Pricing for Profit: Using Customer-Centric Pricing to Improve Profitability—A Q&A with Bob Lindgren

Dr. Ronnie H. Davis,

Senior Vice President and Chief Economist

Center for Print Economics and Management

REPORT PAGE 2 OF 6 NOVEMBER 27, 2018

Pricing for Profit: Using Customer-Centric Pricing to Improve Profitability In a recent Management Alert, we discussed the “three C’s of pricing—costs, customers, and competition—and how printers should consider each of these factors in making pricing decisions. Of course, the theory does not always match the practice, especially given the fact that there are complex dynamics involved in considering even one of the three C’s. In this Management Alert, we drill down to explore the second C—the customer—and discuss some tactics for implementing customer-centric pricing. Optimizing pricing strategy requires careful consideration of two basic economic concepts. The first is price elasticity or the sensitivity of a buyer’s purchase decision to price. The second is the marginal impact on the firm of the acceptance of an order at a given price. The best measure of the first is the “hit ratio” with each customer. If it’s high (we get almost every quote) there is an opportunity for a price increase, and if it’s low (our quotes are seldom accepted) there is an opportunity for more sales with a price reduction. In either case, the measure of our indicated action (price increase or reduction) is the difference between revenue received (the billed amount) and actual out-of-pocket expenditure to produce the work. For this purpose, traditional budget-hour costs are very misleading as they include significant amounts that are not incremental (rent, overhead, front office, etc.). Q&A on Customer-Centric Pricing with Bob Lindgren To gain additional insight into this topic we conducted a Q&A session with Bob Lindgren. Bob began his career in printing in Chicago over 50 years ago, after earning his MBA in accounting and finance from the Graduate School of Business of the University of Chicago. Following his service as an accounting manager for a Chicago-based printer, Bob joined the staff of Printing Industries of Illinois and began a career of over 40 years advising printers, first in the Midwest and then in the nation’s largest industry group, Printing Industries of America—Southern California, where Bob currently holds the title of President/CEO Emeritus. He has advised printers both in Southern California and the Midwest for more than four decades. Question: Bob, first of all, can you explain how most printers make decisions about prices? Answer: Printers almost always determine their price by looking at their “cost.” Cost is usually defined by using hour rates that try to include all the costs of operation using only a limited number of hours. That’s why we tell ourselves that the 40” 4/C costs $300/hour when the crew only earns $40/hour. Question: What is wrong with this approach to pricing?

REPORT PAGE 3 OF 6 NOVEMBER 27, 2018

Answer: It ignores the reality that prices are determined by the value that the job confers on the buyer and what the buyer believes they may obtain from another acceptable supplier. Setting the price based on cost is like trying to hit the target by facing the other way. Question: What do you mean by focusing your pricing on customers? Answer: The object of the game is to get as much as there is to get, but also get the order. The whole process has to focus on the relationship with each customer and what they are actually buying. Question: Define “hit rate” and how to calculate it. Answer: The core measure of the effectiveness of your pricing system is the “hit rate.” It’s simply the percentage of quotes that turn into orders. The higher the hit rate the more likely it will be to fully utilize the plant and equipment you already have. Question: Define utilization rates and how to calculate them. Answer: There are 168 hours in every week, so a press that’s running 40 hours a week is 24% utilized. It could produce four times as much work in the available time. Question: What is the problem with relying on estimating systems to determine prices for a print job? Answer: An estimating system using numbers based upon only limited utilization produces numbers that are too high to sell enough to fill the available time. Question: Won’t I lose money if I sell at lower prices? Answer: Remember that the press with the $300/hour rate has a crew earning $40/hour. If you sell additional hours for $250 you will earn $210 for each hour. If you don’t sell them, you will earn nothing. Question: How can you determine which customers will pay a higher price for a job and which customers might be more price sensitive? Answer: That’s what the power of the hit ratio is all about. A customer with a high hit ratio thinks of you as a sole source and isn’t focused on price. One with a low hit ratio is a price buyer.

REPORT PAGE 4 OF 6 NOVEMBER 27, 2018

Question: Describe and explain how a printer can employ utilization rates and hit rates to increase profitability. Answer: Your business has a set of overhead costs (building, equipment, front office) that are volume insensitive. When you sell a job, you have to pay for the paper, buyouts, operator wages, and sales commission. What’s left over is called “contribution to overhead.” If you collect enough contribution dollars to cover the overhead, you’ve broken even. Generally, the best way to build contribution dollars is to more fully utilize the capacity. This is done by using the hit ratio as a guide to the price point that will produce a sale. Question: All this sounds great “in theory,” but how can you actually implement this system in your firm? Answer: The first step is to think about your customers. For example: Group A are people who really like and appreciate our work and give us the order 80%+ of the time. Group B are people who we have a decent relationship with and they give us the order 40% of the time. Group C are people who will let us quote but we only get the order 20% of the time. Group D are people who are strict price buyers (government agencies, etc.) and we get the order 5% of the time. Question: OK, then what happens? Answer: Group A gets a markup of 3% because there’s clearly room to get a little more. Group B gets our standard prices. Group C gets a 7% discount. Group D gets a 15% discount. Question: So, what’s the result?

REPORT PAGE 5 OF 6 NOVEMBER 27, 2018

Answer:

Question: Why are we better off? If the mark-ups or discounts hadn’t been used the results would have been… Answer:

By simply matching pricing to market realities contribution to overhead and profit has almost doubled! Question: What about your sales force? How can you get them to buy in since many sales people are focused on selling based only on price? Answer: It is also critical to address the sales compensation system as sales reps and the firm should be on the same page. Logic would suggest a percentage of contribution, as that is what we’re trying to maximize. However, because contribution is affected by plant performance, this approach can produce issues. Changing to a percentage of value added (sales minus materials and outside purchases) will accomplish the firm’s objectives is a simpler fashion. In changing from a percentage of the gross system to one based on value added, one is more likely to keep the sales force on board if the focus is on changing behavior and not reducing sales compensation. For example, if the present system is 8% of the gross, the new approach would be about 11% of value added. Question: What do I have to do to get there?

Answer: Clearly there are many hurdles between operating at the level of most printers, and operating at a higher capacity utilization, something approaching full capacity. These include staffing challenges, supervision of new shifts, and getting your staff to accept this culture change, just to name a few. Creating a detailed plan and then implementing that plan—with careful

Customer Type A B C D

Base Price $1,000 $1,000 $1,000 $1,000 Mark-Up/Discount 3% 0% -5% -15% Offered price $1,030 $1,000 $950 $850 OOP Cost $600 $600 $600 $600 Contribution $430 $400 $350 $250 $1,430

Customer Type A B C D

Base Price $1,000 $1,000 $1,000 $1,000 Mark-Up/Discount 0% 0% 0% 0% Offered price $1,000 $1,000 $1,000 $1,000 OOP Cost $600 $600 No Sale No Sale Contribution $400 $400 $0 $0 $800

REPORT PAGE 6 OF 6 NOVEMBER 27, 2018

monitoring of progress as you move from just breaking even to becoming a real profit leader—are needed. But the rewards of implementing a true “marginal decision making” philosophy are great. If we accept the reality that prices are not set by our estimating system but by our customers and our competitors, we can make it our mission to sell as much as we can for as much as the customers are willing to pay.

Thank you Bob—there is a lot to think about from your discussion. The key take-away, I believe, is that printers can gain a significant advantage if they implement, as much as possible, a customer-centric pricing strategy.