Capturing the price that is initially set is just as important as setting the initial price right. On Liozu & Hinterhuber’s pricing capability grid, one must be equally proficient in price setting and price setting to be considered a pricing champion as profit leakages from poor discounting practices can have a detrimental impact on the firm’s bottom-line.
In 2013, McKinsey & Co. looked into just how detrimental this impact was for a global lighting supplier. They broke down every single discount and promotion from the initial list price, to the invoice price, but also beyond the invoice price all the way to the pocket price.
Definition: The term ‘pocket price’ refers to the effective price paid by a customer in a transaction after considering all relevant discounts, promotions and rebates.
The study showed that the invoice price this lighting supplier received was, on average, 32.8% lower than the list price. And then followed the off-invoice discounts such as cash discounts due to early payment, foregone interest from carrying receivables, freight expenses, etc. Off-invoice discounts led to a pocket price that was only half of the list price. Half! After setting an initial price of $100, they only end up with $50 in their pocket.
And this is not a stand-alone example - it’s merely the consequence of failing to discount systemically and back discounts by data rather than gut feel.
Using the Pocket Price Waterfall
The pocket price waterfall shows each and every “profit leakage”, that is, every price reduction/cost of making a sale after the initial list price. This will provide a useful overview of why some customers become unprofitable, but also why some turn out very profitable.
If you have a large sales team, you will probably see that some salespeople are actually quite good at discount management already - and breaking down their on-invoice and off-invoice discounts will provide a useful guideline for what discounts are needed and which are not.
It is important for us to emphasize that we are not inherently against giving discounts, rebates or allowances, but if the pocket price waterfall is not used to keep track of these, it easily gets out of hand. When you create your own, try looking for both profitable and unprofitable customers, and use this insight to create discounting guidelines, diagnose challenges, and provide solutions in terms of more strict control, especially of off-invoice discounts, and help your salespeople realize just how much their behavior can influence the bottom-line.