Gain Insight Using the Price Waterfall
When executives direct their focus on pricing, they need analytical tools that enable them to quickly get a lay of the land and identify opportunities for profit improvement. One of the most indispensable of these tools is the price waterfall.
A waterfall chart is a visualization that shows the cumulative effect of a series of positive or negative values that are applied to an initial starting value. And a price waterfall is a waterfall chart that focuses on price and shows the cumulative effect of all discounts and rebates on profitability.
Generally, the waterfall chart starts with list price, but it can start with any base price that discounts and rebates are applied to. (Discounts are price variances that are applied before the invoice price. Rebates are price variances that are applied after the invoice price.) The price waterfall shows the discounts to get from list price to invoice price and then any further rebates to get to pocket price. Variable costs can also be added to the end of the price waterfall to show visually just how much pocket profit is left over after all discounts and rebates are factored in.
The Value of the Price Waterfall
The price waterfall is valuable because it allows executives to see the scale of each individual price variance in comparison to all the others. Executives can track how much total value is being captured from the market (and how much is being given back) from start to finish. The value is tracked from list price to invoice price all the way down to pocket price (or down to pocket profit if variable costs have been added).
The results can be striking. The price waterfall is a simple, easily understood visualization tool that offers incredible insight. You can plainly see in the waterfall above that the Annual Volume Rebate makes up over half of the total value of price variances.
The price waterfall allows management to understand how discounts and rebates affect profitability at a high level as well as to drill down into more granular details.
Want to get a handle on the differences between two different product categories? Make a price waterfall for each of them. Want to find out if there is a different utilization of specific discounts and rebates across sales regions? Make a price waterfall for each of them. Want to discover which products in a portfolio are actually using your Early Order Rebate or your Shipping Rebate? Yep, you guessed it: make a price waterfall for each of them.
A Few Price Waterfall Usage Notes
It should be noted that the values in a price waterfall are additive (i.e., they do not cascade). Cascading discounts work by applying additional discounts to the new net amount after previous discounts have been subtracted. For instance, assume you have 3 cascading 20% discounts that are applied to a $100 product. The first 20% discount takes off $20 and lowers the price to $80. The second 20% discount is applied to the new net amount of $80, NOT the original starting price of $100. Thus, the second 20% discount takes off $16 and lowers the price to $64. Likewise, the third 20% discount is applied to the new net amount of $64, so the third 20% discount takes off $12.80 and lowers the price to $51.20.
Converting the 3 cascading 20% discounts to additive discounts means keeping the base constant for all the calculations. In this case, the base is $100 for all calculations. Thus, in a price waterfall, these 3 cascading 20% discounts result in a 20% first discount, a 16% second discount, and a 12.8% third discount.
While calculating the final price with cascading price variances requires stepping through the individual price variances and determining the new net price at each step, calculating the final price with additive price variances is as easy as adding up all the discounts: 20% + 20% + 20% = 60% total discount. That is why we use additive values in a price waterfall.
You may also notice that the total price variance is greater for additive price variances vs. cascading price variances, keeping number of variances and the variance magnitude constant. This is because the base for additive price variances is the top-line price, while the base for cascading price variances is the new net price, which decreases with each price variance added.
The price waterfall allows executives to create a benchmark for scenario analysis. They can ascertain whether proposed changes to their commercial policy will leave the firm in the same or a better position. Simply compare the current price waterfall to the projected price waterfall under the proposed policy.
Additionally, opportunities for reducing overall price variances without negatively affecting profitability may be uncovered. For instance, if a firm finds that a particular channel is very sensitive to Co-op Advertising Rebate spend but not Annual Volume Rebate spend, then it may be time to adjust the policy for that channel. Remove dollars from the Annual Volume Rebate and add some of those dollars to the Co-op Advertising Rebate. The end result is a decrease in price variances for that channel without a decrease in profit.
Finally, executives may want to compare the price waterfall of their firm with (estimated) price waterfalls from competitors. Once determining how their firm’s discounting practices compare to the industry norm, they can then have an informed conversation about whether to bring their discounting practices in line with the norm or whether to go in another direction.
The price waterfall is an essential visualization tool for any pricing project. Pricing professionals should not leave home without it.