Maintaining balanced revenue and profit is critical for any company. When using Segment Pricing and Fenced pricing along with Revenue Management it is important to monitor how much revenue is sold at which price and profit levels.
In the chart below (from a real company) I have demonstrated what I consider to be a healthy business in a country. This particular company discounted their services based on the size of the customer and time horizon of the services provided. The red dotted line is the profit margin when using long-run average cost modeling and is noted on the right axis. However, as we discussed in Segment Pricing it is profitable for a company to use marginal costing to gain incremental revenue as long as it covers the minimal costs. This is the economic model where one can price down to Marginal Revenue = Marginal Costs.
But it is not wise to price all of your business with marginal revenue. In the end, one has to pay for all of the expenses that are incurred. Only a portion of the business can be priced with marginal revenue once the core business is already established. For example, once a cargo ship is sailing, or a factory is producing, or a hotel is built the costs of the next shipment, widget produced, or the next hotel guest is very minimal.
The chart below shows the different discount levels that a company offered and the amount of revenue and profit received. The blue bars are the revenue, the green bars are the amount of profit, and if there are red bars that is the amount of loss based on long-run average costing (meaning marginally profitable).
You will notice that only about 20 to 30% of this company’s business is marginally profitable. The other 70 to 80% of the customers pay for the total cost of the operation, which means the revenue from the marginal customers is all incremental profit.
Now in the next chart below you will see a very different story. This company offered pricing to large manufacturing companies in another country and most of the revenue earned was at heavily discounted prices. As a result the company overall experienced huge losses and the business was out of balance with most of the revenue being only marginally profitable. This company did not have enough customers that were fully profitable.
This was a case of a company getting addicted to a revenue drug! The company saw large amounts of revenue from these customers and went all out to close the business at whatever price. And the results were disastrous from a profit point of view, and the tax authorities in that country dis-allowed the losses. The tax authorities argued that the citizens of that country should not suffer from the poor decisions of the company’s management. It took several years for the company to finally walk away and reposition its business, and it was all because they were not monitoring their revenue mix to make sure that it was balanced in the first place.
In the next article I will continue on this theme discussing the importance of avoiding a maturity mis-match.
Three Tree Solutions 