Price Waterfall

Businesses often face the challenge of how to price their products or services. Plenty of hidden costs go into the final product or service provided to the customer, and it can be tricky to find the right mix of price and quality that meets customer expectations while also ensuring that the business is profitable.

To have a clear view of all these factors and to ensure that the company is making money, businesses use a price waterfall analysis.

What Is a Price Waterfall?

A price waterfall is a visualization tool that businesses use to see all the factors that go into pricing a product or service. This includes direct costs, such as material and labor, as well as indirect costs, such as rent, marketing, and overhead. Companies use price waterfalls to understand how the purchase price ultimately reaches their pocket margins (NET or NET 3).

With a price waterfall analysis, businesses can see exactly where their profits are coming from and where they might be able to save money. This type of analysis can also help businesses understand how changes in costs will affect their bottom line.

For example, let’s say a business is selling a product for $100. The direct costs of the product are $60, and the indirect costs are $40. The company’s profit margins would be $0 (or 0%) if they were only selling one product.

But if the company sells 10 products, their total profits would be $400 (or 40%). This is because, while the fixed costs remain the same, the variable costs are spread out over a larger number of products.

Synonyms

• Price Analysis: The entire pricing process, including analyzing all the factors that go into the retail price of a product or service.
• Cost-Plus Analysis: An analytical tool businesses use to understand the costs associated with a product or service. This includes both direct, indirect, and hidden costs.
• Pocket Price Waterfall: A term used to describe the final price of a product or service after all the costs have been accounted for.

Why a Price Waterfall Is Important In Revenue Management

Pricing policy evaluation plays a critical role in revenue management for two key reasons:

1. They help businesses understand their costs so that they can price their products or services accordingly.
2. They help businesses track their progress in meeting profit goals.

Revenue management is all about maximizing profits, and a price waterfall analysis is the best way to ensure that a business is pricing its products or services correctly.

Price Optimization

Pricing products or services is an inexact science, and there is no perfect price that will cover all the costs while also meeting customer expectations. The goal of price optimization is to find the right mix of price and quality that meets both goals.

For example, a company may price its product lower for bulk orders, or higher for custom orders. By using a price waterfall, businesses can ensure that they are pricing their products and services appropriately for each customer, maximizing profits and minimizing losses.

In addition, a price waterfall can also help businesses to better understand their customers’ needs and preferences. As well as providing insight into future pricing, this information can be used to tailor products and services to meet customers’ needs.

Identifying Profit Leakage

Another key benefit of using a price waterfall for transaction price management is that it can help businesses to identify areas where they are losing money. This is known as “profit leakage” or “revenue leakage.”

For example, let’s say a company has a product that costs $100 to produce. The company sells the product for $120, and the customer pays shipping and handling charges of $10. The company’s profit margin on this product is $10 (or 8.3%).

Now, let’s say the company decides to offer free shipping on this product. The customer still pays $120 for the product, but the company’s shipping and handling costs increase to $15. The company’s profit margin on this product is now only $5 (or 4.2%).

By looking at the complete picture of the cost of goods sold (COGS), it’s clear that free shipping has a direct impact on the company’s bottom line. By using a price waterfall analysis, businesses can identify areas like this where they are losing money and make changes accordingly.

What Is a Price Waterfall Analysis?

Price waterfall analysis is a structured approach to determining the optimal list price for a product or service. The analysis begins with an initial price, which is then adjusted upward or downward based on various factors, such as the cost of goods sold, desired profit margin, and competitor pricing.

By systematically considering all of these factors, businesses and sales departments can arrive at a pricing strategy that maximizes revenue and profits. 

Challenges of Price Waterfalls

Some businesses find themselves struggling when it comes to implementing price waterfall models. Here are a few reasons why:

It can be difficult to determine the correct order of price levels.

• Especially if a business has a complicated supply chain, the price waterfall method sometimes leads to an inflexible and complex pricing structure.
• Sometimes, it can encourage a “race to the bottom” price, rather than focusing on value-add, meaning reduced profit margins.
• When prices constantly change in the name of revenue optimization, customers can become frustrated, lose trust, or find a new vendor with a more reliable invoice price.

Despite these challenges, price waterfall models can be an effective way to optimize pricing and boost profits. When used correctly, they can help businesses to better understand their costs, track their progress toward sales KPIs, and identify areas where they are losing money.

How to Develop a Price Waterfall using CPQ

CPQ (Configure, Price, Quote) software utilizes a functionality called the price waterfall to provide a transparent breakdown of how a product or service’s final price is determined. It essentially acts like a step-by-step visual guide, starting from the initial list price and cascading down to the net price the customer pays.

Here’s how to create a CPQ price waterfall:

1. Defining Stages:

CPQ allows you to set up various stages, each representing a pricing factor. These stages typically include:

• List Price: The base price of the product or service.
• Special Price: A pre-negotiated price with a specific customer or based on a contract.
• Discounted Price: The price after applying various discounts (volume, partner, etc.).
• Prorated Price (optional): If the product/service is offered for a shorter period, the price is adjusted accordingly.
• Net Price: The final price the customer pays after considering all adjustments.

2. Sequential Calculation:

The software calculates each stage’s price based on the previous one. For instance, if no contract exists, the special price might be derived from the list price. Then, discounts are applied to the special price to arrive at the discounted price, and so on.

3. Visualization and Transparency:

CPQ can present the price waterfall as a visual representation, often a table or chart. This allows salespeople and customers to see a clear breakdown of how the final price is reached, including the impact of each discount or adjustment.

Benefits of using CPQ for price waterfalls:

• Accuracy: Automates calculations, minimizing errors in the quoting process.
• Efficiency: Saves time by streamlining the pricing process.
• Transparency: Provides clear visibility into how the final price is determined for both salespeople and customers.
• Control: Allows for defining and managing various pricing rules and discounts within the software.

CPQ software streamlines the creation of price waterfalls, enhancing the accuracy, efficiency, and transparency of the company’s quoting process.

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