Few commodity businesses are renowned for their marketing prowess. How do you market a product that has virtually no differentiating features, a price that is more or less fixed, and a level of capital intensity that seems to call for chasing orders no matter what their profitability?

For many years, the answer to that question has been simple you don’t. Instead, you aimed for a low cost position and tried to run as much volume as possible past your fixed cost base. Product and service differentiation? Managing the order mix? Prioritizing customer segments? These were luxuries best left to industries where a half percent upswing in return on sales is less cause for excitement.

Volume, average cost, and market price are no longer the key drivers of profit and chasing tonnage has ceased to be viable

But the rules are changing. Successive waves of mergers, restructurings, and downsizings not to mention a relentless focus on benchmarking have flattened out the big differences in average costs that used to characterize such industries as pulp and paper, steel, non-ferrous metals, and transportation. Rival commodity companies of roughly the same scale now find themselves with cost curves of roughly equal slope (although factor cost differences still exist between locations and facilities). Volume, average cost, and market price are no longer the key drivers of profit, and chasing tonnage has ceased to be a viable route to profitable growth. Companies must instead turn to new approaches in sales and marketing approaches that used to be dismissed as ineffective or inappropriate for commodity goods.

These approaches are not revolutionary. Most have long been familiar to managers in consumer goods industries. Yet applying them in commodity markets can make a dramatic impact on the bottom line. Our experience has shown that unexploited pricing and marketing opportunities exist on the order of 5 to 10 percent of return on sales opportunities that can be captured quickly and without recourse to long redesign projects or strategy rethinks.

Exploiting these opportunities will require a shift in managerial mindset away from the traditional tonnage mentality that permeates the culture of so many commodity businesses. This mentality is the product of some of commodity marketing’s most deep-rooted and pernicious beliefs about products, customers, and competitors, among them:

• "Price is a given." Commodity marketers often believe that the same services are provided by everyone which prevents them charging for "extras."
• "Volume is what counts." To sales people, this means that market share trumps all other considerations: fill that volume quota or else! To production people, it means keeping the plant busy no matter what even with make-forward or make-to-stock.
• "The competition wants the same tons as us." As all players chase all customers, commodity businesses miss a golden opportunity to cherry-pick customers and match market segments with the facilities that can best serve them.

  Commodity businesses are missing a golden opportunity to cherry-pick customers

• "The customer only cares about price." Across-the-board cost reduction becomes king, and mix management and service elements like lead time and product quality are ignored.

Changing these ingrained beliefs will require commodity companies to use information and incentives to reshape the behavior of their sales and production organizations. It will require them to soften their focus on levers at the plant level (volume, average cost, market price), and tighten their focus on the selection of orders and customers and on the differentiation of products and services. Above all, it will require them to gain insights into the true profitability of every customer and every transaction, and to make this information transparent to production and sales. Only then can commodity companies use price to capture much of the profit that currently remains hidden.

Finding the hidden drivers of profit

The best way to start is by getting an understanding of the true order economics of your business. Contrary to conventional wisdom, price and cost in most commodity businesses vary widely between apparently similar orders. Managers’ lack of information and focus on volume often lead them to overlook these variations. They thus lose the ability to distinguish between good and bad orders, and to price and manage mix accordingly.

In order to identify these variations and to exploit the pockets of untouched profit they represent companies must shift from a plant-level view, where price is considered fixed and cost is seen purely as a function of output, to an order-by-order view, in which the true revenue and costs per order can become transparent.

The first step in discovering the true profit and cost consequences of a transaction is to break it down into a "pocket margin waterfall" (Exhibit 1). Start with the list price and begin subtracting discounts and extras to arrive at the invoice price. You may well be using invoice price to monitor your price performance. If so, you have probably failed to subtract a number of other pricing factors that diminish the actual price you receive.

These "pocket price" elements include payment terms, customer-specific rebates, and freight costs all of which must be deducted to arrive at the pocket price, or the "true" revenue a company earns from a transaction.¹ From the pocket price, subtract the cost of making the standard product, and then deduct three crucial but often ignored cost components, namely:

• Fall-down costs, or the extra expense of meeting the requirements of a nonstandard order. Examples include material offcuts left over from orders for nonoptimal (in terms of the plant’s capability) widths, and yield losses from high-quality specifications for, say, surface and material texture. The result may be lost revenues when the excess material produced is sold as non-prime stock at a discount, or additional costs when it has to be reprocessed. Believing that it is their non-prime material that is generating the losses, many companies fail to allocate fall-down costs to the original, apparently attractive, order.
• Bottleneck costs, which arise in the manufacture of products that require additional processing time in a plant’s bottleneck processes. The cost here is the lost contribution per throughput time of such products in comparison with the contribution that a standard product would make in the same time. The importance of bottleneck costs grows with the complexity of the manufacturing process. High-end products almost always incur bottleneck costs. A typical example of bottleneck costs is an order for thin metal products that have to be processed twice through one or more production stages.
• Nonproduction costs, or the fixed charges and overheads that standard cost accounting systems fail to include. Examples include packaging, order handling costs, stockholding costs, and technical services.

Subtracting these neglected cost components and pocket price elements from the invoice price leaves you with the pocket margin the true profitability of a transaction. These additional costs can represent as much as 20 to 40 percent of revenues (Exhibit 2), and sometimes vary dramatically between orders that carry identical invoice prices. They exist right along the value chain in most commodity businesses, making it vital to understand and include them at every stage, not just for the most capital-intensive processes. Who in commodities has not heard of gate price and cost?

Identifying the opportunities

Once you have developed a "true" costing method one yielding a pocket margin that takes account of all key profit and cost drivers you are ready to begin using your new insights to guide sales and pricing decisions. The best opportunities are usually found in three areas:

• "Reengineering the waterfall," or improving the benefits and reducing the costs of all the elements that go to make up the pocket margin. Options might include changing the price structure (for instance, by charging for specific services or recovering freight costs), and reducing internal fall-down and bottleneck costs (Exhibit 3). Transparency can make it possible to identify and implement process improvements quickly.

• Improving the customer and order mix by raising the profitability of every customer, adjusting the customer mix (pursuing the most profitable and abandoning the least profitable), or both. Again, the key is transparency. When a customer’s full order book is made transparent, it becomes possible to improve production planning by gathering orders into bigger lot sizes (perhaps with orders from other customers), or to work with the customer to modify product specifications to streamline manufacturing. Such joint discussions of total system profitability have often revealed mutually beneficial solutions and enabled companies to establish long-term partnerships with their most attractive customers.

  As the true order economics for major customers become clear, they explode the notion that all customers are equally desirable. Once disabused of this belief, a company can begin to adjust its customer mix through rebate programs, active targeting, and dropping the most unattractive customers. Its goal should be to find the customer mix that best suits its facilities and capabilities.

• Adjusting strategic levers such as the segment and market mix and the distribution and channel structure. Commodity companies seldom use segmentation to identify and target attractive pieces of the market. Transparent order economics give them a fact-based method to determine which segments are the best fit with a given facility. They can then target the segments that yield the highest profitability, or that will pay a premium for special services such as short delivery times. Transparency enables companies to build up their strategy account by account, to decide which products should be marketed to which customers, and to plan which price strategy to use in which geographic markets.²

When these previously unrealized pockets of profit along the value chain are captured, the total impact can be huge (Exhibit 4 and the boxed inserts).

Changing behavior and decision making

Sales, marketing, and production managers are often surprised to find that apparently similar orders actually differ in profitability by up to 20 percent. This discovery will overturn many of their old assumptions. Production then begins to focus on the orders that are profitable to make, while sales and marketing hones in on the products that are profitable to sell.

The aim should be to establish joint decision making between production and sales so as to strike the right balance between market realities and production capabilities. In practice, this means that both functions must have a thorough knowledge of the market and understand tradeoffs between customer needs and production capabilities, and their impact on profitability. Both functions must have accurate information (which can be provided via simple tools and systems) and working guidelines to help them balance market and production requirements. The best results are obtained when functional barriers are torn down, all unnecessary layers between sales and production are eliminated, and processes are simplified.

The key to changing behavior in the sales and marketing organization is to make information transparent and align incentives accordingly, with a new focus on pocket margin instead of revenue or volume. This will help to combat the mentality that every order is attractive, and start salespeople thinking about such issues as:

• What part of the customer’s order book should we target?
• What opportunities are there to improve profitability for our company and the customer?
• What delivery conditions will maximize both customer value and profitability?
• What price policy should we adopt, and how should we manage order acceptance?

Salespeople will progress from negotiating with upstream production facilities to achieve maximum deliveries to focusing on satisfying key customers profitably. The new information at order level has the additional benefit of making sales more aware of production capabilities and limitations. It can then begin to participate in decisions on vital production issues, such as process improvements designed to help the company serve prioritized customer segments more effectively.

Production management will also have to change its behavior. It has traditionally had a strong internal focus, concentrating on maximizing output and plant yield in order to reduce cost, and making major investments to increase output. Transparent order economics along with a growing awareness of customer needs born of fruitful dialogue with sales will help disabuse production managers of the belief that large increases in output are all that counts, and convince them that making many small operational shifts and focused investments can add customer value. Production managers will begin to consider new issues, such as:

• What segments should our plant focus on?
• Which are the key customers that we would like to serve within each segment?
• What process improvements must we make to meet the needs of our chosen customers and segments?
• What routes to market are appropriate for these customers and segments?
• What product revisions and innovations should we initiate?

Production decision making will gradually become informed by solid facts about performance throughout the organization, instead of internal production data and outdated or erroneous assumptions about markets. As they begin to understand the company’s true order economics, production managers will gain a comprehensive picture of every link in the value chain. This helps them avoid the trap of repeatedly reducing service levels, streamlining product offerings, and creating uniform product standards all of which serve only to commoditize their offerings further.

The pocket margin approach

Since many companies in commodity industries measure profitability only at an aggregated level, the task of measuring it at order level may seem daunting. Moreover, sales and production sometimes seem to speak different languages, which can make it difficult for them to work together. Experience suggests that such barriers can be overcome through a simple four-stage process:

1. Establish a reliable method for calculating true order economics. A crossfunctional team made up of technical, financial, and sales or order logistics managers should be charged with this task; it is not an exercise that an accounts department can complete on its own. Companies that have already moved away from the old variance cost system to activity-based costing will have a head start.

The key is to pinpoint fall-down and bottleneck costs, which can most easily be done by working along the production process for each major product type. Using a standard product as the base, identify the additional process steps, higher yield losses, slower speed, reworks, and so on that are required to fulfill a given order. The bottleneck cost is most accurately calculated per hour of processing time; this can later be translated into a volume measure. The actual value of these bottleneck and fall-down costs can then be consolidated into a simple method showing the extra costs per process step over and above those for a standard product (Exhibit 5).

Other price elements can be established by taking a second look at standard financial information. Remember that you must include less obvious elements such as the value of payment terms, the cost of holding customer-specific stock, and so on. Once you have identified all the key profit and cost drivers and estimated their value, you can determine the pocket margin for a specific order, or the aggregated pocket margin for an entire customer segment or geographic market.

2. Make order economics transparent and accessible to key decision makers so that they can be used to guide everyday pricing, sales, and order acceptance decisions. The sales department should have access to the cost method; a simple model for simulating order and customer profitability may also be useful. Regular follow-up reports at order level will be needed for monitoring the pocket margin and key profit drivers. Order economics should be used dynamically. The pocket margin numbers must be integrated into the financial reporting system and kept up to date. And it is just as important to track achievements against the pocket margin as it is to monitor conventional productivity measures.

3. Equipped with facts about order profitability and customer needs, production and sales can now speak the same language and work together to identify opportunities for improvement. A rigorous account planning process is an effective means to this end. Since it now has detailed information at order and customer level, the sales department can start to use noncommodity pricing and marketing techniques, such as customer/ order mix management, customer partnership, channel management, and effective price structures. Account plans can match the most appropriate of these tools to customer requirements, and production can direct its cost reduction and process improvement efforts to areas identified in the account plans.

Account planning is not a one-off exercise; crossfunctional teams of sales and production managers should regularly update the plans in the light of company performance and market changes. This process will put the spotlight on the profitability of the whole value chain, and lay the foundation for continuous improvement.

4. Finally, the detailed information on order economics and key customer buying factors obtained in earlier steps can be used to review broader strategic levers, such as segment, market, and channel mix. Here again, the trick is to get sales and production to question their usual practices and jointly prioritize markets, segments, and products. Regular information sharing and intense working sessions will facilitate this process. Thorough market strategies will prove critical in guiding investment decisions that match production capabilities to customer requirements.

This four-stage approach should not be viewed as strictly sequential. Use the 80/20 rule, and get some early results to reduce skepticism and gain commitment.

Some discoveries may prove embarrassing, but companies will gain productive new insights about operations and customers

Transparent order economics will allow commodity companies to challenge their old way of doing business. Some discoveries may prove embarrassing, but companies will gain productive new insights about their operations and their customers. As transparency increases their room for maneuver, many new avenues are suddenly open to them to increase profitability and to grow. And, as a few farsighted commodity companies have discovered, the benefits can be tremendous.