With increasing customer demand for lower prices and a limited understanding of the competition, an organization without a disciplined pricing strategy can become an easy pushover. More often than not, this results in excessive discounting and attempts at competitive matching that accelerate pricing and margin erosion.
What is Price Erosion?
A reasonable price erosion definition is essentially a negative price realization in the market. The perceived value of a product slowly declines during the product lifecycle as a result of attempts at competitive matching that accelerate pricing and margin erosion.
Many factors contribute to price erosion, including shorter product lifecycles, budget constraints, and increasingly sophisticated buyers; but your lack of pricing discipline shouldn’t be one of those contributing factors. Implementing a sound pricing strategy prepares your company to deliver up-to-date pricing guidance to sales reps wherever they might be at the time of contract negotiations.
Price Erosion Formula
With revenue being the selling price, here are ways to breakdown your budget using these margin erosion formulas:
- The gross profit (P) is the difference between the cost to make a product (C) and the selling price or revenue (R):
- P = R - C
- The mark up percentage (M) is the profit (P) divided by the cost (C) to make the final product:
- M = P / C = (R - C)/ C
- The gross margin percentage (G) is the profit (P) divided by the selling price/revenue (R).
- G = P / R = ( R - C)/ R
If intuition, guesswork, and emotion currently drive your pricing decisions, it’s time to stop what you’re doing and take a hard look at your pricing strategy. Subjective, inconsistent pricing means you’re probably leaving money on the table today and undermining your future sales.
What is Margin Management?
Margin management is a term used to describe the comprehensive approach to analyzing risk from a margin perspective while addressing costs and revenues as a single unit of risk.
The goal of this process is to maximize net margins in any market environment even when input and revenue prices are equally high or low.
Tips to Avoid Price Erosion and Margin Erosion
Tired of under-valuing your own products and being out-negotiated by sophisticated buyers? It's time to reverse that trend with a strong strategy supported by the latest pricing technology. Aside from margin erosion formulas, here are five pricing strategy tactics that can help set the stage for a more disciplined, consistent, and profitable sales organization.
1. Segment customers by willingness to pay
Many sales organizations sell product lines with good/better/best variations in quality and value. When a price sensitive customer seems unwilling to pay more for the higher-value options, sales reps often feel pressure to offer all three options at similar price points to win the business. This practice creates a significant risk for margin erosion.
When sales reps enter negotiations with a good indication of a prospect’s willingness to pay using customer analytics and segmentation, they’re able to improve sales offers and avoid driving down prices on higher-end products. With a highly price-driven customer, for instance, the best sales strategy is to offer only lower-end products instead of a full range of value propositions. This strategy makes managing prices easier during negotiations and helps sales organizations control margin erosion for higher-end products.
2. Set accurate floor, target, and stretch prices
When most of your deals need to go through your exception process for approval, the review might seem like an indication that you have pricing under control. However, too many price approvals via exception usually indicate the lack of a disciplined pricing strategy. Meanwhile, the sheer volume of exceptions tends to obscure deals that genuinely require scrutiny and slows the sales process. While reps wait for quote approval, prospects may lose interest or opt for a competitor’s products and services.
To reduce these exceptions, take time up front to establish accurate floor, target, and stretch prices for each product and customer segment. This practice offers several benefits: reducing discounting, accelerating approval for sales reps, and allowing sales and pricing leaders to employ the exception process more effectively. Building on a consistent, objective pricing framework also tends to produce logical price bands that help slow the rate of price erosion while protecting market share.
3. Reduce variance in pricing bands
If your company offers tiered, good/better/best product lines, tight pricing bands help protect prices on the higher-value or premium options. To get these tight bands, you need the ability to determine when a price is truly too low, and then implement floor, target, and stretch prices for each tier in the product line. When sales reps then use customer segmentation to selectively offer these options, it reduces variance in price bands, shrinking exposure risk and slowing price erosion.
4. Introduce new products to target value-driven customers
When you combine a strong pricing strategy and customer segmentation, your company also gains the necessary insights to develop new products that target your highest-value prospects. These offers might be brand new or come from bundling services and other added value with existing products. And, when launching brand-new products, the ability to initially target value-driven customers with the highest willingness to pay is a great way to extend the product’s probable lifecycle and slow margin erosion.
5. Use pricing software to adapt to changing market conditions
Pricing software combines data from your sales transaction history with a variety of market intelligence sources. Based on that information, the software offers pricing optimization and the ability to quickly adjust your pricing to reflect changing conditions. It also delivers objective pricing guidance and more accurate forecasts of price changes over the life of a product.
Overall, pricing software helps to organize and implement the discipline and automation needed to slow margin erosion. These software solutions offer agility and predictive insights that allow sales and pricing leaders to determine which tactics and strategies are most effective in preserving profits.
Developing a Sound Pricing Strategy
Without a consistent strategy, out-of-control pricing and rampant discounting are certain to accelerate margin and price erosion within your organization. But if you’re tired of under-valuing your own products and being out negotiated by sophisticated buyers, you have the ability to reverse this trend.
The PROS Platform helps businesses develop effective omnichannel pricing strategies and drive hassle-free execution at scale, adding precision and excellence to their pricing practices. Explore our potential revenue calculator to learn more about how the PROS Smart Price Optimization and Management helps can help you maximize your revenue potential.