and product strategies, as well as pricing and cost reduction tactics. Assigning the right resources to the right areas can prove a true competitive advantage for the long run.

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Contacts
For more information about applying a waterfall pricing approach in your company, please contact: Anthony Milani anthony.k.milani@accenture.com Ray Florio raymond.c.florio@accenture.com Tiago Salvador tiago.l.salvador@accenture.com Hyun Suk Oh hyun.suk.oh@accenture.com

About Accenture
Accenture is a global management consulting, technology services and outsourcing company, with approximately 266,000 people serving clients in more than 120 countries. Combining unparalleled experience, comprehensive capabilities across all industries and business functions, and extensive research on the worlds most successful companies, Accenture collaborates with clients to help them become high-performance businesses and governments. The company generated net revenues of US$27.9 billion for the fiscal year ended Aug. 31, 2012. Its home page is www.accenture.com.

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