August 7, 2013
I’m not sure in what context I first heard the term “fence-posting”. It’s not a new concept, but it has come up in discussion a few times recently so here’s my take on it.
In short, fence-posting is a behavioral tendency to price right up to, but not below, a pre-determined threshold. It occurs when a company establishes a workflow approval or escalation process to limit excessive price discounting or to maintain margins, but has no incentive to price above the floor. Another corresponding term is a “trigger discount,” which is when an unnecessary discount is applied to close a deal. These discounts originate from a fear that without the discount a sale won’t close, resulting in zero dollars in commission.
Theoretically, the likelihood that a deal will close (resulting in sales commission) increases as price decreases. As long as commissions decline at a rate which is less than the probability of a sale increases, it’s entirely rational behavior to develop an itchy trigger finger and offer up discounts as a starting point in negotiations. This is true up until the point where additional internal approval is required to move a deal through the sales cycle; right up to the price floor or fence.
Assume that Sales is commission is paid as straight 3% of revenue. In the example below, the probability of closing the sale increases by 10% for an incremental 5% discount, so the commission maximizing move is to offer a 30% discount, which nearly ensures the sale and $2100 in commision, but generates a negative margin for company. Purely revenue- based compensation plans don’t provide an incentive structure which is profit maximizing, but often it’s not possible to make the leap to a profit-based compensation plan, so Price or Margin Floors are put in place to limit the downside. These floors are never going to be as effective at eliminating trigger discounting as aligning individual and organizational incentives, but they can at least prevent negative margin transactions in most cases.
Once Targets and Floors are in place, you can easily monitor sales behavior to see the degree to which a fence-posting issue is occurring. In the scatter chart below, Price Floor Per Unit is plotted against Customer Negotiated price. The data points which fall on or just below the 45 degree line, where those two price points are equal, are likely to be pricing opportunities – examples of products subject to fence-posting. You can set the same chart up by Sales Rep to see who are the biggest culprits in the area.
Over time, as customer negotiated prices are set right at or above price floors, if the only source of data available for list price setting is historical transaction data, it will appear as though it is not possible to achieve higher pricing because the upper range of price points has disappeared. Providing kickers, or additional compensation for sales above the floor is one way to combat this issue. Another technique is to track and report on Target Price Realization % by Rep, which can help identify who is really selling value and capturing the profit upside for your company.
In the short run, the best a pricing manager can hope for is to draw attention to the fence-posting behavior and possibly re-work the pricing thresholds to mitigate the issue. Armed with this data, in the long run with some executive level clout behind you, pricing managers can help get to the source of the issue and push for margin based compensation. Until that time, keep fighting the good fight and raising awareness on the topic by finding your own ways to measure and report on it and let us know how its going.