Benchmark study of North American pulp and paper producers finds that emphasizing strategic price management and market segmentation can pay off

Marketing's Impact on Financial Performance Often Overlooked

By now, forest product executives are well aware of the lagging financial performance of the industry in general, and the relative performance of their own companies in particular. The industry's lagging performance has also become a subject of concern and debate for securities analysts and shareholders. Annual reports and press releases are replete with plans and programs certain to improve value-creation performance.

And yet, while average industry performance has been inadequate, some forest product companies have consistently outperformed others. In fact, a few have outperformed the broader manufacturing sector of the U.S. economy.

Much theory, research, debate, and conjecture have been advanced to explain these variations in performance across the industry. And while differences in parameters such as cash flow management, cost structure, and investment strategy have explained pieces and parts of the differences in performance, large portions have defied quantitative explanation. However, no one-until recently-had attempted to quantitatively measure marketing skills and executions across the industry and then relate those measurements to financial performance.

A study of this relationship conducted by Andersen Consulting suggests that more than 40% of the differences in forest products company financial performance is driven by marketing, a capability that is often either under-emphasized or ignored. This benchmarking effort was designed to identify which of 23 broad marketing and selling skills companies use, and to measure which ones most affect bottom-line performance. In addition, the study measured the impact of relative skill strength (i.e., the difference between doing "the basics" and employing more advanced marketing concepts).

FIGURE 1: Programs that consider the "8 P's" of marketing have not been an area of focus for most firms in the pulp and paper industry.

A SIMPLER TIME. Systematic marketing-optimizing the mixture of product, price, place (distribution), partnering, promotion, position (branding), packaging, and people (sales force)-has not been an area of focus for most firms in the pulp and paper industry. Historically, the market was dominated by demand growth that was closely correlated to GNP growth and limited competition that resulted from the high-capital cost of entry.

Profitability was driven by expansion, asset utilization, and cost cutting. Sales and marketing departments focused on throughput-selling whatever volume the production department managed to make. Efficient producers grew, while inefficient producers struggled-with the latter ultimately being either consumed or closed. And while the market's "cyclical" nature created cash flow problems for over-leveraged firms, many producers stayed in business owing to the patience and long-term expectations of their investors.

But pulp and paper markets have changed, as have the expectations of investors. Product market cycles have increased in both amplitude and frequency. In fact, some senior executives have begun to speak of market volatility rather than cyclicality. Investors have come to expect higher and more consistent returns.

As the market has changed, firms have turned to a variety of strategies to bolster their financial performance, including product and regional diversification, vertical integration, new high efficiency paper machinery, total quality management, and re-engineering. But few of these strategies worked well and, for those that had an effect, the improvements were short-lived.

Still, some companies have managed to break away from "the pack." Previous research aimed at understanding these over-achievers uncovered three major value drivers that set them apart (P&P, February 1997, p.67). First, successful companies develop a strong market/segment focus (i.e., they focus on fewer segments, building customer understanding, capability, and dominance in those segments). Second, successful companies improve their discipline at capital deployment (i.e., their capital investments are less driven by the prior year's cash flow, focusing instead on long term value building). Third, these leaders strive to build operational excellence-not just in the mill, but across the entire supply chain and also across core skills, such as selling, pricing, and new product development.

BENCHMARKING PERFORMANCE. In a more focused study of this third lever-operational excellence, specifically in the areas of sales and marketing-Andersen Consulting sought to understand, through the benchmarking effort, which activities and strategies (and in what combination) create the most value as measured by return on sales (ROS). Study participants included marketing and sales executives from 80 business units across the U.S. and Canada, representing 90% of forest products companies having more than $2 billion in annual sales. The reported average ROS for these units over a typical business cycle was 9%.

FIGURE 2: For "the average company," some skills offer more leverage than others.

Participants were asked several hundred questions about their company's marketing and sales strategy, marketing activities, and organization. The questions covered the "eight P's of marketing" (Figure 1)-product, price, place (distribution), partnering, promotion, position (branding), packaging, and people (sales force). The questions also surveyed support activities and "enablers," such as information systems, work processes, and organization structure. Using advanced regression analysis techniques, business unit responses were compared with aggregated company performance (ROS) across recent market cycles in an attempt to isolate the effects of marketing on financial performance.

The analyses-performed at a 99% confidence level-suggest that more than 40% of the differences between the ROS performance of otherwise similar companies resulted from differences in sales and marketing skills. A company that earns a 5% ROS over a business cycle can make up 40% of the difference between its ROS performance and that of a 15% ROS peer (i.e., 4 percentage points) by improving marketing and sales capabilities. Stated another way, the average $500 million business can generate as much as $70 million more in ROS by improving its marketing skills.

For firms that have endured nearly 20 years of continued cost-reduction, restructuring, and downsizing-all of which are primarily defensive in nature-it is possible to point to some positive, and effective, strategies that can improve performance. And while building marketing and selling capability cannot compensate in total for deficiencies in other commonly recognized value levers (e.g., cost reduction, operating efficiency, etc.), it is clearly a powerful tool for building shareholder value.

Here is an important caveat, however. The following discussion is based on deviations from average performance. While the improvement potential of
various skills for the "average company" is an important insight, the effects are highly firm specific. The skills that are most important-on average-may not be vital to a specific firm. The data does, however, support direct comparisons between specific companies, as well as comparisons between specific companies and average performance.

SKILLS THAT MATTER MOST. The study suggests that some marketing and sales skills matter much more than others. Interestingly, the skills that seemed to have the largest impact on ROS were not those that responding executives ranked as important. For example, skills involving selling strategy-though important-tend to be overemphasized by executives, at the expense of more strategic skills, such as strategic price management and market segmentation.

Figure 2 illustrates the average impact of the 23 different skills. For the average company, "strategic price management" ranked as the most important skill in driving bottom line performance. "Executing an effective brand strategy" was also very important.

Strategic price management seeks to understand and exploit the market dynamics and competitive behaviors that drive industry price levels. While it is clearly illegal for competitor-companies to communicate with one another about their prices and price strategies, there is a wide range of legitimate (and legal) tools companies can use to effect price levels.

The study asked executives whether their companies are actively engaged in:

• Understanding the balance of supply and demand over time. This involves estimating the cost structure and capacity of competitors and constructing a "cost curve" for the industry segment (Figure 3), developing robust demand forecasts, and modeling the effect on price of capacity surpluses and deficits.
• Managing supply-demand balances. This includes activities such as withdrawing capacity during market downturns, signaling expansion plans, or knowing when to favor capacity acquisition over capacity creation.
• Avoiding price wars. This includes activities such as quickly following a market leader's (or competitor's) price increases or avoiding price discounts as a tool for building market share. Once started, price wars are notoriously difficult to stop.

If Supplier 3 elects to expand capacity (Figure 3B), total market capacity will exceed demand, which typically causes market prices to decline. Depending on the scope of the capacity increase, Supplier 4 may be rendered economically non-viable, Supplier 3's contribution margin may be virtually eliminated, and Supplier 1's and Supplier 2's contribution margins will be reduced.

Another strategic price management skill is capacity management, which the study suggested is the largest driver of value. And yet, only 38% of responding companies indicated they actively managed capacity. Conventional operating wisdom-and managerial accounting-advises that facilities continue to produce as long as net prices exceed the variable cost of production. But these conventions tend to encourage manufacturers to produce at near capacity rates while neglecting the effect of excess supply on market prices.

Recognizing the potential power of removing capacity from the market (i.e., actually shutting down capacity), International Paper is exploring new ground. Employing principals of "marginal economics," the company discovered that the conventional wisdom was false. Understanding that the "marginal ton" (i.e., the last ton produced) typically costs more to produce than an "average ton," and that the marginal ton typically sells for less-sometimes a lot less-than the average ton, the company changed its production decision-making model. By considering both the cost of producing a marginal ton and its likely selling price, the company now schedules production rates that maximize profitability rather than asset utilization.

FIGURE 3: Cost curves can illustrate the effect of incremental capacity on market price.

FIGURE 4: A simple "smell test" can tell you whether the segmentation has value creation potential.

According to the study, understanding the interplay on price of supply and demand is a value producing activity. This includes developing supply curves and detailed demand estimates to understand how potential changes in the demand-supply balance are likely to affect price. And yet, more than 40% of the industry's firms do not perform this seemingly critical analysis. This suggests that capacity addition decisions are likely made without critical facts that affect not just company economics but the financial performance of the entire industry.

By underemphasizing this activity, companies are leaving substantial profits "on the table." Analysis suggests that the best company-practitioner of this skill is foregoing $2 million in ROS improvement opportunity. The worst practitioners are foregoing much more-$18 million annually-and most companies were closer to the worst than to the best.

EFFECTIVE BRAND STRATEGY. "Branded products" tend to sell for premium prices relative to generic products. In the forest products industry, several firms have established strong brand identities. These brands include: Charmin and Cottonelle toilette tissues; Puffs and Kleenex facial tissues; Pampers, Huggies, and Luvs disposable diapers; and Dixie Cups.

But successful brands are not necessarily limited to consumer products (e.g., Hammermill is a well-established communications paper brand produced by International Paper), nor is a brand limited to a product or product-line name. For example, the entire range of Mead Paper's products and services also can be considered as a brand.

FIGURE 5: There are at least ten distinct approaches to understanding and segmenting customers.

FIGURE 6: Following a "combination approach" to segmentation can help a company carve out profitable and defendable niches.

A "brand" is the condensed summary of all of a customer's perceptions and experiences-good and bad-vis-à-vis a specific product (or service) or family of related products. And, while advertising can contribute to building a favorable brand image, the customer's experiences with the product and related service are far more important. Thus, a favorable 15-year sales relationship may contribute strongly to building a brand, as might on-time performance, frequency of complaints, and senior management visits. In paper markets, a customer's perception likely includes the supplier's behavior during the last price-cycle peak.

The study measured how well companies met three important requirements for strong brands:

Distinctiveness: Some aspect of the combination of product-service-price features and characteristics-an aspect that is relevant to customers-must be distinctive compared with the offerings of competitors. Failure on this dimension leads to "commoditization." As the number of relevant distinctions in a firm's offering increases, so does the difficulty of emulation for competitors.

Consistency: The distinctions-whether shorter delivery times, more reliable delivery, lower prices, better technical service, or more consistent quality-must be delivered consistently. This dimension is a common failing for many companies. Customers are smart enough to realize that 98% on-time delivery during 11 months, but not 12 months of the year, is not 98% on-time delivery.

Communication: Customers must be aware of the distinctiveness and consistency of delivering product. That requires communication. And while advertisements are helpful, they generally have less impact than the sales person and customer-service representative, with whom customers communicate daily.

Companies that have strong brands recognize these requirements as common sense. Conversely, brand weakness is generally the result of either insufficient distinctiveness or inconsistency (i.e., failure to deliver the valued distinction consistently).

Within the paper industry, Consolidated Papers is a well-known example of a firm that has built a strong brand, the distinctiveness of which, is delivered consistently. And while the firm's coated printing paper competitors have improved their own quality and consistency, Consolidated Paper's brand name has remained one of the strongest in the segment. The company's formula is conceptually simple-its distinction is the consistency of its products and services.

Several advantages accrue from this distinction. In the coated paper market, consistency is a product feature that is highly valued by customers, and Consolidated's product is simply more consistent than that of its competitors. To deliver its value proposition consistently, the company has engineered its manufacturing and business processes (e.g., ordering and scheduling) to eliminate elements that cause inconsistency of performance. In fact, Consolidated has been so successful in stabilizing its performance that merchants and printers can be found complaining about the firm's service inflexibility, and with the same breath, praising its product consistency.

Strategically, Consolidated Paper's choice of a "skill-based" distinction (i.e., one that comprises a complex set of activities that need to be done well) rather than product characteristic-based distinction (i.e., brightness, smoothness, or strength) makes imitation by competitors difficult.

Brand strategies can also be effective for products that have traditionally been considered commodities. For example, a market pulp producer can differentiate its products on a number of dimensions. Low price is an obvious choice for the lowest cost producer. Product specifications (i.e., wood species, purity, and viscosity) or product uniformity are also obvious and viable choices. Somewhat less obvious-but still viable-choices include logistics and delivery or technical service. Differentiation is possible on these dimensions, as well.

How does brand value affect a company's "bottom line" performance? In most forest product market segments, a true price premium is a very rare thing. Instead, price premiums-and with them higher earnings-materialize in subtle but powerful ways:

• Capturing a greater market share among the most profitable customers.
• Discounting less frequently and less substantially during weakening market periods.
• Lowering costs of production, complaints, and returns.

STRATEGIC SEGMENTATION. The managers of most companies know that meeting all of the needs of all prospective customers is a path to lower profits (i.e., rational customers prefer high-quality, high-functionality, and low prices). But the market behaviors of many firms seem to disregard this "common knowledge" (i.e., they fail to effectively segment their markets).

Segmentation is the process of dividing broad markets (e.g., buyers of kraft linerboard) into segments or customer groups based on common needs or characteristics that a company can profitably satisfy. While market segmentation is a common strategy for most paper companies, there is a substantial difference between "doing it" and doing it effectively.

Several segmentation strategies are common. The most prevalent is a simple segmentation strategy by size (e.g., box converters with annual sales of less that $20 million) or opportunity (e.g., kraft linerboard buyers that might be converted to mottled-top stock). Somewhat more sophisticated firms commonly consider customer satisfaction scores for large individual customers or large customer-type groups and seek to improve the identified weaknesses. The first approach generally ignores customer needs and the company's ability to meet them. The second approach captures needs, but it ignores profitability issues (i.e., whether the target customer's expectations can be met profitably).

In contrast, effective market segmentation seeks a profit-driven focus. As a result, the segments focus on some customers and not others; they focus on some needs and not others. As an example, a linerboard producer might choose as a market segment independent box producers with steady production rates which require certainty of supply, and that prefer just-in-time delivery of materials to minimize inventory space and cost.

The linerboard producer's operations (production scheduling, logistics, customer service, etc.) are designed to maximize profitability while satisfying these needs. Of course, the challenge in segment design is identifying which customers-and which of their needs-to serve well and which to downplay.

Few companies actually have profit-producing segmentation strategies. A simple "smell test" (Figure 4)-consisting of both marketing and business criteria-can tell you whether the segmentation has value creation potential.

In the benchmarking study, five segmentation skills were measured.

• Has the firm made choices to achieve focus (i.e., have managers decided which customers to serve, how much to serve them-more, less, or not at all-and which improvements to emphasize)?
• Has the profitability of the segmentation choices been analyzed (e.g., performing cost-to-serve analyses)?
• Are the segments actionable (i.e., can the sales force tell which customers are in which segments)?
• Are the segments a good match with the firm's assets and skills?
• Are the segments better matched with the firm's capabilities or those of its competitors?

The study also shows that most market segmentation within the paper business is based on firm size (e.g., large customer firms or small customer firms). But the paper firms with generally better ROS performance have found stronger segment differentiators. These differentiators include customer firms that place a high value on superior service, those with specific logistics support needs, or those that place a high value on product quality. The innovative-and high ROS-market segmentors create organizations and strategies for serving these specialized segments. In addition to traditional demographic factors (e.g., customer size), there are at least ten distinct approaches to understanding and segmenting customers (Figure 5).

Effective segmentation strategies take into account industry structure, company performance, company business objectives, and other factors. For example, a low ROS performing company should probably segment customers based on profitability (i.e., potential revenue and cost to serve) as its primary approach. On the other hand, a company in a high growth segment and geography might effectively segment customers by traditional factors such as geography, firm size, and product needs. Finally, a company that competes in a duopoly (i.e., a market dominated by two large competing firms) is better served by focusing on customer needs as a way of segmentation. Such value-added growth opportunities are less likely to stimulate competitive discounting (i.e., a price war).

High ROS companies often combine these approaches, analyzing everything from a customer's buying behavior to the customer's operating constraints. These analyses can result in sophisticated combinations of product and service attributes-which can be very difficult and expensive for competitors to copy-and can help focus a firm's sales and marketing efforts.

Figure 6 illustrates using the "combination approach" to segment printers. Buying behavior-direct or merchant-is the first important criteria. The next most important criteria are "constraints." In servicing printers that purchase paper directly, distance from the producer's mill is a real service constraint from the mill's perspective. Servicing these direct purchasers requires different set of actions and capabilities than servicing printers that purchase paper through merchants, where a more relevant constraint might be credit worthiness of the printer.

The next criteria are customer needs (i.e., the "most important" characteristics of the product-service combination). Understanding the relative importance of various product and service characteristics-individually and in combination-is a task requiring a high degree of skill and techniques not commonly used in the paper industry, such as "conjoint" or trade-off research. Pioneered years ago in consumer goods, this technique is one of the best for uncovering what customers really care about. Unlike customer satisfaction research, which generally suggests "everything is important," conjoint uncovers what really matters and what doesn't, allowing a company to define segments clearly.

ALIGNING THE ORGANIZATION. Many organizations suffer "silo effects"-a myopic view of "the world" that results from insufficient communications and interaction between functional groups within the organization. The result is a myopic view of the business and the organization's strengths and challenges. Inadequate performance by the organization tends to drive intra-organizational friction and competition rather than organizational cooperation and improvement.

The marketing group "sees" a manufacturing group that does not control costs, while the manufacturing group sees a marketing group that targets high cost-to-serve market segments and serves the segments in ways that increase cost. This silo effect is one of the largest barriers to performance and, not surprisingly, high-performing companies typically better penetrate silos, getting people in different groups to work together for a common purpose.

Once a company has chosen-through segmentation-which customers to serve and how to serve them, aligning the organization to consistently deliver the "value proposition" (i.e., the combination of product and service attributes) is the critical next step. The study measured the parameter, seeking to correlate it with ROS performance.

Fully 40% of the responding companies do not align their organizations, or do not do it well enough to matter. Only one-fifth of responding companies-the high performers, not coincidentally-do this well.

On the other hand, it was interesting to learn that organizational structure (different from organizational alignment) had no apparent effect on performance. Successful marketers were found among all types of organization structures, suggesting how the work gets done is more important than the shape of the organization chart.

WHERE TO START. Though "it depends" is an unsatisfying answer, the study demonstrated that there is tremendous value in finding where a company stands relative to the benchmarks because very few companies have truly "average" characteristics. Hence, accepting the average conclusion and moving in the average direction is appropriate for very few companies. The study also demonstrated that "instinct" was an unreliable guide to high-value levers.

Executives were asked to rate the relative importance of the "8 P's" of marketing to their business. Their answers poorly correlated with the measured contribution of each skill. More specifically, the importance of "sales skills" and "partnering" were overrated (i.e., while executives tended to rate them as important, the skills were not correlated with ROS performance). On the other hand, strategic and tactical price management, branding, and customer segmentation were underrated skills (i.e., much more important in driving ROS performance than the surveyed executives thought).

Interestingly, several skills had little apparent impact. These included promotion (including internet-based promotions), packaging, and channel strategies. There are several reasons that a particular skill set might show little impact:

It is truly ineffective

No market competitors engage in the related activities.

Most market competitors have the same level of skill in the related activities.

"Basic capabilities"-those skills that seemed to pay off if they were used, irrespective of the level of performance and skill-included brand strategy, understanding how customers make purchase decision, ensuring consistent products, effective sales support, and maximizing realized net price for each transaction. Not surprisingly, many average performers find that they can create substantial value by working on these skills.

"Advanced capabilities" are skills that benefited high ROS performers disproportionately-by a ratio of 3:1-as compared with low ROS performers. These skills include strategic price management, partnering strategy, information systems, and defining a value proposition to customers. The implication is that while strategic price management is the most value-adding skill, its benefits accrue disproportionately to firms that are exercising many other skills first.