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Order the new MDM Special Report: Business Planning for Distributors
Sick from Eating Low-Hanging Fruit?
Consider strategic pricing
By Brent Grover
Some distributors have eaten so much low-hanging fruit that they have gotten indigestion from it!
After sitting through countless seminars, reading a cascade of articles and installing world-class computer systems, the leaders of many high performance wholesale distributors have achieved the following:
- Greatly improved asset management – both inventory turnover and days sales outstanding are much more efficient.
- Significantly better personnel productivity – no company in distribution is a top-quartile performer with mediocre people management.
- Reduced sales cost – through a combination of smarter sales compensation programs and more enlightened deployment of the sales force.
Other distribution management accomplishments include wiser use of bank financing, larger order/drop sizes, ongoing customer profitability analysis and disciplined strategic planning.
In spite of all this excellent work, many executives are still unhappy with their company’s return on sales and return on investment. I see many unhappy faces when declaring to trade association gatherings that wholesale distributors should not be satisfied with less than a steady 20-30% (pretax) return on investment, which for most firms equates to at least a 3% (also before tax) return on sales. Top quartile companies in most lines of trade achieve these returns and more, which I would argue is essential for investors in typically low-growth, high-risk distribution enterprises.
How can these clever and hard-working managers do so many things right and still not achieve the holy grail of consistent, top-quartile profit results? I believe the answer is that they have not yet gained control of their pricing. It has been said, “strategic pricing is the next big thing in wholesale distribution”. I agree!
Strategic Pricing: Drinking the Kool-Aid
I want you to wash down all that low-hanging fruit you’ve eaten with the Kool-Aid of strategic pricing. This particular management fruit, however, is anything but low hanging. It will be hard to reach; the journey will be painful for some companies. Embracing strategic pricing may necessitate the most hardheaded wholesale leaders to undergo a ‘deeply moving personal experience’.
One of my speaking topics for distributor audiences is what I call “The Sacred Cows of Distribution”. The purpose of the speech is to point out some of the management dogma that wholesalers accept without question, and to disprove those ‘sacred cows’, one by one.
Without revealing all ten of the sacred cows, I’d like to put the on spotlight one of them right now: lack of pricing discipline. Management needs to regain control of pricing. That statement itself is actually misleading, because it implies that management once had control of pricing – which in some companies is definitely not the case!
The following two graphs depict the current state of distributor pricing. The X-axis is the order quantities of a particular stock item purchased by many customers. The Y-axis is the unit price paid by each customer. You might expect that the data points plotted in the graph will line up nicely, clustered in a logical way as in Exhibit A: as the quantity purchased goes up the price paid goes down to reflect the customers’ buying power and the lesser cost per unit of handling larger orders. Unfortunately (try this with one of your items), the graph often looks more like Exhibit B – the data points are all over the place. There doesn’t seem to be any correlation between customer buying power, order size and unit price.
Strategic pricing makes order of this chaotic situation. The principles of strategic pricing are as follows:
- Distributors have really cool software and powerful computers that can do almost anything we ask.
- Mega and large customers have greater buying power than medium, small and micro customers.
- Customers are much more concerned about prices of the Alpha and Beta items they buy often and in large quantities, than they are about less important items they purchase infrequently and in small amounts.
- Some items are highly visible and easily compared; others have a low profile and are harder to shop.
- Selling prices should be based on the value perceived by the customer rather than the cost the distributor pays to the supplier. (If the product were obtained at zero cost for some reason, would the distributor want to give it away free?)
I have to ask you to indulge me a bit on the next few principles – I know they are close to home:
- Managing the pricing on each item to every customer is not the highest and best use of outside sales rep (OSR) time.
- Incentive sales compensation programs, even straight commission plans, do not change OSR behavior all that much when it comes to the pricing of individual items.
- OSRs do not have the information they need to correctly price every item to each customer.
- Distributors lose a huge amount of gross margin dollars when supplier price increases are not passed along to customers.
- All of the items in a given product category, bought from a particular supplier, or sold to a particular customer, do not need to be sold at exactly the same margin percentage or discount.
You’re incorrect if you have concluded that my argument is to take the outside sales reps out of the pricing loop. They are closest to the customer and get direct input from the marketplace. My premise is that the OSRs have many demands on their time, and don’t have the capacity to be on top of every pricing nuance. Most outside sellers have to rely on their own set of experiences (with their customers only) and their impressions – often out of date – of various competitors and changing market conditions.
The company’s database is comprised of facts from transactions with all customers and suppliers on all products. The computer has the computational ability to extract and organize related information, and to identify trends and construct pricing models.
Strategic pricing is a labor-intensive process in its early stages. Computer analysis is not a substitute for human judgment – computer programs don’t have reasoning skills. Management needs to be deeply involved in strategic pricing.
The basic steps in the first stage of a strategic pricing project are:
- Extract transaction data from the company’s system.
- Analyze the data to understand the current situation and gauge the opportunity for improvement.
- Segment the customers and products.
- Create pricing matrices using the transaction data and segmentation.
Other steps in the strategic pricing process include writing software, if necessary, to automate the ongoing strategic pricing processing on the distributor’s transaction system. Another step may include developing list prices for the distributor’s entire product offering. One of the objectives of strategic pricing is to avoid basing sell prices on product cost.
Strategic pricing is phased in over a period of one to two years. The initial stage is usually limited to micro and small customers, and to lower priority items for some larger customers. Later stages include expansion of the effort to include higher-priority items to larger accounts.
Strategic pricing has been successfully implemented in several wholesale distribution lines of trade over the past few years. Some suppliers have sponsored these programs in an attempt to help their own distributors become more profitable. In a few cases the suppliers themselves engaged in strategic pricing first, and then urged their top distributors to follow their examples.
The results are, in a word, IMPRESSIVE. Several of our clients, and other distributors we’ve interviewed, report sustained increases in gross margin percentage of 150-400 basis points (that is, 1-1/2 to 4 percent). For a $20,000,000 distributor, a 2% increase in gross margin % equates to $400,000 in gross margin dollars. For a $100,000,000 distributor, that 200 basis point increase equals $2,000,000 in added gross margin dollars.
Most of those added gross margin dollars, except for sales commissions, flow straight to the bottom line. In the preceding examples, assuming a sales commission rate of 20%, the $20,000,000 distributor would enjoy $320,000 of additional pretax profit (1.6% of sales); the $100,000,000 distributor would earn an additional $1.6 million (also 1.6% of sales). As a sustainable improvement, an increase in return on sales of that magnitude would launch a mediocre distributor well into the top quartile each year. The dollar and time investment in strategic pricing would be recovered very quickly.
Most of those added gross margin dollars, except for sales commissions, flow straight to the bottom line. In the preceding examples, assuming a sales commission rate of 20%, the $20,000,000 distributor would enjoy $320,000 of additional pretax profit (1.6% of sales); the $100,000,000 distributor would earn an additional $1.6 million (also 1.6% of sales). As a sustainable improvement, an increase in return on sales of that magnitude would launch a mediocre distributor well into the top quartile each year. The dollar and time investment in strategic pricing would be recovered very quickly.
Isn’t it time for you to taste the strategic pricing Kool-Aid?
Brent Grover’s firm, Evergreen Consulting, LLC, advises owner/managers of closely-held distribution and manufacturing companies about the challenges of strategy and ownership succession. Brent, a former national firm CPA and business school accounting instructor, has published several articles about these topics. He was in the distribution industry for over 25 years, most recently as CEO of National Paper & Packaging Co. Brent can be reached through his Cleveland office at 216-360-4600 or brentgrover@evergreenconsultingllc.com.
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