Many distribution leaders, investors and analysts line up to praise companies that consistently raise their gross margins. High gross margin and EBITDA percentages are often seen as measurements of management quality.
Sit in on an operating review at a big distribution company and, in most cases, there’s a lot of planning around how to improve gross margins. Even if the focus of the discussion is EBITDA growth, the path to getting there is through price increases.
Leaders have various ways of driving margin growth. Some talk about it in terms of getting paid for the value the company is adding. Others demonstrate that even a small increase in gross margin is significant because it’s pure profit dropping to the bottom line. That means if you run a 10 percent EBITDA business, a 2 percent price increase improves your profitability by 20 -- to 12 percent EBITDA. Gains like that are really hard to find. Additionally, it’s absolutely true that many customer-facing employees give away discounts not required in many situations.
Add all this together and the bottom line is that executives push price increases to help the bottom line.
And yet, there’s a contradiction in such approaches. Many of the same executives who are teaching “sell on value” then turn around and demand “most favored nation” pricing from their suppliers. Additionally, most of us do quite a bit of price-shopping for our personal purchases.
In other words, we want our customers to be willing to pay for value beyond the price of the product but we don’t want our suppliers (at home or at work) to sell to us that way.
It’s easy to say, “That’s just business,” because – after all – what great general managers do is drive profits by creating a gap between revenues and costs. However, like all business principles, a focus on gross margin growth can be taken to an unhealthy extreme.
Consider these possibilities:
- It’s impossible to know the tradeoff in sales losses incurred by raising prices. No distributor can reliably measure lost sales but every company in our industry is subject to the law of price elasticity of demand. When you raise prices, you lose sales. This is a real loss even though you can’t measure it.
- High margins are inconsistent with market share growth. If you have a small share of a large market, you might wish to grab more market share instead of raising prices. This is particularly true of industries facing consolidation – the big players win in such circumstances and so rapid expansion is essential to building enterprise value.
- Raising prices is not the same as maximizing profitability. A lot of factors go into generating EBITDA or net income for a distributor, not just gross margin. You need to keep down operating costs, of course, but you also have to fund working capital and build volume to leverage off of your fixed cost base. Raising prices can create resistance to getting these gains.
As pricing guru Bob Sherlock points out, pricing decisions are not made in a vacuum – customers and competitors are watching and reacting. This reality is typically not factored into models distributors develop to forecast the effects of raising prices. These spreadsheets usually assume little to no sales erosion but cannot take into account how competitors might exploit your decision to charge your customers more money for the same products.
I completely understand that there is a large opportunity for most distributors to manage pricing with greater discipline. There’s often no correlation between prices charged and order sizes, for example, even on the same SKU’s. However, most of these initiatives start out as margin enhancement projects as if it’s always and obviously the right thing to raise prices. Even the implementation of the projects is usually focused around training sales and service people how to charge more.
Certainly, most distributors need to manage their pricing with greater discipline – that’s important even just to be consistent with your customers. However, I have two suggestions for distribution leadership teams:
- Don’t assume that higher margins maximize profitability. Gross margin and EBITDA dollars are more important than high percentage rates. You put dollars in the bank, not percentages. You need to figure out the combination of sales volume and rates that optimizes your dollars.
- Carefully consider the gross margin and EBITDA percentages you need to accomplish your strategic goals. For example, if you have a small amount of market share, you should consider lower gross margin rates to drive share growth. If you have large market share, this is probably not very important and you should go ahead and wring profits out of your existing P&L.
In any case, carefully consider the broader implications of raising prices – you can almost always improve financial results in the short-term with higher gross margins. But you might be sacrificing long-term performance if you are not very careful and deliberate.