Price and Margin in an Uncertain World

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HAVING THE RIGHT CONVERSATION ABOUT PRICE AND MARGIN IN AN UNCERTAIN WORLD

By Peter McNamee, PhD, Senior Solutions Consultant, SmartOrg

When managers talk about the long term prospects of a product or product line, the conversation often centers around three questions:

  • How many units can we sell?
  • What price can we sell them for (adjusting for discounts, returns, channel costs, partnership agreements, etc.)?
  • How much does it cost to produce them?

Solutions for an uncertain worldWhen the conversation is expanded to include the effects of uncertainty, you need to keep the conversation centered on these questions. However, having useful and productive discussions in an uncertain world requires a careful choice of mental models to refine these questions, particularly in the area of cost.

The evaluation of most products falls someplace between two extremes:

  • The “widget” model: Widgets are sold at a price determined by demand, the competitive landscape, and by your position in the market (reputation, pricing policy relative to the competition, etc.) The cost of producing the widget depends on your production process and is relatively independent of the price realized. In this model, three separate conversations can be had about the three uncertain factors in (Units Sold)*((Unit Price) – (Unit Cost)).
  • The “value added” model: Prices are determined by the cost of some raw material (e.g., oil or paper), and your cost is mostly determined by this same raw material cost. Margin=((Price-Cost)/Price) is a measure of how well you can do the value added piece. In this model, three separate conversations might involve the factors in (Units Sold)*(Unit Price)*(Margin).

In a “widget” world, uncertainty on Price does not affect Cost, and uncertainty about Cost does not affect Price. So Unit Price and Unit Costs are good candidates for productive conversations and assessments. You would not want to carry on a conversation directly about uncertainty in Margin, which combines these two uncertainties.

In a “value added” world, uncertainty in Unit Price and uncertainty in Margin can be discussed and assessed independently. Conversations about the future are always difficult, and having conversations about uncertainty is even more difficult. Explicit models of this sort can help refine the questions so that the conversations become more productive and insightful.

Got White Elephants or Pearls? Shoot Elephants and Shuck Oysters!

By Don Creswell, SmartOrg

What does your current portfolio look like? I’ll bet if you take a “value snapshot” you will find there may be a herd of white elephants (projects that are costing you money with little chance producing much value). Most companies do. You may also have a collection of easy-to-do, but low-value projects as well as some risky, high-value projects.

The question is: do you really know what your portfolio looks like?

Few companies start at “ground zero”, building portfolios from scratch. Whether formalized or not, your portfolio exists, made up of the projects/products under development. If you were to take a “value” snapshot of your current portfolio, you may be very surprised at what you would find. Such a snapshot is called a “portfolio sweep.”

A sweep identifies the health of your portfolio, identifying opportunities for adding value, assessing risk vs. reward and identifying projects that need to be killed or significantly refocused.

A sweep begins by developing and evaluating business model that addresses fundamental questions:

  • Market and customer needs: Does anyone care?
  • Strategic and economic value: Should we do it?
  • Technology/product solution: Can we do it?

Innovation chartThe evaluation creates a portfolio of all projects, developing a graphic the one below, placing each project into one of four quadrants.

  • “Bread and Butter” projects (upper left quadrant) are easy-to-do projects but return low value; these are basically incremental projects.
  • “White Elephants” (lower left quadrant) are hard to do and do not have high value. These are candidates for killing or reallocating resources.
  • “Oysters”(lower right quadrant) are risky but, if successful, have the potential for becoming “Pearls” (upper right quadrant). Like nature, it takes a lot of oysters to make a pearl. This is where you want to take prudent risks.Typically, a sweep reveals significant opportunities for improving the value of your portfolio. To support value-based management of your portfolio over time, the sweep may be base-lined and updated to show changes in the risk vs. reward mix over time.

The Smart Organization: Creating Value through Strategic R&DFor an in-depth discussion of project and portfolio value management, refer to chapters 9 through 11 of The Smart Organization: Creating Value through Strategic R&D by SmartOrg founders David and Jim Matheson. (Amazon)

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