An independent study by the McKinsey Consulting Group indicates “the fastest and most effective way to enhance corporate earnings is to raise prices.”
There are a variety of ways to increase earnings. Obviously a company can raise prices or reduce costs. A company can also often enhance earnings by increasing their volume of business – provided there are no additional costs – this is referred to as “business efficiency.” What is surprising about this McKinsey study is the huge impact just a small price increase has on corporate earnings – as compared to the impact for the same amount of cost savings.
McKinsey says that “for a typical S&P 1500 corporation, a 1 percent increase lifts operating profits by 8 percent. This impact is nearly 50 percent greater than what would occur with a 1 percent reduction in variable costs (such as direct labor) and more than three times greater than the impact of a 1 percent increase in sales volume.”
So anyone negotiating a sale needs to remember what just 1 or 2 percent can do for the company’s bottom line. Be careful with your concessions. If you are forced to provide a price concession, don’t forget to ask for something in return. During your discovery process, search for “Both-Win” ways to help your customer while at the same time enhance the price you are going to get.
And don’t give it away! The impact of a few percentage points in price goes both ways. From McKinsey: “A decrease of 1 percent in average prices has the opposite effect, bringing down operating profits by that same 8 percent if other factors remain steady. Managers may hope that higher volumes will compensate for revenues lost from lower prices and thereby raise profits, but this rarely happens; to continue our examination of typical S&P 1500 economics, volumes would have to rise by 18.7 percent just to offset the profit impact of a 5 percent price cut. Such demand sensitivity to price cuts is extremely rare. A strategy based on cutting prices to increase volumes and, as a result, to raise profits is generally doomed to failure in almost every market and industry.”
In the course of a business transaction, there are many negotiations taking place where price erosion can occur. There are often a variety of discounts, incentives, promotions and other giveaways that help close a deal. After an order is placed there may also be cash discounts, prompt payment discounts, extended payment terms (i.e. 60-90-120 days to pay), volume discounts or even rebates. Some negotiations even deal with ‘performance penalties’ that provide customers discounts if for some reason delivery schedules are not met or orders are not filled according to plan. Each one of these elements, if not negotiated appropriately, allows profits to “leak away.”
Prices are impacted by hundreds, sometimes thousands, of individual negotiations each day. Standard and discretionary discounts allow percentage points of revenue to drip off the table one transaction at a time. At the end of the day, you have to look at what really the company is really putting into its pocket. With all of these negotiations happening, there are ways to find and capture an additional 1 or 2 percent. It pays to use your negotiating skills!