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Amid volatile costs for raw materials, CFOs grow bolder about increasing product prices.
Tim Burke, CFO Europe Magazine
November 3, 2008
In recent years, product pricing warranted daily discussions between CFO Alan Hippe and his colleagues at Continental, a €16.6 billion German tyre maker. Today, those conversations are just as likely to be taking place by the hour. Amid rising raw material costs, "pricing is key," Hippe says. "It's a discussion at every board meeting, at every level." Although cutting process costs has offered some respite, the company now has little choice but to share the burden with customers. While in the past it never raised prices more than once a year for any product, that has changed. Its replacement tyre business, for example, has raised prices three times in the US and twice in Europe this year, with further increases likely in 2009.
Continental's experiences speak volumes about the groundswell of change in corporate pricing strategies. Once a sensitive topic that companies broached gingerly for fear of losing valued customers, record-high prices of oil and other commodities have emboldened executives to raise prices more aggressively than ever. In today's tough climate, in fact, it's common for companies to break the taboo of speaking about increases publicly without having to worry about a customer backlash. And, if handled well, a small increase can go a long way towards boosting the bottom line, contends Simon-Kucher & Partners (SKP), a marketing and strategy consultancy. In an analysis of FTSE 100 balance sheets, its consultants reckon these companies could achieve an average profit increase of 14% by raising prices by only 2%.
Yet according to Marco Bertini, a professor of marketing at London Business School, price increases are often primitive and managed in an ad hoc fashion. If companies are trying to find ways to boost their bottom lines, recalibrating the prices of goods and services can make a bigger impact than many companies realise, he contends. That said, "the level of sophistication [in terms of how companies deal with their pricing] is not very high." But a range of CFOs are showing that under their leadership, pricing strategies can be turned into the carefully executed exercises that they should be.
Consider Ciba Speciality Chemicals. Like other companies, the SFr6.5 billion (€4.2 billion) Swiss company has experienced recently the effects of rising input costs working through its supply chain, including a 50% increase in the price of gas isobutylene, a key ingredient in its antioxidant business. Subsequently, Ciba's profit margin fell to 5.2% in the first half of 2008 from 8.2% in the same period the previous year.
The company has battled to keep production costs flat, absorbing a rise of about 10% in energy bills through practices such as lean manufacturing. It also wants to save up to CHF500m by 2010 through an efficiency programme.
But the way CFO Jürg Fedier sees it, cutting costs isn't enough. "You can save whatever you want, but if you're not able to get some traction from a margin protection point of view or a pricing programme, you're going to be nowhere," he says. "That's a fact of life." To this end, Fedier used a recent earnings call to announce that Ciba had a new, "aggressive attitude" towards pricing. This year, it raised prices on a long list of products, including increases of about 20% for its paper imaging, pigment and additive products.
For a company like Ciba, with almost 10,000 individual products, it's crucial to differentiate price changes for different products. Consultants at SKP point out that prices on niche products, for example, can be increased at a greater proportion relative to input costs with little impact on volumes. On the other hand, large price increases are not advisable for products that can easily be bought from competitors, something that companies understand intuitively but often do little about.
To address this at Ciba, there's a steady flow of information between finance, operations, procurement and sales, analysing costs and prices on a product-by-product basis. "We know at any one time what the potential impact of movements in raw material prices is going to be on the end-product price," Fedier says. "Then, depending on the strategy for that particular product, you determine to what extent you're able to pass [cost increases] on in price." A price hike is not always a foregone conclusion, Fedier notes, citing stiff competition from China which forced its latex business to cut prices despite soaring costs. "The perfect idea would always be to recover whatever rises are coming through raw materials," he says. "But the market may not allow you to do that."
Customers need to be taken into consideration when pricing products. (See "What's the Difference?" at the end of this article.) Understanding high-value customers and their willingness to swallow price increases is critical to a strategy's success. That's more than clear at airlines such as Ryanair, a €2.7 billion Irish budget carrier which has built its name on low fares. CFO Howard Millar calls the company's customers "very price sensitive," a fact of life that "you ignore at your peril."
As he explains, Ryanair knows the triggers that allows it to jack up its prices, keeping fares low until two weeks before a flight, when time-pressed travellers have fewer options, so are willing to pay more. As CEO Michael O'Leary has joked, the best yields are derived from passengers travelling to funerals, "because they generally don't get a lot of notice, they book late and they have to travel at certain times."
Talk It Out
Once a price increase gets the green light, communication becomes key. It's at this juncture that consultants at SKP recommend using press releases, interviews and conferences to prepare customers and other parts of the market for the increase. "Only if the rationale and impact of the price increase are made transparent will customers have a chance to react accordingly and to prepare themselves," the company explains.
The amount of advanced warning needed depends on how much lead time a company has before raw material costs work through to the P&L. Some companies may have to announce immediate increases, while others can give customers a few weeks — or even months — of warning. Either way, offering a reason for the increase is crucial. When Evonik Industries, a €14.4 billion German industrial group, was planning to raise the price of its powder coating products in October, it sent out a press release in August, explaining that the "relentlessly rising costs of raw materials, energy, labour and logistics have made this decision unavoidable, despite all efforts to further enhance productivity and cost reduction."
But companies still need to tread carefully. At Salzgitter, a €10 billion German steel group, finance chief Heinz Jörg Fuhrmann says he is sceptical about the "more aggressive and public" pricing communication policies that many companies are following today. If a company wants long-lasting relationships with its customers, Fuhrmann argues, it should ensure they hear about price increases directly in "personal and trustful communication" rather than through press releases. Does he think companies will ever return to holding these discussions behind closed doors? "I hope that we return to this kind of communication," he says.
Whenever a price increase is communicated to the market, the work doesn't stop once there. At Lanxess, a €6.6 billion German chemicals group spun out from Bayer in 2004, CFO Matthias Zachert describes the pricing process as a circle. Information about the changing cost of raw materials flows throughout the company. If prices are raised, the sales force feeds back information from the front line about customers' reactions. Then, monthly reports let the company monitor the end result on the P&L statement and determine whether further increases should be considered. "This is how the circle is eventually closed," he explains.
One crucial step, the CFO adds, is to be able to differentiate between an increase or drop in sales due to a price increase or owing to, say, a change in volume. That sort of analysis, he says, is the only way to know whether a pricing strategy is working.
The current pricing strategy at Lanxess seems to be working. Zachert points out with some pride that for the past three years the company has been able to recover input-cost inflation through price increases. And that hasn't dented demand — as a report from JPMorgan in October notes, "Lanxess holds a strong track record of growing prices and volumes in tandem."
For Zachert, a disciplined approach to pricing is something that has to be driven into the culture of a company. "Million dollar" IT systems can help with more efficient reporting and tracking of data, he says, but it's more important that his staff "get a grip on volatility" in the current market. "Good processes, systems and instruments don't mean anything if people are not using them," Zachert insists.
More to Come
Indeed, people are as important as the process when it comes to price management, and the biggest change for finance chiefs in this new era of pricing may be the increase in the level of their personal involvement. Traditionally CFOs have distanced themselves from the nitty-gritty of price setting. But as the subject becomes more strategic, many are finding themselves drawn into the process. That's not a bad thing for a company, or CFOs themselves — Ciba's Fedier says that becoming more hands-on in pricing has allowed him to develop an even greater understanding of Ciba's markets.
More finance chiefs will have an opportunity to do the same. The Economist Intelligence Unit, a sister business to CFO Europe, forecasts that commodity prices will continue to fall in 2009 due to weak demand. By October 2008, oil had already fallen to less than $70 a barrel from its record of $147 over the summer. Although prices won't rebound in 2010, the Economist Intelligence Unit says, "in the longer-term, commodity prices are expected to recover in tandem with stronger global demand, particularly from developing countries." Speculation that OPEC would cut oil production in October highlights the continuing volatility in input costs that companies face.
At Continental, CFO Hippe worries that the company's price hikes won't cover the rising cost of rubber during the second half of 2008. He expects more price increases during the first half of 2009, although he's hopeful that they won't need to be as extreme as this year. But he cautions that even when raw material prices fall in a slowing global economy, another problem emerges: dwindling demand, which has its own impact on margins. Whatever happens, he says, "this won't be over in 2009."
Tim Burke is senior editor at CFO Europe.