September 25, 2014
What metrics are you using to measure your Pricing effectiveness? Does the word ‘Average’ feature in a number of those metrics? Probably!
The problem lies in the fact that many of your colleagues from Sales, Marketing or Finance find solace in a consolidated, aggregated and averaged view of your business’ performance. It is what they are used to. It makes things simpler, in their worlds. For example, ASP (the Average Selling Price) is I am sure, a familiar term used in your Sales teams to describe customer performance. Marketing tracks Average Margin or Contribution Margin by product. For those who have already taken the positive step of introducing a Price and Margin Waterfall, this may even be an Average Pocket Margin.
The consequence of this is, as a Pricing Manager you have probably been asked to report Pricing Performance using these same metrics. It is, after all what everyone understands.
And therein lies the fundamental flaw. Average and Pricing just don’t really mix that well.
Let’s face it, Average Price Performance is…. well …. it’s the Average. It’s the price point somewhere in the middle. It does not tell you very much from a Pricing perspective. It does not help you understand where things are working well or not. It tells you nothing about the spread of customers, how many are buying above or below the average. It does not provide any insights into your pricing variation.
So, why is Variation in Pricing so important?
Let’s take the example of two similar products (A and B). They both have the same ASP, but the distribution (or variation) of their pricing is very different, as represented below:
Is the Pricing Performance of these two products the same? Would your response to performance and assessment of the need for corrective actions be the same? If you were only measuring ASP, it would be. It’s the insight gained by looking at the variation the leads you to draw the conclusion that different courses of action are required.
Variation analysis is of course not new to business management. It sits fairly and squarely as the foundation of six sigma process quality optimization:
Any process improvement should reduce variation, so that you can more consistently meet customer expectations. Furthermore, it’s a fundamental principle of Six Sigma philosophy that you cannot improve quality unless you can measure it. This in fact applies to any aspect of Six Sigma.
The same can and should be applied to measuring and improving Pricing Effectiveness.
So, how do you measure Pricing Variation?
Well, using your Pricing Analytics Tool, you could plot out the Pricing Distribution for every product in turn, going through them to identify those with high variation. There is, however, a quicker way: use statistics.
This first step is to start by calculating the Standard deviation:
This is the Average difference between any value in a series of values and the mean of all the values in that series. It measures the variation in a distribution of values.
The second step is to use a normalizing metric to enable easy comparison of many Products that are sold at different pricing levels (e.g. those sold for cents vs those sold for 10’s or 100’s of dollars). This is something we call the Coefficient of Invoice Price Variation:
This is calculated as the Standard Deviation divided by the Mean. It is expressed as a value between 0 and 1.0 or as a percentage.
The higher the value, the more variation there is in your pricing. A Coefficient of Invoice Price Variation greater than 0.10 is generally considered to represent high variation.
In pricing terms, if you are running your business based on Average metrics, you are going to end up with Average, not optimized, performance. It is the Pricers responsibility to reduce the amount of Price Variation, tighten the distribution, but this does not mean optimizing the average. You need to identify areas of excessive variation and finding ways to reduce that variation. Variation analysis needs to become part of your standard process and part of your Pricing Effectiveness metrics.
The choice of business metrics and the importance you give them show what you value. If you value reducing Price Variation, you need to make it central to your business metrics. You put it on your scorecard. You include it in your dashboard. It becomes part and parcel of your day to day language used by all groups in your organization to discuss Pricing Effectiveness.