Is now the time to reduce margins to boost volumes?

Published in Asset Finance Europe April 2010

The asset finance industry has navigated some troubled waters over the last couple of years, and the outcome has been different for individual players. One recurring theme though, for those strong enough to have weathered the storm, is that their margins have held up well. Everyone always knew there would be winners and losers from the recession, and, if some of my recent conversations are representative, it seems that some of the stronger players with access to cash are now wondering whether now might be the time to drive home their success by trimming their margins to boost the size of their portfolios.

Which takes us to the question: what is the best way to profitably boost volumes?

When I was the managing director of CitiCapital Fleet, rarely a week went by without someone saying “We’re doing really well but if only our prices were cheaper we could do much more business”.

I heard this from our sales team, account managers, sales managers and sales director. Everyone loved it when we won new business.  Everyone was pleased that we were busy and apparently successful. We trumpeted the success of our salespeople when they won a new client. The focus was on volume; profit was a rather more nebulous concept. Most of our people couldn’t see the direct relationship between our prices and our bottom line results. It was a typical example of “Never mind the quality feel the width”.

Our clients too were happy when we won business. As we were almost always put in a competitive situation for every deal, it meant that we were always the cheapest when we won a deal. So of course the client was happy with us then; they had just bought something at a low price.

And when we didn’t win a deal, clients would say “We like doing business with you but if only your prices were cheaper we could do much more business together”.

It seemed to me that there was a silent conspiracy in place. Everyone wanted our prices to be lower. I found myself wondering what level to pull to increase our margins.

We had controls in place, of course, to stop our people quoting prices below a certain threshold. Those thresholds were based on targets which were formed by reference to our annual plans. We knew that if we wrote the planned volume of business at the planned price, we would make our planned gross profit, cover our fixed, costs and make our planned net profit. Our parent company would be happy and we would all get our bonuses.

I went along with this approach until, one day, a client confided in me that our prices were so low that he was worried about our long term viability. I went back to the office and asked to see the details of our costings. Our pricing people were slightly miffed that I should challenge them in this way and it is absolutely true that on reviewing their costings I discovered that they had done everything right. Right, that is, according to our internal rules, but quite clearly these rules were not helping us to arrive at prices that made sense in the market.

In the intervening 15 years I have looked in detail at the pricing practices of dozens of asset finance companies and discovered that we were not alone in setting prices that made sense to us but no sense at all in the market. Broadly, I have found five different approaches to pricing:

  1. “We know our prices are right because we are setting them in accordance with our annual plan”. This, of course, is tosh, as I have already shown. The Plan is a promise that a management gives to its parent company but it does not tell the management what prices to offer to the market for a particular product on a particular day.
  2. “Our experienced salespeople take a commercial view”. I am a chartered accountant and I spent a dozen years working in the back office in awe of salespeople who would go out and bring back the deal. I felt sure that these modern hunter-gatherers must have a great grasp of the intricacies of pricing. Then for eight years I became a salesman. I issued quotes, won business, earned commission and had success. I showed clients the value of our product, so that they would focus on this rather than our price. It worked. But my pricing was still a hit and miss affair. Often I would lose a deal for a relatively small amount, and just as often when I won a deal I would be left with the sneaking feeling I could have charged far more had I only had the confidence to aim higher.
  3. “This is the way we have always done our pricing for this sales channel”. I see this quite often. “We always charge this client an X% margin” or “We always include a fixed £x per month as an overhead contribution for this sales channel”. And I always then have to explain that that is meaningless as far as the customer is concerned, they just want the price to be right. There is no reason why “cost-plus” should produce the right price. It almost always produces the wrong price and guarantees you can be undercut by someone with costs lower than yours.  Risk-based pricing, a current hot topic in the industry, fits into this category too. Just because you’ve priced in some extra basis points to cover risk, it doesn’t automatically follow that the resultant price will be acceptable in the market.
  4. “We aim to hit a target return on equity”. This is perhaps the most illusory of all pricing methods. The salespeople are told that the ‘right’ prices are those that exceed the company’s ROE hurdle. Some ROE calculations are remarkably complex, leading to the impression that they bring some sense to the topic of pricing. In fact they do nothing of the sort; ROE-based pricing is a great tool for protecting the company from unacceptably low pricing but does not give any clue as to the optimum price that will be acceptable to a particular customer on a particular day for a particular product.
  5. Optimised pricing. Here the company attempts to pull together every scrap of information and evidence about the acceptability of prices for each of its products in each of its markets, and overlays this with information about the price-sensitivity of each of its individual customers. Such an analysis is usually complex and can involve millions (and in some cases billions) of pieces of data, but this is the only method I have found that can deliver justifiable prices that can truly be said to be optimal; delivering prices that maximise the probability of winning a specific deal at the highest possible price.

Which brings us on to the four pricing outcomes.

The chart shows the four possible outcomes when a pricing decision is made. (It assumes that the person issuing the quote knows something about their competitors’ prices, but we will ignore that issue for now).

Outcome 1. Price is pitched high and sales volumes are therefore low.

In many businesses this would be regarded as failure, but in some it is business policy. For example, for an asset finance company with a cash constraint this might be a perfectly rational pricing policy.

Outcome 2. Price is pitched low and sales volumes are therefore high.

Here again this is a completely rational outcome. It can be business policy to do this; “Pile it high sell it cheap” can be a powerful marketing tool. Sadly this outcome can also hide poor sales performance; the sales or marketing team have not done a good enough job in explaining the particular merits of this product and the special value it will bring to that customer (or that group of customers), so the company could only sell the product at a low price.

Outcome 3.  Price is pitched low and sales volumes are low.

This, of course, reflects a total failure of sales and marketing. Something is seriously wrong and immediate corrective action is called for.

Outcome 4. Prices are being pitched high and sales volumes are high.

This may seem counter-intuitive but this outcome usually reflects real sales and marketing skill – this is the area where sales and marketing people really get to show their value. Alternatively, this outcome can arise when customers do not know the real market value of a product or are happy to pay more because of some convenience factor.

It is important for businesses to know where every sale is falling within this chart. Every outcome should drive an action.

  • Outcomes 1 and 2. Decide if the price/volume mix is as you wish it, and, if it isn’t, change prices to drive turnover towards the desired outcome.
  • Outcome 3. Take immediate action to identify the cause of the problem and to remedy it.
  • Outcome 4. Analyse the reason for the success and see what can be done to achieve this success across other product ranges.

Our industry provides a great service for British businesses. Yet the returns we have made over the years have been modest and have broadly mirrored macro-economic cycles. It seems to me that more lessors are now paying more attention to their pricing than ever before, and that can only be a good thing.

And so, back to my original question: Is now the time to reduce margins to boost volumes? In my view the answer is no. Now is the time to boost volumes and margins simultaneously; reduce margins to pick up volume you would otherwise lose, and increase margins to pick up money you are currently leaving on the table. The trick, of course, is to work out which to do when.

Professor Colin Tourick

 

 

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