4thqtrjrnl Full

The Journal of
Professional Pricing
VOLUME 15 z NUMBER 4 z FOURTH QUARTER 2006
The Worl ds Onl y Associ at i on Dedi cat ed t o Pri ci ng Management
A Prof essi onal Pri ci ng Soci et y Publ i cat i on
PPS Year End 2006 Survey of Todays Pricing Professional
Eric Mitchell
How to Price Spare Parts More Protably: A Pragmatic Approach
Richard Zinoecker
Pricing Over the Product Lifecycle: Adapting Strategy in an Evolving Market
John Hogan and Thomas Nagle
Managing by Results Versus Managing by Means
Ron Baker
The Journal of Professional Pricing
ADVISORY BOARD
MR. JEROLD BERNSTEIN
President
The Price Improvement Team LLC
MS. JANELLE BRECHON
Manager, Global Price Management
& Global Customer Support
Eaton Corporation
MR. XAN CHAMBERLAIN
Sr. Manager, Global Services Pricing
Hitachi Data Systems
MR. MARTIN COALSON
Asst. VP, Product Development
& Yield Management
Union Pacifc Railroad
MR. ROBERT CROSS
Chairman & CEO
Revenue Analytics, nc.
MS. KARYN GAYLE
Senior Margins Manager
Acuity Brands Lighting
MR. JIM GEISMAN
President
Market Share, Inc.
DR. SCOT HORNICK
Vice President
Mercer Management Consulting
DR. RICHARD LANCIONI
Professor of Marketing
Temple University
MR. GARY RITZERT
VP, Retail Consulting
AC Nielsen
MS. STACEY SCHAEFFER
Senior Marketing Manager
SAS Institute, Inc.
MR. MARK SHAFER
VP of Revenue & Proft Management
Walt Disney Resorts
PUBLISHER & PRESIDENT
ERIC MITCHELL
PROFESSONAL PRCNG SOCETY
MARETTA, GA
ADMINISTRATIVE STAFF
DENNIS BICKEL
VCE PRESDENT OF MARKETNG
& CPP PROGRAM
HELEN CAUTHEN MITCHELL, CMP
MEETNG DRECTOR
MICHELLE P. DURFEE
SPEAKER RELATONS MANAGER
STEPHANIE HUDSON
MEETNG PLANNER
DARNELL SHEPHERD
PROJECT COORDNATOR
KATRESE PHELPS
DRECTOR OF MEMBERSHP
JOAN TERRY
MEETNG PLANNER
LATONIA DUGGER
MEMBERSHP ASSOCATE
WYNETTA JONES
MEMBERSHP ASSOCATE
PROFESSIONAL PRICING SOCIETY
3535 ROSWELL RD., SUTE 59
MARETTA, GA 30062
PHONE: 770.509.9933, FAX: 770.509.1963
EMAIL: info@pricingsociety.com
URL:www.pricingsociety.com
The Journal of Professional Pricing
TM
is published quarterly
by Professional Pricing Society; Publisher Eric Mitchell. All Rights Re-
served 2006. Professional Pricing Society accepts no responsibility
in connection with any liability that might develop as a result of mate-
rial published; opinions expressed are those of the authors and do not
necessarily represent the publisher. No part of this publication may be
UHSURGXFHGLQDQ\IRUPE\PLFUROP[HURJUDSK\RURWKHUZLVHRULQFRU-
SRUDWHGLQWRDQ\LQIRUPDWLRQUHWULHYDOV\VWHPZLWKRXWWKHZULWWHQSHU-
mission of the copyright owner.
4 The Journal of Professional Pricing Fourth Quarter 2006
From the Publisher
by Eric G. Mitchell
A
s 2006 comes to a close, everyone at the Professional
Pricing Society would like to thank you our members
and sponsors for your continued support. The great
news is that because of your support, 2007 promises to
be an even better year, with four events that will present incred-
ible experts and speakers. In total, PPS will offer more than 20
Certied Pricing Professional workshops in 2007, many of them
for the rst time.
Two big PPS events are scheduled for the rst half of 2007: CPP
workshops in San Diego and the 18th Annual Spring PPS Con-
ference in Atlanta.
Certihed Pricing Professional Workshops
The Certied Pricing Professional (CPP) Program continues to
grow in attendance and in the number of workshops held. We
will offer a pair of two-day workshops in 2007. The rst will be
Feb. 22-23, 2007, at the Westgate Hotel in beautiful San Diego;
the second will be July 12-13, at the Westin OHare in Chicago.
These two-day programs are popular because Pricers may earn
two credits toward their CPP designation.
8an Diego Workshop, Feb. 22-23, 2007
Pricing, Bundles and Tiering Presented by Robert Docters
and Bert Schefers, Partners, Abbey Road Associates
Price Negotiations for Pricers Presented by David Palmer,
CPA, MBA, Ph.D., Silicon Valley Management Consultant and
Adjunct Professor, Santa Clara University
Making Protable Decisions Presented by Kent B. Mon-
roe, J.M. Jones Professor of Marketing, Emeritus, University of
Illinois at Champaign, Distinguished Visiting Professor, Uni-
versity of Richmond
Best Practices Presented by Jim Saunders, Partner, Pricing
Solutions, Ltd.
Pricing Organization Transformation Presented by Larry
Montan, Director, Pricing Center of Excellence, Deloitte Consult-
ing LLP and Jia Li Moore, Manager, Human Capital Practice,
Deloitte Consulting LLP
An expanded description for each course is available on your PPS
Web site www.pricingsociety.com where you may download the
PDF of the entire brochure.
PP8 Conference and Workshop in Atlanta,
April 18-20, 2007
Mark your calendars to join us at the Spring Conference on April
19-20, 2007 in Atlanta with workshops on April 18. Dont miss
this opportunity to meet and network with over 500 peers who
are also involved in pricing.
We are very excited about our conference program. George Stalk,
Jr., Senior Vice President and Director for The Boston Consulting
Group will be the lead keynote speaker. You may know George
because of his best selling book: Hardball Are You Playing to
Play or Playing to Win? George also co-authored two best-sell-
ing books on time-based competition: Competing Against Time
and Kaisha: The Japanese Corporation. Business Week identi-
ed George as one among a new generation of leading manage-
ment gurus. He was also listed as one of the top 10 consultants
by Consulting Magazine.
Joining George on stage as keynote speakers will be Larry Mon-
tan, Director, Deloitte Consulting LLP, Paul Hunt, President,
Pricing Solutions, Mark Burton, Vice President, Holden Advi-
sors and Matt Johnson, Director, Simon-Kucher & Partners. You
may have also seen Larry and Paul at past PPS conferences; their
presentations are always incredibly valuable.
Remember, the best way to keep up with PPS programs and services is
by frequently checking our Web site www.pricingsociety.com.
I hope you had a wonderful holiday season and all the best for
2007!
Eric Mitchell
President
Professional Pricing Society
The Journal of Professional Pricing 5 Fourth Quarter 2006
CONTENTS
THE JOURNAL OF
PROFESSIONAL PRICING
8 PPS Year End 2006 Survey of Todays Pricing Professional
by Eric Mitchell
The Professional Pricing Society has been surveying the pricing community every two years since
1998. In late 2006, we again surveyed pricers and received a record 886 survey responses. This is
up dramatically from 630 responses in 2004 and 258 responses in 2002. The survey results are
widely used to benchmark salaries and salary trends, as well as job satisfaction and pain points
among pricing professionals. PPS sincerely hopes you nd useful nuggets for your situation in
this latest survey.
14 How to Price Spare Parts More Protably: A Pragmatic Approach
by Richard Zinoecker
The importance of after-sales business has increased steadily over the last few years. Market lead-
ers such as Caterpillar have built a crucial competitive advantage for their business with new ma-
chinery. Additionally, they have demonstrated that it is possible to create a successful business
model in the after-sales business.
22 Pricing Over the Product Lifecycle: Adapting Strategy in an Evolving Market
by John Hogan and Thomas Nagle
Products, like people, typically pass through predictable phases. A product is conceived and
eventually born; it grows as it gradually gains in buyer acceptance; eventually it matures as
it attains full buyer acceptance; then it ultimately dies as it is discarded for something better.
Although there are exceptions to this process (death sometimes comes prematurely, and youth
sometimes extends inordinately), these typical phases present the opportunity to anticipate the
future of most products.
28 Managing by Results Versus Managing by Means
by Ron Baker
Imagine four friends getting together every Friday night to play poker. Over the course of a year,
Player A wins 75% of the time; Player B, 15%; Player C, 5% and Player D, 5%. Knowing these
results with exact certitude, are you prepared to draw any conclusions regarding the outcome of
the games? We may be tempted to conclude Player A cheats, but we might also be tempted to
surmise that Players B, C, and D have awful poker faces.
T
he Professional Pricing Society
has been surveying the pricing
community every two years
since 1998.
In late 2006, we again surveyed pricers
and received a record 886 survey responses.
This is up dramatically from 630 responses
in 2004 and 258 responses in 2002.
The survey results are widely used to
benchmark salaries and salary trends, as
well as job satisfaction and pain points
among pricing professionals. PPS sincerely
hopes you nd useful nuggets for your situ-
ation in this latest survey.
Pricing Demographics
Respondents primarily are from very large
companies: 36% work for companies with
annual revenues of $5+ billion; another
26% have revenues from $1 billion to
$5 billion. Only 7% of pricers are from
companies with revenue of $50 million
or less.
The number of employees in the respon-
dents companies devoted primarily to
pricing is remarkably similar to previ-
ous surveys: 38% of respondents have
one to 10 pricing people, 37% have 11 to
50 professionals, 10% are in the 50-100
employee range and 15% employ 101 or
more pricers.
8alaries
Most categories of pricers salaries surged
in recent years for all levels of professionals
Managers, Directors and Analysts.
Pricing Managers average annual salaries
jumped from $88,000 in 2004 to $93,400
in our 2006 survey, up 6%. Directors
reported their salaries rocketed from
$121,000 to $132,000, up 9%. Pricing
Analysts reported their compensation rose
to $64,000, up 5%.
However, at the more senior levels, com-
pensation was largely at; Vice presidents
saw their average salary decline 0.8% to
$168,000, compared with two years ago.
The overall average pricer (all categories),
regardless of title, now earns $101,000
per year compared to $95,000 in the last
survey an overall growth rate of 5.9%
over the two-year period.
See gure 1.
8alary Trends by ndustry
Several industry salaries have surged in
2006. Distribution pricers earn 30%
more than they did in 2004 (2006 average
$107,000); B2B rose 18%, and industrial
pricers earn 15.5% more than two years
ago.
However, average salaries differ by in-
dustry. Financial services pricers reported
their salaries average $110,000 in 2006;
startlingly, this represents a huge decline
from the 2004 results, which averaged
$123,000. Pricers in high-tech elds earn
The Professional Pricing Societys 2006 survey of pric-
ing professionals yields some surprising results. While
most pricers salaries have surged in recent years, that
is not true for all positions, particularly for pricing ex-
ecutives, whose saIaries IargeIy remained at. Find out
how your salary and job experience compare to industry
norms. This article was written by Eric Mitchell, President
of the Professional Pricing Society. Eric can be reached
at mitchell@pricingsociety.com.
PPS Year End 2006 Survey of Todays Pricing
$139
$100
$71
$53
$151
$108
$73
$59
$169
$121
$88
$61
$168
$132
$93
$64
$0
$20
$40
$60
$80
$100
$120
$140
$160
$180
Vice President Director Manager Analyst
2000 2002 2004 2006
S
a
l
a
r
y

E
x
c
l
.

B
o
n
u
s
e
s
Figure 1: Salary by Title
Marketing
36%
Sales
10%
Finance
20%
Sr. Management
21%
Other
13%
$110,000, $2,000 less than two years
ago.
See gure 2.
Job Title Mix' Largely
Unchanged from 2004 to
2006
Senior managers (Vice Presidents, General
Managers and Directors) represent 29%
of all pricers, similar to previous years;
Managers represent 42% of all pricers,
2% more than in 2004. Analysts represent
22% of all pricers, the same as in the
previous survey.
See gure 3.
Who Works for Whom? How
Experienced are Pricers?
Of all pricing professionals, 21% report
directly to senior management, 3% points
more than two years ago; 36% report to
marketing executives, compared with 41%
in 2004. Currently, 10% report to sales
(the same in 2004); 21% of pricers report
to Finance, up from 18% in 2004.
When it comes to experience, 11% of
pricers are newcomers to the pricing eld;
almost 42% have two to ve years experi-
ence, 27% have six to 10 years experience
and 21% have 11+ years of experience.
Professional
Figure 2: Average Pricer Salary by Industry
Analyst
22%
Manager
42%
Senior Management
29%
Other
7%
Figure 3: Job Title Distribution Amongst Pricing Professionals
See gure 4.
Job 8atisfaction
This is the second time we have surveyed
how satisfied pricing professionals are
and identified their unmet wants and
needs. On a scale of 1 to 5, where 5 is very
satised and 1 is very dissatised, pricing
professionals rated their job a 3.69 overall.
Vice Presidents and Directors labeled their
happiness as 3.79, Managers as 3.73 and
Analysts as 3.58.
Job 8atisfaction
We asked pricers to rate their level of job
satisfaction in a number of categories: 84%
are satised knowing that pricing is vitally
important to their company; 74% nd
their career challenging and 72% said they
are satised with the respect they receive
from their peers.
However, 37% are either dissatised or
very dissatised with the training oppor- rr
tunities provided by their company, and
34% are dissatised with the recognition
and acknowledgement they receive from
the company.
When asked how to improve their situa-
tion, the majority of comments plead for
better communication and support from
upper management. They also mention
wanting more training and better working
tools. More staff and better compensation
also are mentioned.
Critical 8kills for the Job
We asked respondents to identify the most
critical skills needed to be an effective
pricing professional. They rank problem
solving as the most important, followed
by communicative skills, quantitative
program knowledge, achieving established
goals, performing as a team player and
having organized work habits.
Marketing
36%
Sales
10%
Finance
20%
Sr. Management r r
21%
Other
13%
Figure 4: Which Area Does the Pricing Function Report To?
How to Price Spare Parts More Protably:
AIthough spare parts often factor into a company's prots, few com-
panies take full advantage of the opportunity spare part pricing offers.
In fact, they deal with the complexity of pricing thousands of parts
by resorting to standardized and undifferentiated rule of thumb
methods. The resuIt? Signicant untapped prot potentiaI. With a
systematic approach, companies can see prots increase with no
customer complaints. This article was written by Richard Zinoecker,
who is a Director at Simon-Kucher & Partners. He can be reached by
e-mail at richard.zinoecker@simon-kucher.com.
T
he importance of after-sales business has increased
steadily over the last few years. Market leaders such as
Caterpillar have built a crucial competitive advantage
for their business with new machinery. Additionally,
they have demonstrated that it is possible to create a success-
ful business model in the after-sales business. While the Ger-
man premium carmakers Mercedes and BMW have faced harsh
competition selling cars and are no longer immune to granting
substantial discounts and incentives in their primary business,
they have so far managed to cling to their competitive advantage
in the after-sales business, an area that is much harder for new
challengers to emulate.
Spare parts make up the backbone of the after-sales business.
Roughly two-thirds of the after-sales revenues of European engi-
neering companies is generated with spare parts. In comparison
to labor-intensive parts of the service portfolio, such as service
contracts, training or retting, spare parts have lower xed costs
because the workload is stable. Spare parts have the potential to
generate considerably higher margins than the rest of the service
portfolio. Therefore, the signicance of the spare parts business in
the bottom line of machinery and engineering companies is typi-
cally even higher than implied by its percentage in revenues.
Although the parts business typically provides a signicant lever
to increase overall protability, many companies do not optimize
their spare part pricing. They price thousands of parts by resort-
ing to standardized and undifferentiated rule-of-thumb pricing
methods. Many companies also maintain that prices for spare
parts are already lofty and that the priority of tackling that issue
is moderate at best. It is our rm belief and our experience that
this assumption is erroneous. The untapped prot potential in
the spare part business is, as a rule, substantial. In one project,
a German world leader in manufacturing machinery equipment
with annual spare part revenues of 300 million euros was able
to increase its prot by more than 10 million euros annually
without any customer complaints. Based on the example of a car
manufacturer, Figure 1 illustrates how pricing for accessories on
a simple cost-plus calculation would yield very suboptimal re-
sults (prices that are either too high or too low). The customers
willingness to pay is independent of the production costs of the
accessories (see gure 1).
In this article, different pricing methods for spare parts will be
presented. There is a common thread in all these methods: The
aim of each of these methods is to increase protability by prag-
matically taking into account customer value. At the same time,
customer complaints should be minimized and overall customer
satisfaction increased.
Several possible methods are necessary as a single method can-
not meet all the requirements to spare part pricing. Depending
on the primary goals of a company in its after-sales business, the
number of spare parts in its portfolio, the nature of the business
(e.g., B-2-B or B-2-C business) or the existence of market play-
ers imitating spare parts, these requirements may differ consider-
ably. Also, companies start from different levels of sophistication
Figure 1: Customers Willingness to Pay Versus Car Accessory Pro-
duction Costs
A Pragmatic Approach
in pricing their spare parts. The idea of the methodology box
in this article is that each company should be able to select the
best approach(es). On the basis of this multi-method approach,
every company should be able to generate additional prots in a
short period of time.
Due to logistical reasons and customer value considerations, au-
tomotive and engineering companies increasingly are opting to
offer a limited number of spare part kits or spare part bundles
rather than single parts. The methodologies introduced here are
especially suitable for pricing such spare part kits.
Problems with Common Pricing
Methodology and 8pecihc Challenges of
8pare Parts Pricing
As we have pointed out, most companies, despite the high prot
potential, rely on relatively undifferentiated rules of thumb
when pricing spare parts. Typically, an undifferentiated cost- parts. Typically, an undifferentiated cost- parts. Typically, an undifferentiated cost-
based mark-up is determined in order to achieve a predened
target margin. In order to
keep up with updated target
margins, these mark-up factors
are frequently adjusted across
the board to establish the new
list prices for spare parts.
Companies that rely on such
uniform and undifferentiated
cost-plus pricing are prone to
the following negative conse-
quences:
1. Standard parts can be obtained through channels other than
the original machinery or plant manufacturer. Using a conven-
tional uniform mark-up on standard spare parts results in much
higher prices than the regular catalog prices in this channel.
While the revenues generated with these parts are usually low,
such a discrepancy between the companies prices and the trans-
parent market prices can damage the companies price image
and cause a signicant number of customer complaints.
2. An average, undifferentiated mark-up factor does not capture
the customer value for proprietary parts. The customers willing-
ness to pay is not fully utilized.
3. A mechanical pricing method does not reect the fact that the
competitive situation is not the same for all spare parts. Competi-
tion for spare parts should be dened more broadly than only the
competitors in the primary business. Competition also includes
spare part imitators and the possibility of self-manufacturing.
Spare parts with a high turnover are sometimes imitated on an
industrial scale by so-called spare part pirates.
4. The conventional pricing method does not reect the fact that
a large portion of revenues and prots are realized with only a
limited number of key spare parts.
5. Often, price lists for spare parts are negotiated lump-sum in
annual price negotiations with business customers. Undifferenti-
ated price appreciation creates a high transparency for customers
and consequently may result in higher demands for discounts.
In a nutshell, conventional pricing for spare parts does not allow
a company to realize the full prot potential of spare parts. Pro-
cessing matters typically override customer value considerations.
Therefore, paradoxically, despite the not-so-high overall price
level, customers are disgruntled.
The framework for spare part pricing is rather specic. The fol-
lowing play an important role in that framework:
1. Complexity: Compared to the machinery/primary product
business, the spare parts busi-
ness involves a much higher
variety and complexity. Price
lists with tens of thousands
of parts make it impossible
to identify optimal prices for
each individual part.
2. Heterogeneity of parts:
The range of spare parts com-
prises original equipment ma-
nufacturer (OEM) parts, but
also parts that are bought from other companies. For the parts
manufactured in-house, the batch size in production may vary
considerably. A low batch size has a tremendous effect on the cost
base for specic parts.
3. Limited customer focus: The price sensitivity for spare parts
is lower than in the machinery business. This is due to the high
variety of parts, the limited comparability and the lower level of
involvement of customers in the purchasing process.
4. Exclusivity: Once a customer has bought new machinery, the
machine manufacturer is usually not in direct competition with
other suppliers for these parts. Therefore, for a limited time, the
manufacturer is in an exclusive position. For very valuable parts,
buying new machinery may represent an alternative for repairs
using spare parts.
5. Interdependency with machinery business: While price
sensitivity is rather low over the exclusive period, too high af- ff
ter-sales prices can have a backlash effect regarding the buying
decision for the next generation of machinery. Increasingly, the
A mechanical pricing method does
not refect the fact that the competitive
situation is not the same for all spare
parts.
operating costs also are factored into the calculation for buying
machinery.
The approaches in the methodology box presented in this article
attempt to reect the specic characteristics of spare part pricing
while avoiding the typical associated problems.
Recommended Approaches to
Pricing 8pare Parts
Preparatory Step 1: Selection of Reference Parts
In order to keep manageable the work involved in pricing thou-
sands of spare parts and still apply more sophisticated approaches
than a uniform mark-up factor, it is advisable not to individually
price every spare part. Rather, it is advisable to determine refer-
ence models or representatives for groups of homogeneous parts
that can be treated similarly. The remaining parts can then be
priced by transferring the prices of the reference parts or the pric-
ing method applied to them.
Preparatory Step 2: Prioritization of Parts for Pricing Pur-
poses
As was pointed out, the fact that prices for thousands of parts have
to be determined may result in all parts being treated identically.
However, the 80/20 rule also applies to spare parts: A limited
number of short-lived wear and tear parts accounts for a very
large proportion (typically more than 80%) of the total spare
parts turnover. This breakdown of revenues is usually rather stable
over time. Therefore, historical invoice data are appropriate to
determine the importance of individual spare parts or spare part
categories. Based on their relative turnover or revenue share, the
spare parts are then classied into A, B, and C parts.
The level of complexity of a pricing method should vary according
to the priority of the parts. A parts justify a high pricing effort.
For the absolute top-priority parts, even a precise determination
of the customers willingness to pay using sophisticated market
research-based pricing methods such as conjoint measurement,
as depicted in Figure 1, may be justied. As a rule, determining
optimal or near-optimal prices by taking into account the cus-
tomer value of the three or four most important group of parts
realizes a large percentage of the overall prot potential. For the
remaining parts, it is sufcient to rely on more pragmatic stan-
dard pricing methods.
Pricing Methodology Box for Value-based
8pare Part Pricing
The following methodology box contains ve methods for pricing
spare parts. The rst two are universal pricing methods that can
be applied to determine value-based prices for all spare parts. The
next three approaches can be used to complement these methods
for special or more important parts. (See gure 2.)
1. Differentiated Cost-Plus Pricing Based on Differentiated
Mark-Ups for Spare Part Categories
Due to the variety of parts that have to be priced and the fre-
quency of price adaptations over time, pricing of parts based on
mark-up factors related to the manufacturing or procurement
costs is a viable and pragmatic method for the whole range of
spare parts.
However, even when using a cost-plus approach, it is essential
that the customer value is taken into consideration. As the ex-
ample given in Figure 1 shows, the value of the parts could be
approximated in a cost-plus approach if an algorithm to correctly
classify the parts existed. So the primary task in making a mark-
up approach more customer-driven is to correctly classify parts
into value groups.
Several factors can have an inuence on the customers willing-
ness to pay. The most important factors may differ across in-
dustries. For example, the stage of the product lifecycle of the
machinery can have a high impact on the value perception. A
customer segment that has grown used to using the machinery
and is unwilling to switch to another generation typically has a
high price tolerance. Differing absolute price levels may warrant
a differentiation in mark-up factors, as very cheap parts are un-
likely to lead to negative price perception even if based on a rather
high mark-up factor. This effect can be observed in the example
of automobile accessory parts shown in Figure 1.
The two most important inuencing factors for spare parts for
industrial goods are arguably the complexity of spare parts or sets
of parts and the (potential) competitive intensity. Both factors,
complexity and competitive intensity, can be split into different
Figure 2: Methodology Box for Pricing Spare Parts
Figure 3: Relevant Characteristics of Complexity and (Potential) In-
tensity of Competition
categories. Figure 3 shows a possible classication based on the
two criteria.
Highly complex parts are normally self-manufactured and require
several steps in manufacturing. The quality of high value parts
must be excellent to maintain the functionality of the machine.
The likelihood that these parts can be copied or imitated by
spare part imitators or by the customers themselves is very low.
On the other side of the spectrum are standard-parts that can be
purchased easily elsewhere without a detrimental effect on the
function of the machine.
The criterion competitive intensity categorizes spare parts ac-
cording to existing or at least potential competition. A price
comparison can either be possible directly in a 1:1 comparison
or indirectly with parts fullling a similar function.
Combining the four characteristics of the two criteria yields a
total of eleven distinct categories with a uniform mark-up fac-
tor within the category. The more complex the parts are and the
lower the (potential) competitive intensity, the more the higher
mark-up factors for a spare parts group are justied. Figure 4
shows the connection between the two criteria and level of target
mark-ups. The arrows within the categories indicate the level of
mark-up factors derived by the value-oriented approach compared
to a uniform mark-up factor in following a standard cost-plus
approach (see gure 4).
For parts with low comparability and high complexity (categories
9-11), a uniform mark-up factor does not tap the full customer
value. For these parts, considerably higher mark-up factors can
be realized. Uniform mark-up prices for simple standard parts
(categories 1-3), by contrast, may be too high and disrupt the
customers overall price perception.
This is not to say that a company cannot inuence the classica-
tion of spare parts. For externally sourced standard OEM parts,
which can be purchased from sellers other than the original ma-
chine supplier, there is normally little scope for value pricing. Such
parts would fall into the category with the highest competitive
intensity and the lowest complexity and therefore the lowest mark-
ups would be applied. One approach to overcoming this limitation
is by reducing the comparability of these parts and positioning
them in a higher mark-up category by labeling. This is done
by removing the original manufacturers labels and substituting
them with the companys own labels. Even without putting the
companys own labels on parts, the removal of original labels only
is a powerful way to make parts less comparable. Yet the feasibil-
ity of this approach depends on the buying or bargaining power
of the company with the original parts manufacturer.
One of the most critical and most difcult tasks is to determine
the optimal mark-up factors for each spare part value category.
An advisable method is to determine the price of selected A
parts based on market research or expert estimates of customers
willingness to pay and then calibrate the mark-ups accordingly.
Alternatively, benchmark values from comparable industries can
be a pragmatic solution for determining the level of the mark-
up factors.
The method set out in this section eliminates the main prob-
lem associated with the standard mark-up pricing of spare parts,
namely the lack of customer-value orientation. This is not to
say that all potential problems associated with cost-plus pricing
are eliminated. The cost base can differ between parts sourced
externally and parts manufactured internally. In addition, the
quality of the cost information can differ considerably depend-
ing on the batch size. If such distortions occur, normalized or
standardized cost information should be the base for cost-plus
pricing. Alternatively, inconsistencies in the production costs
need to be corrected.
A differentiated mark-up method is especially suitable when a
company faces the task of having to deal with a large variety of
spare parts and/or when the spare parts portfolio is subject to
frequent price changes. When using this method, classication
of parts can be assisted or even automated with the help of an
appropriate IT infrastructure. An automated computer-aided
procedure would then classify parts automatically according to
predened criteria.
2. Consistency-Oriented Pricing for Spare Part Product
Families
The method outlined in the next section also is based on a detailed
consideration of the customers willingness to pay. It can be used
in addition to or as an alternative to the previous method.
The basis of this method is the clustering of parts into spare part
product families. Spare part families contain parts that are per-
ceived as comparable in terms of price by customers due to their
similar product qualities. For instance, screws in different sizes
and made of different materials could belong to one product
family (see gure 5).
The main objective of spare part pricing based on product families
is to achieve a high degree of consistency in the prices of spare
parts. By maintaining such a high level of consistency, the pos-
sibility of spare parts whose prices are perceived to be inated
would be ruled out and customer complaints should be mini-
mized. At the same time, prots realized with spare parts can
be increased by basing the prices of parts within a family group
closely on their related customer value. By applying a stringent
denition of product families, the complexity of spare part pric-
ing can also be reduced considerably.
Figure 4: Mark-up Factors for Different Parts Categories Versus Uni-
form Mark-up Factor
Figure 6: Example of Pricing Based on Spare Part Families
First, the prices for reference parts within a product family need
to be determined. In doing this, the same consideration (for the
calibration of mark-up factors) in differentiated cost-plus meth-
ods apply. Parts in the same product family are then priced (de-
pending on their similarity) relative to the reference part. (See
gure 6.) This is done from key criteria which, from a customers
point of view, drive the value perception. For the product family
Screws, the materials used, the number of windings or the size
could be suitable criteria.
Superior or inferior value in the key dimension results in a cor
responding price premium or lower price for the part compared
to the reference part in the product family. In applying thi
method, the price setting is completely detached from the cos
of producing the parts. Any inconsistencies in the manufactur
ing or purchasing costs are zeroed out. When applied consist
ently, this method also can reveal inefciencies in sourcing and
manufacturing.
3. Value Pricing Considering Substitution with New Prod
ucts
In some cases, a single spare part or a set of spare parts consti-
tutes a signicant percentage of the machinery. Due to the higher
mark-ups for spare parts in comparison with new products, it is
possible that the repair costs including spare parts and invested
working hours even exceeds the price of a comparable new prod-
uct. In such a case, the customer must decide whether he wants
to stick to the existing machinery and repair it or whether he
should invest in a new machine. Therefore, the upper price limit
for large valuable A spare parts needs to take into account the
price of new machinery. Ideally, the relevant set is made up of
both the price of ones own product as well as that of alternatives
of competitors. A similar logic should be applied in the pricing
of predened spare part maintenance kits.
As a rst approximation, research has shown that the maximum
tolerable price for a repair of machinery (including spare parts
and invested working hours) is typically in the range of 50-70%
of the price of a new product. A few situational factors should be
considered to ne-tune this rough guideline. The most relevant
factors are illustrated in gure 7.
The willingness to pay for smaller repairs with lower total costs
tends to be higher. Furthermore, the vital function of the machine
inuences the willingness to pay for a repair: if the machine oper- rr
ates in an important production step, the spare part upper price
limit may be higher since an immediate repair is a clear priority
as negative opportunity costs occur if production is negatively
affected. A similar rule can be applied if several machines need
to be replaced in order to ensure smooth production processes or
if damage is caused by improper handling by the customer.
4. Competitive Prices for Spare Parts
In contrast to the machinery business, the direct comparison with
specic spare part prices of competitors is of lesser importance.
Yet, for important A parts, a one-to-one competitive comparison
may make sense. It is essential that the concept of competition
is not dened too narrowly for spare parts. Where imitations
by spare part pirates exist, competition should include these
competitors. The same goes for used spare parts traded in sec-
ondary markets.
For the remaining spare parts, the overall spare part price image
is a crucial element for customer satisfaction. Since customers are
not able to compare prices for all component parts, individual
easily comparable standard parts perceived to be over-priced or
inconsistently priced can have a strong negative image effect. This
issue is addressed by applying the methods outlined. While an
unfavorable price image does not always adversely affect after-sales
Figure 5: From Spare Parts to Spare Part Families
Figure 7: Situational Factors That Determine the Upper Price Level
for General Repairs
business in the long term, it can, however, put the company at
a competitive disadvantage and indirectly have a negative effect
on the spare parts business.
It is strongly recommended that the price image in after-sales
business be closely tracked and monitored. Many companies
still know little about how their customers perceive their spare
part price levels.
5. Customers Willingness to Pay Determined by Expert
Judgment
Except for the absolute top priority parts, it usually does not make
sense to determine customers willingness to pay for spare parts
in the same complex way as
for new products. A pragmatic
way to determine the customer
value for A and maybe B parts
is to use estimates of in-house
experts. If the pool of experts
is set up in a representative way
that ref lects the full market
knowledge of the company,
this method can yield valid re-
sults. To achieve this, the pool
of experts should involve all
relevant divisions. Besides sales experts (front-ofce and back-
ofce), staff from the after-sales service department should be
included. The challenge with such an expert estimate is to answer
the question: How much is the customer willing to pay for this
spare part without referring to the current price of the spare part?
Moderation tools structuring the price discussion can provide a
valuable contribution and considerably enhance the validity of
the price estimates.
Conclusion
v The spare parts business provides a means to compensate for
the shrinking margins in the new machinery business. Despite
the high possible prot potential in spare parts business, many
machinery and plant manufacturers determine the prices of parts
on the basis of undifferentiated rules of thumb.
v More sophisticated methods focus on value-based pricing while
taking into account the specic characteristics of spare part pric-
ing. Untapped potential for higher prices is identied and fac-
tors negatively inuencing the customers price perception are
eliminated.
v A value-based cost-plus pricing approach for spare parts should
differentiate the mark-up fac-
tors of spare parts according
to value drivers such as the
complexity of parts and the
(potential) competitive in-
tensity.
v Clustering spare parts into
homogeneous product fami-
lies and establishing a con-
sistent pricing pattern with-
in the product families help
minimize customer dissatisfaction.
v A methodology tool box offers the opportunity to select the
appropriate method according to the specications of a company
and to vary the pricing approach according to the importance
of the spare parts.
The spare parts business provides
a means to compensate for the
shrinking margins in the new machinery
business.
Pricing Over the Product Lifecycle: Adapting
P
roducts, like people, typically pass through predictable
phases. A product is conceived and eventually born; it
grows as it gradually gains in buyer acceptance; even-
tually it matures as it attains full buyer acceptance;
then it ultimately dies as it is discarded for something better.
Although there are exceptions to this process (death sometimes
comes prematurely, and youth sometimes extends inordinately),
these typical phases present the opportunity to anticipate the
future of most products. This understanding helps make up a
rms long-run strategic plan with protable pricing as the bot-
tom-line measure of that plans success. As a new product evolves
through four phasesdevelopment, growth, maturity and de-
clineones pricing strategy and tactics must vary if they are to
remain appropriate.
Market Development
In this stage, buyers are price insensitive because they lack
knowledge of the products benefits. Both production and
promotional costs are high. Competitors are either nonexistent
or few, and are not a threat since the potential gains from market
development exceed those from competitive rivalry. Pricing
strategy signals the products value to potential buyers, but buyer
education remains the key to sales growth. Following are value
communication approachesother than pricethat marketers
should consider.
Communicating Value with Trial Promotions
Determining the actual price that rst-time buyers should pay
depends on the relative cost of different methods for educating
buyers about the products benets. If the product is frequently
purchased, has a low incremental production cost and its benets
are obvious after just one use, the cheapest and most effective way
to educate buyers may be to let them sample the product. Still,
not all innovative products can be economically promoted by
price-induced sampling, and many products will not immediately
reveal their value when sampled just once. Many innovations (e.g.,
Web-enabled cell phones) require that buyers learn skills before
they can realize the products benets. Without a marketing
program to convince buyers that learning such skills is worth the
effort, few buyers will sample at any price. In these cases, market
development requires more direct education of buyers before they
make their rst purchases.
Communicating Value with Direct 8ales
For innovations that involve a large dollar expenditure per
purchase, education usually involves a direct sales force trained to
evaluate buyers needs and to explain how the product will satisfy
them. For example, in the early 1990s, enterprise software was
considered a risky purchase due to the high degree of uncertainty
about the ability to integrate the software into a companys IT
architecture. But rather than growing sales by pricing their
product cheaply, SAP, a market leader in enterprise software,
mitigated the uncertainty by providing new customers access to
successful installations and by partnering with integration rms
to ensure successful implementations. This resulted in a ninefold
increase in SAPs sales in the mid-90s.
Marketing nnovations Through
Distribution Channels
For innovative products sold through distribution channels, the
innovator must convince the distributor to vigorously promote
the product. One way to do this is by offering distributors a
low wholesale price, leaving them with high margins, thereby
giving them an incentive to promote the product with buyer
education and service. However, when distribution channels are
more competitive, that extra margin often is passed on in price
discounts, thereby eliminating the promotional incentive. To
avoid this situation, innovators may keep the margins at normal
levels but pay incentive fees for stocking new products, co-op
advertising, in-store displays, premium shelf space and on-site
service and demonstration.
Market Growth
During the market growth phase, buyers concerns about a
products utility give way to concerns about the costs and benets
of the product. As buyers become more informed about product
attributes, they are more responsive to lower prices. At this time,
competition emerges, and both the original innovator and later
Any Iong-term strategic pIan that seeks protabIe pricing
must acknowledge that pricing strategy changes over the
Iife of a product. Signicant pricing decisions require an un-
derstanding of the products position in its lifecycle. There
are four phases, and thus, tactics: development, growth,
maturity and decline. This article was written by John Ho-
gan, Ph.D., and Thomas Nagle, Ph.D., both of the Strategic
Pricing Group, a member of Monitor Group. Their respec-
tive e-mail addresses are john_hogan@monitor.com and
tom_nagle@monitor.com.
Strategy in an Evolving Market
entrants begin to assume competitive positions. High rates of
market growth enable industry-wide expansion, generally limiting
price competition. The innovator and its competitors must decide
whether their marketing strategies will be geared more toward a
differentiated product strategy or a cost leadership strategy.
Pricing the Differentiated Product
A differentiated product may be tailored to a particular buyer
segment or directed at multiple segments. If a differentiated
strategy focuses on a particular segment, the company earns its
rewards by skim pricing (capturing high margins at the expense
of large sales volumes) to the segment that values the product
most highly. Godiva, BMW and Gucci use skim pricing to
focus their differentiated product strategies. Conversely, if the
strategy is more broadly aimed at multiple segments, companies
should set neutral or penetration prices and earn rewards from
the sales volume that its product can attract. Kodak, Toyota and
Caterpillar use neutral pricing to sell their products to a large
share of the market.
Pricing the Low-Cost Product
A cost leadership strategy can also be aimed at a particular segment
or multiple segments. For companies seeking industrywide cost
leadership, penetration pricing is often a component in the strategy
implementation. When the
source of a rms anticipated
cos t adva nt a ge depends
on selling a large volume,
it may set low penetration
prices during growth to gain
a dominant market share, and
later maintain those prices as
a competitive deterrent while
still earning prots. Wal-Mart
uses this strategy successfully
to achieve substantial cost economies in distribution and high
sales per square foot.
Price Reductions in Growth
The best price for the growth stage, regardless of product strategy,
is normally less than the price set during the market development
stage. New competition in this stage gives buyers more alternatives
from which to choose, and their growing familiarity with the
product enables them to better evaluate those alternatives. Pricing
in this stage is usually not cutthroat; generally, new rms can
enter and existing ones expand without forcing competitors sales
to shrink. Sales of Apples iPod continue to grow rapidly despite
loss of some market share to new entrants.
Market Maturity
During this phase, most buyers are repeat purchasers who are
familiar with the product. Increasing homogeneity enables
them to better compare competing brands, so price sensitivity
reaches its maximum in this phase. Competition begins to put
downward pressure on prices since any rm can grow simply
by taking sales from its competitors. Despite such competition,
protability depends on having achieved a defensible, competitive
position through cost leadership or differentiation, and exploiting
it effectively. Margins can be maintained by increasing pricing
effectiveness through unbundling related products, improved
demand estimation, improved control and utilization of costs,
expansion of the product line and re-evaluation of distribution
channels.
Unbundling Related Products and 8ervices
As a market moves toward maturity, competitors can more closely
imitate the differentiating aspects of products in the leading
companys bundle, which makes it easier for someone to develop
just one superior part while allowing buyers to purchase other
parts from the leading companys other competitors. If buyers are
forced to purchase from the leading company only as a bundle,
the more knowledgeable ones will often abandon it altogether to
purchase individual pieces from innovative competitors. In this
situation it is better to sell many buyers most of the products
they need for a benet rather than selling the entire bundle to
fewer of them.
mproved
Estimation of Price
8ensitivity
It i s easi er to est i mate
buyers price sensitivity in
the maturity stage than the
growth stage. In maturity,
when the source of demand is
repeat buyers and competition
remains more stable, one may
better gauge the incremental revenue from a price change and
discover that a little ne tuning can signicantly improve prots.
Conditions for measurement of price sensitivity can be either
controlled or uncontrolled. For example, in an uncontrolled
measurement, marketing researchers might collect data on
consumer purchases of laundry detergent in a grocery store, but
the prices and other variables that inuence those purchases are
beyond their control. In a controlled measurement of the same
behavior, the researchers would select the prices, advertising and
shelf placement of various brands to make the data more useful.
Generally, controlled research produces more accurate estimates
of price sensitivity, but it is often costly to implement a real
world setting to obtain such results.
mproved Control and Utilization of Costs
In the growth stage, new customers and new products initially
require technical, sales, and managerial support that is reasonably
Godiva, BMW and Gucci use skim
pricing to focus their differentiated
product strategies.
allocated to overhead during growth. In the transition to maturity,
a more accurate allocation of incremental costs to sales may reveal
opportunities to signicantly increase prot. For example, one
may nd that sales at certain times of the year require capacity
that is underutilized during other times. Sales at these times
should be priced higher to reect the cost of capacity. A careful
cost analysis will identify those products and customers that are
simply not carrying their weight. If some products in the line
require a disproportionate sales effort, that should be reected in
the incremental cost of their sales and in their prices.
Expansion of the Product Line
Despite increased competition and buyer sophistication in the
maturity phase, the rm may be able to leverage its position (as
a differentiated or low-cost producer) to sell peripheral goods
or services that it can price more
protably. When Novartis, a Swiss
pharmaceutical maker, recognized
the need for broader and more
exible product lines to meet the
needs of smaller market niches in
2004, it committed to investing
$60 million in new packaging
and production capabilities to
support them. The exibility not
only reduced inventory costs,
but also enabled the drug-maker
to better execute a segmented
pricing strategy in an increasingly
fragmented market.
Reevaluation of Distribution Channels
In the transition to maturity, most manufacturers begin to re-
evaluate their wholesale prices with an eye to reducing dealer
margins. There is no need in maturity to pay dealers to promote
the product to new buyers. Repeat purchasers know what they
want and are more likely to consider cost when purchasing than
the advice and promotion of the distributor or retailer. Nor is
there a need to restrict the kind of retailers with whom one deals
the exclusive distribution networks for Apple, Compaq and
IBM have given way to low-service, low-margin distributors like
discount computer chains, ofce supply houses and warehouse
clubs.
Market Decline
Reduced buyer demand and excess capacity characterize this
phase. If costs are largely variable or if capital can be easily re-
allocated to more promising markets, prices need fall only slightly
to induce some rms to cut capacity. If costs are largely xed
and sunk, average costs soar due to reduced capacity utilization,
while price competition increases as rms attempt to increase
their capacity utilization by capturing a larger share of a declining
market. Three options are available to deal with this challenge:
retrench to ones strongest product lines and price to defend
ones share in them, harvest ones entire business by pricing for
maximum cash ow, or consolidate ones position by price-cutting
to drive out weak competitors and capture their markets.
Retrenchment
A retrenchment strategy involves either partial or complete
capitulation of some market segments to refocus resources on
others where the rm has a stronger position. The rm deliberately
forgoes market share but positions itself to be more protable
with the share it retains. Retrenchment is a carefully planned and
executed strategy to put the rm in a more viable competitive
position, not an immediate necessity to stave off collapse.
Harvesting
A harvesting strategy is a phased
withdrawal from an industry. It
begins like retrenchment with
abandonment of the weakest
links, but the goal of harvesting
is a departure rather than a re-
al location of resources. The
harvesting firm does not price
to defend its remaining market
share but rather to maximize its
income. The harvesting rm may
make short-term investments in
the industry to keep its position
from deteriorating too rapidly, but
it avoids fundamental long-term investments, preferring instead
to treat its competitive position in the declining market as a cash
cow for funding more promising ventures in other markets.
Consolidation
A consolidation strategy is an attempt to gain a stronger position
in a declining industry. It is viable only for a rm that begins the
decline in a strong nancial position, enabling it to weather the
storm that forces its competitors to ee. A successful consolidation
leaves a rm poised to prot after a shakeout, with a larger market
share in a restructured, less-competitive industry.
8ummary
The factors that inuence pricing strategy change over the life
of a product. The market dened by a product passes through
four phases: development, growth, maturity and decline. While
it is critical to look at each situation uniquely, the rules of thumb
outlined above are appropriate to use as a starting point before
making any signicant pricing decision.
The debate rages on: Is it better to manage by results or manage by means? One
can argue successfuIIy in either direction, but the more dened path may actu-
ally veer more toward means. This article takes a clear-eyed view of this contro-
versial topic. It was written by Ron Baker and is excerpted from the new book
Measure What Matters to Customers: Using Key Predictive Indicators. The article
is being reprinted with permission of the books publisher, John Wiley & Sons.
Ron, founder of the VeraSage Institute, blogs at www.verasage.com and will be
speaking on this subject at the PPS Spring Conference being held in Atlanta on
April 19-20, 2007. Ron can be reached by e-mail at Ron@verasage.com.
Sometimes the numbers dont explain everything. The numbers are
not the business they are symbols of the business.
Gerald Deitchle
Former Cheesecake Factory Inc. CFO
I
magine four friends getting together every Friday night to
play poker. Over the course of a year, Player A wins 75% of
the time; Player B, 15%; Player C, 5% and Player D, 5%.
Knowing these results with exact certitude, are you prepared
to draw any conclusions regarding the outcome of the games?
We may be tempted to conclude Player A cheats, but we might
also be tempted to surmise that Players B, C, and D have aw-
ful poker faces. In other words, looking at the results does not
give us much indication of the process by which the games were
played. For that, we would need to observe the games before
making judgments.
This difference is the very essence of the debate between those
who believe in what I am going to label management by results,
and others who advocate management by means. The former
claims its roots in the scientic method, while the latter draws
on nature and biological analogies, describing businesses as inter-
dependent systems that cannot be mechanistically manipulated,
especially by measurements. This is such an important debate it
is worth taking a historical detour to explore its origins.
Feuding ntellectuals: Results vs. Means
In 1987, Professors H. Thomas Johnson and Robert S. Kaplan
published Relevance Lost: The Rise and Fall of Management
Accounting, which was named in 1997 as one of the 14 most
inuential management books to appear in the rst 75 years
of Harvard Business Reviews history. The book is credited with
launching the activity-based costing (ABC) revolution.
Despite their historical collaboration, these two thinkers have
gone down very different paths as of late. Kaplan is doing pio-
neering work in the eld of the Balanced Scorecard, and John-
son is moving on to what he calls management by means. In
fact, they are now feuding with each other, and have not spoken
in years.
I thought it would be benecial to compare and contrast the ap-
proaches these two seminal thinkers advocate, since this debate
is far from over, and will inuence management thinking for
decades to come.
Management by Results
In their classic 1992 Harvard Business Review article, The
Balanced Scorecard: Measures That Drive Performance, Robert
S. Kaplan and David P. Norton asserted their case for the
Balanced Scorecard approach, suggesting companies link their
strategic goals to measures in four areas:
Financial Perspective
Customer Perspective
Business Process Perspective
Learning and Growth Perspective
Declaring What you measure is what you get, they also pointed
out how the traditional measures of the industrial era were no
longer relevant to the type of organizations many companies were
aspiring to become that is, knowledge-based. They also ac-
knowledged no single measure can provide a clear performance
target or focus attention on the critical areas of the business.
On the Web site www.balancedscorecard.org, there is an example
of measures used for a ctional airline, in each of the four areas
just listed.
Here are the key predictive indicators (KPIs) suggested for each
area, driven by the strategic mission of the airline:
Managing by Results Versus Managing by Means
Area Ob]ectives Measures
Financial
3URWDELOLW\ Market value
Fewer planes Seat revenue
Increase revenue Plane lease cost
Customer
Flight on-time FAA on-time rank
Lowest prices Customer ranking
More customers Number of customers
Internal
Fast ground turn-
around
On ground time
On-time departure
Learning
Ground crew
alignment
% Ground crew stockholders
% Ground crew trained
Compare these KPIs to the three used by Gordon Bethune at
Continental Airlines, as discussed in his book, From Worst to First:
on-time arrival, lost luggage, customer complaints. Obviously, not
all of these KPIs are going to be relevant hour by hour to each
employee. Others are lagging indicators. Still, this is a superior
approach to managing based solely on nancial reports, because
some of these KPIs do possess predictive capability.
Unfortunately, some companies have put together lengthy score-
cards with a hodgepodge of indicators, many of which are lagging.
Some consultants suggest upward of 25 KPIs, which is an attempt
to boil the ocean. If the Balanced Scorecard is truly rooted in
the scientic method, then surely many of the scorecards could
benet from a shave from Occams Razor. There is no such thing
as a free statistic, as Jeffrey Pfeffer, the Thomas D. Dee Profes-
sor of Organizational Behavior at Stanford Graduate School of
Business, explains in an interview in Fast Company:
Theres an old saying in business: What gets measured is what
gets done. Whats happening today is the ip side of that. Mea-
surement has become a tyranny that makes sure that nothing
gets done.
Ive developed what I like to call the Otis Redding Theory of
Measurement, which is named for his song, Sittin on the Dock
of the Bay. In that song, Redding sings, I cant do what 10
people tell me to do, so I guess Ill remain the same. That line
sounds as if it could be about companies misconceptions about
measurement.
Companies have managed to convince themselves that, since
what gets measured is what gets done, the more they measure,
the more stuff will get done. Last summer, I met a woman who
works for a large oil company, and she told me that the com-
pany has 105 measures for which she is responsible. So I asked
her, How many of those 105 measures do you pay attention
to? Her answer? None. Because in the end, shes measuring
so many things that she doesnt pay attention to any of them
105 equals zero.
Some of the criticisms leveled against the Balanced Scorecard
approach are patently unfair. Kaplan and Norton were very cau-
tious and realistic about its shortcomings, writing:
Even the best objective can be achieved badly. Even an ex-
cellent set of Balanced Scorecard measures does not guarantee a
winning strategy. The Balanced Scorecard can only translate a
companys strategy into specic measurable objectives.
Senior managers may know what the end result should be, but
they cannot tell employees exactly how to achieve that result,
if only because the conditions in which employees operate are
constantly changing.
As with any tool, the Balanced Scorecard can be used well or
badly, and the originators should not be held accountable for
faulty implementation of their ideas. That being said, the jury is
still out on the effectiveness of this approach. As anyone who has
ever worked in an organization can tell you: Hold me account-
able for a specic measurement, and Ill gure out a way to game
the system. This is the intrinsic beauty of human nature.
Gaming the Measurement 8ystem
[Workers] will likely meet the targets even if they have to destroy
the enterprise to do it.
W. Edwards Deming
There is an old medical school joke that asks: What do you call a
student who graduated hundredth out of a class of 100? Answer:
Doctor. Without the context, this statistic is meaningless, as
even the last-ranked student may still be a better doctor than all
the other graduates from lesser-quality schools, or the alternative
of no doctor at all. Even so, it is simply statistically impossible
for everyone to have the top-ranked doctors.
Any measure is going to require judgment, otherwise manipulat-
ing numbers will become more important than creating value for
t is hard to argue with results, and
Toyota is one of the most respected
companies in the world, having
produced one of the highest-quality
products at the lowest cost in the
industry for years.
customers. Consider the many ways clever people can improve on
what is measured, especially if the focus is on quarterly results:
Measuring on revenue per employee? Well outsource what
may be vital tasks, even at the
expense of destroying customer
value.
Measuring time to market?
Well just make incremental,
minor improvements to exist-
ing products.
Measuring sales growth or
imposing revenue targets ?
Well add unprotable custom-
ers. (See my previous book,
Pricing on Purpose, for a more
in-depth discussion of the
harmful effects of this practice
and what to do about it.)
Measuring number of patents led? Well simply bypass the
internal review process and le any idea we can.
Heisenbergs Uncertainty Principle applies to all measures: that
the observer in a scientic experiment affects the result. Consul-
tant and author David Maister captures the essential difference
between a measure and a judgment in a post on his blog:
There is no quantitative system that cannot be gamed. Some
rms like to think that nancial measures are objective, but
thats a delusion. They are not objective if people are making
the numbers look good by hoarding work, failing to share and
collaborate and thinking of their own metrics. Whats objective
about that?
Nevertheless, this one-metric mentality has recently been popu-
larized by James Collins 2001 best-selling book, Good to Great:
Why Some Companies Make the Leap and Others Dont:
[W]e did notice one particularly provocative form of economic
insight that every good-to-great company attained, the notion
of a single economic denominator. Think about it in terms of
the following question: If you could pick one and only one ra-
tio prot per x (or, in the social sector, cash ow per x) to
systematically increase over time, what x would have the great-
est and most sustainable impact on your economic engine? We
learned that this single question leads to profound insight into
the inner workings of an organizations economics.
Walgreens switched its focus from prot per store to prot per
customer visit. Convenient locations are expensive, but by in-
creasing prot per customer visit, Walgreens was able to increase
convenience (nine stores in a mile!) and simultaneously increase
protability across its entire system.
So what would be the one metric for a knowledge company? I
dont know. Perhaps value created per unit of intellectual capital,
but we do not yet have the tools and methodologies to measure
this (though models do exist that try).
On the other hand, perhaps it is the wrong question. I side with
management thinker Charles Handy. In a lecture to the Royal
Society of Arts in London in 1996, he described the fallacy of
the single criterion:
Trying to nd one number
that is the sum of everything
is misguided. There is never
any one number that will
actually explain success in
life, and we are foolish ever
to think that it might be
there. Money certainly isnt
it. Businesses know very well
that profit is not the only
measure. Sensible organi-
zations now have about 18
different numbers they look
at. Nevertheless, the myth
pervades our society that if
you are protable, you are successful. Or if youre in the public
sector, then efciency is what matters. But efciency is not quite
the same as effectiveness. You can have a very efcient hospital
if you dont take in very sick people or people who are not go-
ing to get better, like the old ones. So you push them outside.
Youre efcient but youre not terribly effective. Looking for the
one number has corrupted our society.
Handy is right in one respect when it comes to the productivity
of knowledge environments: the one criterion is not inputs based
on cost or man-hours. That metric tells us nothing about how
well a company is creating value. Maybe a more holistic, inter-
dependent approach is needed, one whereby we strive to improve
the means and enable the ends to take care of themselves. This
is Professor Johnsons argument.
Management by Means
We had been collecting tons of statistics because they were interesting.
But statistics will not construct automobiles so out they went.
Henry Ford, My Life and Work, 1922
Imagine youre planning to construct a building, let us say a 50-
story hotel. It has been estimated that most of the mistakes are
made in such a project on the very rst day. When just 1% of the
project costs have been spent, up to 70% of its life-cycle costs have
most likely been committed. It certainly pays to get the process
right before you spend the rst dollar, so you will end up with
the results you want, at the right total cost.
This is what makes the H. Thomas Johnson and Anders Brms
book, Prot Beyond Measure, such a seminal work, although not
yet fully developed. And while I have severe misgivings about
some of the environmental rants in the book, when he proles
Toyota and Scania the latter now owned by Volvo as two
manufacturers that do not have a standard cost accounting sys-
tem, he is on rm ground. It is hard to argue with results, and
Toyota is one of the most respected companies in the world,
having produced one of the highest-quality products at the low-
est cost in the industry for years. It has an unbroken record of
prots, with zero layoffs, since 1960 a record unparalleled in
the industry and is a erce innovator, and ranks top in any
measure of productivity you care to analyze.
As Glenn Uminger, a nancial controller at Toyota Motor Man-
ufacturing-Kentucky (TMM-K) which Johnson studies in
depth in his book since 1988, says: TMM-K has never had
a standard cost system to track operating costs, and we prob-
ably never will. So how do they do it? How can a manufactur-
ing company run without a standard cost accounting system?
First, Toyota understands price drives costs, not the other way
around. Here is how Johnson and Brms explain it in Prot Be-
yond Measure:
None of these comments is meant to imply that Toyota does not
have accounting and production planning information systems.
Of course it does. Toyota has a comprehensive array of informa-
tion systems, accounting and otherwise, with which to plan, in
advance of operations, and to report results of operations after
the fact. But information from such systems is not allowed to
inuence operational decisions.
Toyota management discharges its responsibility for costs not by
taking arbitrary steps to manipulate operations, but largely in
the vehicle planning stage. During the design stage, long before
the rst penny has been committed to making a vehicle, Toyota
has always placed enormous importance on setting and achiev-
ing cost targets. To do so, over the years Toyota has developed a
famous technique for target costing. Simply stated, target cost is
the maximum cost the company can afford to incur to produce
and sell a vehicle and still earn a required prot at the price cus-
tomers are expected to pay.
Johnson goes on to explain his theory that Toyota operates under
management by means rather than management by results. It
is an interesting viewpoint because it treats the organization as a
living system, based on interdependent relationships, and those
are nearly impossible to quantify. He notes Dr. Edward Demings
observation that over 97% of the events that affect a companys
results are not measurable, while less than 3% of what inuences
nal results can be measured:
Managers who adopt the new thinking offered here will accept
as second nature the idea that what decides an organizations
long-term protability is the way it organizes its work, not how
well its members achieve nancial targets. This chapter compares
the long-term records of Toyota and the American Big Three
automakers to demonstrate the truth of this proposition. It posits
Toyotas principles as an example of new management thinking
called management by means. Management by means is the
antithesis of managing by results, practices identied with
Toyotas American competitors. Those who manage by results
focus on bottom-line target and consider that achieving nancial
goals justies inherently destructive practices. Those who man-
age by means consider that a desirable end will emerge naturally
as a consequence of nurturing the activities of all employees and
suppliers in a humane manner. Managing by means requires a
profound change in thinking that is a bold alternative to con-
ventional management thinking and practice.
Management accounting simply takes accounting revenue, cost
and protability information, which is appropriate for measur-
ing the overall nancial results of a business, and inappropriately
attempts to trace it to the particular activities and products of
the business that gave rise to those results. Assigning such quan-
titative measures to parts of a mechanistic system makes sense.
However, the parts of a natural living system cannot be so treated.
Accounting measures are unable to penetrate the organic, mul-
tifaceted union between customer and company that ultimately
is the source of a companys nancial results. This union is the
reason any company exists.
Because cost and prot are not objects, but are properties that
emerge from relationships, quantitative measures can only de-
scribe them, they cannot explain them. Quantitative measures,
unlike art, music or the stories and myths that humans fashion
with words, cannot convey understanding of the multidimen-
sional patterns that shape the relationships from which results,
such as cost and prot, emerge in a living system.
Henry Ford certainly agreed with this target-costing approach
because the most optimal time to plan total costs is before you
build something, as he makes clear in his autobiography, My
Life and Work:
Our policy is to reduce the price, extend the operations and im-
prove the article. You will notice that the reduction of price comes
rst. We have never considered any costs as xed. Therefore, we
rst reduce the price to the point where we believe more sales
will result. Then we go ahead and try to make the prices. We do
not bother about the costs. The new price forces the costs down.
The more usual way is to take the costs and then determine the
price; and although that method may be scientic in the narrow
sense, it is not scientic in the broad sense, because what earthly
use is it to know the cost if it tells you that you cannot manufac-
ture at a price at which the article can be sold?
Notice Ford never considered any costs as xed. He understood,
in the long run, all costs are avoidable, and by subjecting every
cost to the test does it add value to the customer? he was
able to lower the costs in the factory:
But more to the point is the fact that, although one may calculate
what a cost is, and of course all of our costs are carefully calcu-
lated, no one knows what a cost ought to be. One of the ways of
discovering what a cost ought to be is to name a price so low as
to force everybody in the place to the highest point of efciency.
The low price makes everybody dig for prots. We make more
discoveries concerning manufacturing and selling under this
forced method than by any method of leisurely investigation.
Ford also understood the division of labor between a cost ac-
countant and an effective factory foreman:
The rate of production and the cost of production are distinct
elements. The rating of a department is gained by dividing the
number of parts produced by the number of hands working.
The foreman need not be a cost accountant he is no better a
foreman for being one. His charges are the machines and the hu-
man beings in his department. When they are working at their
best, he has performed his service. The rate of his production is
his guide. There is no reason for him to scatter his energies over
collateral subjects.
As opposed to the cost accounting, or activity-based costing, con-
cept of cost drivers, managing by means uses cost purposes.
Cost drivers assume certain activities drive costs, irrespective of
their relationship to revenue. Cost purposes, by contrast, are driv-
en by those items that create value, hence are blessed by revenue;
therefore, cutting costs to increase protability is the equivalent
of cutting purposes, reducing value and, hence, prots.
Todays business leaders use cost accounting to control and assess
the work that leads to results. You can use accounting to describe
a business external condition, but it offers little insight into the
particular inner relationships that determine those results. It is
unable to penetrate the organic union between
customers and company that ultimately is the
source of a companys nancial results.
Johnsons argument particularly makes sense
when you consider that in an industrial-age
enterprise, value is largely created through
transactions, and accounting systems are very
procient in recording these. Conversely, in
an intellectual-capita enterprise, value is cre-
ated by intangible investments in human,
social and structural capital, and precedes,
sometimes by years, any transactions. This is
certainly true with Amazon, Google, AOL or
pharmaceutical R&D. Accounting is far less
procient in understanding how these costs
create value; hence, it tends to treat them as
period expenses, subject to cuts if times get
tough. It illustrates well the dichotomy of cut-
ting activities that drive cost at the expense
of those that drive purpose.
The British philosopher Ludwig Josef Johan Wittgenstein wrote,
That which you do not know, you should shut up about. This is
good advice for cost accountants, who are often wrong but never
in doubt when it comes to determining the correlation between
costs and creating value. Conventional training in cost account-
ing offers little help here, since it not grounded in theory. Being
able to audit the drunks bar bill offers little help in changing his
or her underlying behavior.
In a paper entitled, Reections of a Recovering Management
Accountant, which was presented at the Society for Organiza-
tional Learning prior to the publication of Prot Beyond Mea-
sure, Johnson included an open conversation with Peter Senge
and Bill OBrien:
Senge: Tom, I dont think you said Toyota doesnt measure
anything. You did say something about how they dont use the
measures.
Johnson: Yes, its the way they dont use them that I nd inter-
esting, not the fact that they do not measure. Toyota measures;
they just dont drive actions with quantitative targets.
OBrien: They dont use it to motivate action.
Johnson: Right, they dont use measures to drive decisions about
how work should be done and what work should be done and
so forth. Of course, they have an excellent accounting system.
They invented what we call target costing. But thats a descrip-
tive measurement concept, really. Its an ex-ante tool, employed
before the work is even started. But once the work begins, cost
targets play no role in inuencing operational decisions. The
things that guide the work come from a different level of ab-
straction than quantitative measures come from. Guiding the
work are things that arent measurable. Over time, they develop
systems and patterns of behavior that are deeply ingrained in
people. These are deep disciplines they have in order to know
how is the work owing? Do we have a capability to detect
normal from abnormal? These are the types of things they focus
on, that everybody comes to know.
Andrew Carnegies favorite saying was,
Watch the costs, and the prots will take
care of themselves. Kaplan would say,
Measure the result, and the means will
take care of themselves. Johnson is saying,
Nurture the means; the results will take
care of themselves. And I argued in Pric-
ing on Purpose, Watch your value, and the
prots will take care of themselves. The
truth, most likely, lies somewhere in be-
tween, which is why I have borrowed ideas
from both of these thinkers. Though, I sus-
pect even Peter Drucker might have agreed
more with Johnsons approach:
I do not believe that one can manage a busi-
ness by reports. I am a gures man, and a
quantier, and one of those people to whom
gures talk. I also know that reports are
abstractions, and that they can only tell us what we have deter-
mined to ask. They are high-level abstractions. That is all right
if we have the understanding, the meaning and the perception.
One must spend a great deal of time outside, where the results
are. Inside a business, one only has costs. One looks at markets,
at customers, at society and at knowledge, all of which are out-
side the business, to see what is really happening. That, reports
will never tell you.
Not Last Words
No one business book or article will be able to settle this debate
conclusively, and I will leave it up to the reader to think for him-
or herself which method or combination thereof you believe
is best for your organization.
Perhaps a good way to think about this dichotomy is if you know
exactly the behavior needed for a worker to perform his or her
job, then input and productivity measures will probably work. If
you dont know what a worker needs to do as is the case with
most knowledge work then
leave the worker alone to gure
out the means and measure the
results.
Theories only progress through
dissension, so I look forward
to the feud between manag-
ing by results vs. means con-
tinuing. Central bankers have
long understood what they
term Goodharts law: Any tar- rr
get that is set quickly loses its
meaning as it comes to be ma-
nipulated. There has been a
debate raging ever since the creation of central banking systems
over whether monetary authorities should pay attention to inter- rr
est rates or changes in the money supply. One nds compelling
arguments on each side. But this may be a false choice. The Good
Lord gave us two eyes, and one can be used to monitor results
while the other watches the process.
To the extent companies continue to track lagging indicators,
even with the Balanced Scorecard approach, this is nothing more
than modern-day pantometry that is, universal measurement,
or simply counting for the sake of counting. To the extent they
posit leading indicators that can actually be falsied, they will
make progress in determining the real value drivers for custom-
ers. The experience with the Balanced Scorecard so far has been
mixed, with some companies abandoning them. This, of course,
does not falsify the basic premise the companies in question
could just have bad strategies but it is a sign that companies
need to pay closer attention
to the processes that drive -
nancial results.
It is for this reason I find
Johnsons argument more
compelling, and more con-
ducive to a knowledge envi-
ronment. Of the two eyes,
the one focused on nancial
results will always be more
myopic. In the intellectual
capital economy, we are just
going to have to become more
comfortable with judgment
and intuition over measurement and counting.
We will have to pay more attention to the process that produces
the measurement, rather than blindly thinking, What you can
measure, you can manage. After all, you do not change your
weight by measuring yourself.
There has been a debate raging ever
since the creation of central banking
systems over whether monetar y
authorities should pay attention to
interest rates or changes in the money
supply.

4thqtrjrnl Full

Hochgeladen von

Dokumentinformationen

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

4thqtrjrnl Full

Hochgeladen von

Copyright:

Verfügbare Formate

The Journal of

Das könnte Ihnen auch gefallen