Alongside supply chain woes and labor shortages, the topic of inflation has dominated distributors’ concerns throughout 2022 and most of 2021. As we’ve covered here at MDM, the 40-year high inflationary environment has resulted in a bumper year for most industrial, commercial and construction distributors, as customers have been willing to pay whatever is needed to acquire product as long as distributors can get it to them.

Pricing strategy has gone hand-in-hand with inflation. With so many factors influencing pricing these past two years, its management has become increasingly complicated.

To gain insight on how distributors are navigating the current pricing environment, we recently spoke with Lee Nyari, managing partner of The Innovative Pricing Group, a consultancy offering price management solutions for distributors. He is a seasoned distribution pricing executive with decades of experience leading strategic pricing projects, and his deep distribution industry pricing background is coupled with engagement leadership roles at top-tier strategy consulting firms. Nyari is a certified pricing professional, a certified public accountant and he holds a full-time MBA in marketing strategy from Kellogg School of Management.

MDM: Inflation has been perhaps the biggest topic of conversation throughout 2022. From what you are seeing, how are distributors handling inflation from a price management perspective?

Nyari: It’s been a mixed bag, really. Distributors have been dealing with a lot, from supply chain challenges, labor shortages, and as you say, also inflation. And when it comes to inflation, it hasn’t been just about product acquisition costs. There has been also a lot happening around freight costs, importation costs, labor, etc. Price is the way you capture value and generate revenues, so it has been a challenging time for some distributors to simply keep up with updating their costs and price structures generally, so they capture enough value and remain sufficiently profitable. Because, of course, if you don’t keep up, you won’t adequately capture your value, and your profitability will suffer.

Agility has been key for distributors. To keep up and deal with these challenges, ideally, distributors should have pricing processes that can react quickly to cost changes. But there are many reasons this may not happen. Poorly defined pricing processes, overly manual pricing processes, myriads of exception records, resource constraints — these are just some examples of what can, and at some distributors do, seem to come in the way.

MDM: Is it just about agility, though?

Nyari: Of course not. In fact, most distributors we deal with have some established pricing processes. Most of them have cost-plus price structures that, at least historically, have worked reasonably well in helping them pass on cost increases. And they have some staff who can handle updates.

MDM: So, at most distributors, like those with use cost-plus pricing systems, all is well?

Nyari: Well, often, not really. It is true that using cost-plus pricing in an inflationary environment can be actually somewhat helpful, including with the agility issue. It can be helpful, because at least theoretically, using cost-plus pricing can mean that as cost inputs change, prices change as well. So in theory, there is some built-in agility if you will, and margins may be somewhat protected. In fact, if you look at the long term, historically, rising costs have not been necessarily a bad thing for distributors. Higher costs tend to cause selling prices to rise in the market as well, and this can mean higher revenues and more profit dollars, assuming the distributor’s margin percentage stays the same.

To take a simple example, if a SKU costs $90 and it was historically sold for $100, then the distributor made $10 in profits, realizing a 10% gross margin. If the cost goes up 10% to $99, and the price is raised also by 10% to $110, then the distributor is realizing higher revenues and also a higher $11 profit. So, when these changes happen, this can be good news. This is partially why cost-plus pricing has worked reasonably well for some distributors in the long run.

But in reality, many distributors seem to be struggling with managing these dynamics in the short run. In some markets, inflation has been somewhat sharp, and it has been continuing for some time now. Managing these cost and price updates can really test the distributor’s pricing system — especially when there are other business challenges to address as well. And we are definitely seeing these challenges across the industry. Too many distributors’ price management systems have not been able to keep up. Unfortunately, some of these distributors are often too late to realize that they are behind where they should be when it comes to managing their pricing updates. At these distributors, margins are suffering.

MDM: What are some of the factors that make the difference? Which distributors tend to respond appropriately to these inflationary pressures, and which do not?

Nyari: There are sometimes issues with the operation of the cost-plus price structure itself. Not all distributor cost-based pricing systems operate the same way. Some cost-based pricing configurations carry particularly more risk than others when it comes to managing the current inflationary environment.

MDM: If a distributor is using cost-plus pricing that has been working for them generally, and if cost-plus pricing helps protect margins, what are some reasons they still may be getting into trouble?

Nyari: Some cost-plus price structures are more robust, and they have more credibility with stakeholders, including sales reps. Others not so much. If a price structure has been working only marginally well in the past, it now may be failing the distributor altogether.

For instance, let’s take an example of a business where stakeholders don’t trust the default system price. In these situations, sales managers tend to act as pricing managers. They use exception price records to make things work. They may use manual price overrides, or they may be inputting myriads of special price points as records to be stored in the pricing system. At these distributors, the price structure may be so broken that might be a nearly impossible task to continually and systematically update selling prices to reflect all the cost changes. You can try to rely on managers to update everything, but that can be a nightmare — especially when there are so many changes and competing priorities. These distributors’ weak price structures are putting them at a competitive disadvantage — even more so now than before. Of course, this is something they can correct, simply by upgrading their price structures.

And even if a cost-plus pricing system works reasonably well, there can still be other problems. For instance, some cost — and price management practices are more likely to lead to decision-making problems — meaning bad (or, as we like to say, “sub-optimal”) pricing decisions. Again, not all cost-plus pricing systems are built the same way. The definition of the cost field that is marked up is not the same across all distributors, and how that cost field is maintained can also differ from one business to another. For instance, in calculating a price, a distributor may be simply marking up the average unit costs accountants calculate to prepare financials. These average unit costs may be slow to move, depending on inventory positions and unit volumes.

And even if the distributor may use a different cost field to mark up, like landed unit cost for example, using average cost for financials can still put them behind the eight ball. That is because financials that rely on average cost, or standard cost, can mask the real magnitude of the distributor’s margin problem for too long — and it can cause them to act late. Late actions are sometimes harder to implement.

MDM: Can you clarify: How do average costs and standard costs mask the margin problem’s magnitude?

Nyari: Sure. Let’s go back to the example of the SKU that initially had a cost of $90 and a sales price of $100, and its cost went up by $9. If it is a high-moving SKU, the distributor may have significant inventories on hand — and, in fact, the distributor may even do some forward-buying. So, the average unit cost might not move up so sharply for a while, and it may stay closer to $90. In these situations, if the distributor keeps selling the SKU for a $100, the company’s financials may show decent margins, if they are based on average costs. And believing this rosy picture can be a real problem.

MDM: Can you clarify why this is a problem? It seems like the distributor is making money (e.g., perhaps because they forward-bought), and the financials just show that this is what’s happening…

Nyari: From a certain perspective, like from an accounting perspective, that may seem true. And some distributors may buy into this thinking logic. But, if you look at things from an economic perspective, this line of thinking is arguably flawed.

Once the forward buy is done, the costs associated with acquiring the inventory available for sale — those costs become sunk costs. They may be what current inventory costs show in the books, but those costs are sunk costs at that point. The economic reality is that once the cost of replenishment goes up to $99, whenever a current inventory unit is sold at that point, that sale will eventually trigger a replenishment at the higher cost, say at $99. So if you look at what’s happening from a microeconomics perspective — unless we are talking about a special situation like obsolete inventory (where there will be no replenishment) or something like perishable goods — the distributor’s marginal cost associated with the sale is in reality $99. It’s $99 because that’s what it will cost economically for the distributor to replenish their inventory — you can no longer get that SKU for $90. If all costs are considered — think rep commissions, inventory carrying costs, etc. — at a $100 selling price, the distributor may be actually losing money on these sales. But again, because of the seemingly decent financials, some distributors think the pricing action can wait. But those financials show history rather than the current economic reality.

And don’t get me wrong; maybe the pricing action should wait. Perhaps competitive sales prices have not yet gone up, and moving prices too quickly would put a key customer relationship in jeopardy. That would be an example of why the distributor may in fact decide to delay the price increase. But that’s a different analysis altogether. The point is that cost hikes should be timely passed on, unprofitable sales should generally be avoided, and there should be no delays to price updates unless there is a clear strategic or competitive reason.

MDM: How can some of these problems be avoided?

Nyari: First, recognizing that you have a problem can go a long way. And you are more likely to recognize that you have a problem if you do not blindly accept margin reporting that some accountant may put in front of you. You are more likely to make good pricing decisions going forward if you think more about your current economics and your current markets and you are less focused on what happened last week. Advanced reporting systems can help — for instance, you can re-calculate your margins using different cost fields, and run different “what if” scenarios using current information. Putting the right resources in place is, of course, also helpful. At the end of the day, much of it comes down to the timely updating of those cost and pricing fields and monitoring so that you only delay pricing actions when necessary.

MDM: That makes sense. What else can go wrong?

Nyari: As always with pricing, culture and execution can come. Some sales reps are very nervous about talking to customers about price increases, and some are very quick to discount prices. Communicate, so your front line knows how to respond to customers asking about rising prices. Build their confidence. Let them know why the price increase is warranted. Let them know what you are seeing in the market. Let them know how price increases were accepted by other similar customers in similar markets. If you have relevant information on what the competition is doing, share that as well. Make sure your sales managers are prepared to talk to their customers about the price hike. You can train them, you can do role-playing exercises with them, and so forth.

Monitor what your reps are doing with price. See which reps are discounting away the price increase you may be trying to implement. See where they are discounting, at which accounts, in which markets, on which products, and so forth. See to what extent they are discounting. And then talk to them. Learn about what they are seeing as well, and make adjustments to your own pricing strategies if you need to. If their discounting is cutting into their own paychecks, make sure they understand this. Perhaps give your reps more incentives to keep prices firm. Maybe even look at controls. It just depends — but if the price change is warranted, you can’t allow it to fail in execution. The stakes are just too high.