Today, five critical factors directly affect a chemical company’s profitability. Products that had been specialties have become commoditized, resulting in increased competition and lower prices. Margins, which generally are based on a percentage of the selling price, tighten when prices are the highest because raw material and energy costs also tend to be highest then. Long lead times in building new plant capacity create supply swings. Dynamic raw material and energy costs make it difficult to consistently meet profit goals. Overseas competitors with lower costs are penetrating the domestic chemical market.
However, companies can minimize the deleterious effects and even improve profitability if they manage these factors properly. The key is making sound pricing decisions through price management. The necessary data to use this approach already exist in ERP [enterprise resource planning] systems.
Before discussing these factors, let’s examine what is meant by price management. It consists of: pricing analytics, deal management, price execution, forecasting and optimization (Figure 1). Companies are best served by focusing on pricing analytics, deal management and price execution first, preferably in tandem, and forecasting and optimization later. Price management builds upon sound business and pricing fundamentals already in place. Without them, price management will just allow poor processes to work faster and you will reach the same undesired outcome, just more efficiently.
This series of methods allows better insight to be gained from data. Pricing analytics can identify areas for action. One example is developing a better understanding of customer “willingness to pay” (WTP). This is a relative statistical quantity that is based on the price elasticity of each individual customer. Some customers are willing to pay more for a product than others. This can be due to the value your product creates in their processes, their relative profit margins or other valued services you provide. Regardless, by understanding a customer’s WTP (and tracking how this changes with time), you can set a price closer to that customer’s reservation price or limit and tailor your product offering to the things they value. This can lead to higher profits and more-satisfied customers than possible with uniform pricing.
Pricing analytics also can help by allowing for price differentiation among customers based on market segmentation, additional research and development costs, supplemental laboratory work, shipping costs, customer service required and other less-tangible product attributes. Figure 2 illustrates how market segmentation can be used to increase profitability.
Pricing analytics can be used to identify customers and products with low and negative margins. As shown in Figure 3, favorable aggregate margins for product groups frequently mask low-margin products. Pinpointing and then weeding out these poor performers can improve profitability.
Deal management involves structuring workflow to ensure profitable actions are taken. One example is managing of quotes. A key aspect is funneling all quotes before being sent to customers through the same channel for approval to provide a check on their profitability. Deal management also includes checks on customer contract compliance. For example, a given customer may have been quoted prices assuming certain minimum volume commitments. If that volume is not being ordered, then charging higher prices is warranted. Figure 4 depicts a common scenario. A manufacturer is willing to offer a greater discount from list price the more a customer purchases, as indicated by the line. However, because of the difficulty in managing data, firms end up discounting in the random manner shown by the discrete data points. Deal management, by addressing such inconsistencies, can help improve profitability when market conditions pressure margins downward.
Price execution relates to how pricing strategy is applied. It should include development of customer-specific price lists that can be readily distributed to salespeople and customers and frequent updating of these lists to reflect current conditions. This enables firms to act promptly based on changes in raw material costs, the calculated WTP and dynamic market conditions. It improves profitability by ensuring that price lists are current and tailored to the specific reservation price of each customer.
Now, with an understanding of price management, let’s examine ways it can be used to address those five key factors that affect profitability.
The lifecycle of a chemical product usually moves through a series of stages. First typically is a period of research and development or, at a minimum, process development associated with commercializing the product. This generally results in patents or trade secrets. Margins and price usually are high because limited competition allows the company to get full value for the product. With time, production becomes more efficient, reducing costs (although not necessarily raw material costs). However, also with time, improved products win market share. And, at the end of the patent’s life, other companies may be able to offer the product at a lower price. Because of this, it is important that a firm be able to recoup its research and development costs prior to the end of the patent’s life.