SAP Profitability and Cost Management (PCM) provides management information for a whole range of business decisions, one of which is the thorny area of product pricing. Specifically, SAP Profitability and Cost Management (PCM) can tell you what it costs to deliver your products to different customers via different channels. It does this accounting for not only the direct costs, which you can attribute directly to outputs, but also the indirect costs, whose relationship with your outputs is usually a bit more… complicated.
PCM uses an activity-based methodology to fairly allocate indirect costs to outputs. I’ve written about using activity-based costing before, for example here, so I won’t go over that again in this post. Instead, let’s think about how the costing information from PCM feeds into decisions about product pricing.
A classic use case for activity-based costing, which I won’t reproduce here for the sake of brevity, illustrates how organisations make can make wrong assumptions about the profitability of their products. A high-selling product may seem to be fundamental to the company’s business model, but if that product is furtively consuming a major chunk of the firm’s indirect costs, it may be less profitable than thought – or even downright loss-making.
How much should I sell a ‘Doodad’ for?
If PCM is used to calculate the costs of a product, it can help the business set a price for its products so that they are profitable.
You need to know the true cost of your products so that you don’t inadvertently set a selling price so low that you lose money every time you sell it. But at the same time you need to consider what’s happening in your market. Set a price that’s too high, and customers don’t buy either because the benefits they get aren’t worth it or because they can get it cheaper somewhere else.
So you’re developing a new ‘doodad', but it’s going to cost you £30 for every doodad that you put on the shelves, and you want your customer to pay you £36 a pop. What if the customer can buy an identical doodad from another supplier for £25? What if the customer isn’t perceiving £36 pounds worth of value from the doodad?
Well, first of all, if we run the numbers early enough we can decide to abandon doodads altogether. Suppose we carry out our analysis and find out that the market isn’t willing to support our expensive doodad, given what we’re going to have to charge to make a profit. One option would be to make an early decision not to bring it to market. The resources that we were going to use to build, sell and support doodads can be redirected to more useful activities.
Secondly, we investigate whether there’s a way of producing the doodad more efficiently. With PCM, we can look at the activities that go into bringing the doodad to market, and lets us compare against the same activities for widgets and jiggers. Is there something about the doodad that makes it so much more expensive? Can we change our processes to bring about improvements that can bring the costs down?
Thirdly, can we use segmentation to fine-tune our pricing to different segments of our customer base?
Segmentation is a way of ensuring that we don’t leave money on the table. It’s a technique for dividing our customers into different groups, and offering different pricing models within each of those groups.
For example, suppose we have a product that PCM tells us costs us £90 per unit to deliver. So let’s say we set a price of £100. Some potential customers – let’s call them Segment A – might be willing to pay £150 for it; if we sell it to them for £100, we’re missing out on £50 of profit each time.
On the other hand, if we put the price up to £150, to maximise revenue from those willing to pay the extra, we risk losing sales from some of our customers – let’s call them Segment B – who would have paid £100 but aren’t prepared to go to £150.
What we’d really like to do is be able to set a price of £150 for Segment A and a price of £100 for Segment B, while preventing or discouraging Segment A customers getting the lower Segment B price.
The idea behind segmentation is to make sure that you maximise revenue by arranging your potential customers into segments based on willingness or ability to pay different prices. Sometimes this is done by offering modified versions of the same product; sometimes it’s done by making the customer jump through a hoop or two to get the lower price.
Here are some examples:
- Business travellers can be charged more than holiday-makers. Travel companies segment these different markets by offering lower rates to those customers who travel either side of a Saturday night, or to those who travel outside rush hour.
- Theatre-goers and sports spectators pay different prices depending on where their seats are in the venue.
- Car manufacturers produce high-end versions of car models with more or better features.
- Software developers offer the same product with restricted features. This is particularly interesting, because different segments of user are usually using the same software, it’s just that additional development has been done to allow features to be enabled or disabled. So in this case, it costs the developer more to build a product that will be sold at a lower price, but the benefits of being able to offer a less expensive version of the product make it worth it.
- Different price lists are available for different sectors, such as government or education.
- Discounts can be offered to customers who use channels with lower cost-to-serve; for example applying for a financial product online rather than in branch.
- If the customer places an order for a larger volume of goods or services, they can be given a discount. This is so common than the customer will often expect it.
The following table shows some of these examples, and illustrates that there isn’t necessarily a correlation between cost and pricing.
Some approaches to segmentation can be modelled easily within PCM. Customer segments and channels are often modelled in the Cost Object dimensions, and this allows you to produce excellent supporting evidence for pricing decisions – e.g. offering a specific discount for online customers, or showing the impact of special pricing for different verticals.
PCM results can also feed into price discussions where deals are being negotiated. For example, it gives sales people solid information to support discount offers such as "if you give us the same volume of business but over fewer orders, our costs are this much lower and we can offer you this much discount”. Basing these negotiations on solid data avoids the risk of offering a discount that actually penalises the supplier.
The implication of all this is that segmentation in your pricing strategy should be reflected in your PCM model as well, so that you can carry out profitability analysis. Analysis of the revenue side of the profitability equation is fairly easy, because it tends to be bottom-up. But you need your PCM customer dimension to be segmented in line with your pricing, otherwise you don’t have the required cost analysis.
Key points to remember
- You need to know what it costs you to get your products to your customers.
- If your customers don’t want to pay £11 for your widget, you won’t change their minds by pointing out that it costs you £10 to get it to market and you’d like to make a small profit.
- If you’re faced with a product that costs more to produce than you can sell it for, you don’t have to produce it any more.
- But you might also consider using PCM data to analyse activity costs and make improvements to your processes. You can either control your costs and bring the price down while still being profitable, or make the product better and therefore more valuable to the customers.