Implementing an effective pricing strategy can be one of the best ways to achieve better gross margin. This article outlines a pricing model developed by Texas A&M University’s Supply Chain Systems Laboratory and provides a look at how some distributors are using it to update their pricing strategy.
 
About three years ago, F.W. Webb, a regional distributor of plumbing, heating, cooling and piping products, took a part of its legacy IT system and dedicated it to improving the customer and product information available to salespeople.

About a third of our prices were being set manually by salespeople,"says Lawrence Mohr, the distributor’s now-retired senior vice president of information technology. "We needed a way to provide information to inside sales so they could make a better pricing decision in a 10-second time frame."

The distributor became involved with a Texas A&M University consortium focused on pricing and profitability. As a result of that project, the Bedford, MA-based F.W. Webb decided to move forward with a model created by researchers in A&M’s Supply Chain Systems Laboratory based on two years of work with consortium members.

The result, Mohr says, was a program that uses variables already in F.W. Webb’s system, such as actual sales and profitability of a customer. "Our system says this is the classification for the customer for this product, and here is the recommended price."It is broader and more mathematical than models F.W. Webb has used in the past, Mohr says.

"The model is not designed to replace the salesperson,"says A&M researcher Pradip Krishnadevarajan. "It is designed to provide the required information in a concise manner so the user doesn’t have to go back and look at several different screens. There is no time to do that. The system is the science. And the user brings in the art to make an effective pricing decision."
 
How It Works
In a time of economic uncertainty and volatile costs, pricing is top of mind for many distributors like F.W. Webb. Many have already cut as much as they can, and now are looking for longer-lasting solutions to preserve and expand their gross margins.

Some of the standard pricing methods – cost-plus or list-price-with-a-discount, or a combination of the two – are not necessarily the best ways to ensure continued profitability.

Texas A&M devised its pricing model so that it could be implemented on any IT system. The model uses variables related to:

• customer type
• inventory stratification
• frequency customers buy a product
• product costs
• historical gross margin levels

All of these variables are typically readily available in any distributor’s system. The model also works in the cost of serving a customer.

In short, these variables drive a set of pricing rules that are focused on the customer, product and location where the purchase is being made. The rules help salespeople make better decisions under the gun.

"We don’t get into software development but instead leverage technology as a means to an end,"Krishnadevarajan explains. "It’s a transfer of knowledge to the distributor’s IT person or provider. We provide the blueprint on what needs to happen and provide guidance on implementation and the education of their employees."

The flexible model helps distributors like Engine Warehouse Inc., Houston, TX, adapt the concept to their needs.

Instead of putting in a new pricing strategy across-the-board, the distributor is doing it piece-by-piece. The two-location company started small by using the A&M framework to set prices for one line that was up for a price update mid-year.

Engine Warehouse President Robert Graham says on that line in the first month -July 2008 -the distributor saw a 1.5 percent improvement in gross margins. This month, the distributor has seen improvements on top of that.

"It’s a good indicator of the power the framework has,"Graham says. "We’ve realized the gains, and we are going to expand on them. We didn’t go in and throw everything out and start over. Change is difficult for everyone. To be able to make slight changes in how you do business and realize profit improvements, nothing could be better than that."

The company plans to push and broaden the concept through the rest of the business, including examining pricing and service levels based on customer type.
 
Shedding Subjectivity
F.W. Webb’s Mohr says that the A&M model takes some of the subjectivity out of pricing as it classifies customers based on actual recorded behavior.

"The salespeople may feel that they are familiar with whether a customer is good or not, but when you have thousands of products and hundreds of customers, there is no human being that can integrate that information,"he says. "But the computer can calculate that in a split second."

The weakness in F.W. Webb’s old model, according to Mohr, is that the variables that determined customer types were subjectively set by branch managers without the integration of historic sales, volumes and profitability. There was simply too much data to manually consolidate.

One of the key points in A&M’s model is gaining real visibility into the cost to serve each customer. "To be profitable, you have to understand your total costs,"Mohr says. That means including freight, salary and wages, invoicing and infrastructure costs. It also includes how expensive it is to serve each customer based on that customer’s behavior.

"Few salespeople say they sell below cost, but they often do,"says Paul Sommerfeld, director of applications and training for Communications Supply Corp., a WESCO International company, which plans to integrate parts of A&M’s model into their current pricing setup.

"When it comes to margin with salespeople, the biggest hurdle is psychological. Many don’t understand the cost factor behind the pricing they are giving. They are in a way going to feel guilty about offering a substantially higher price on a higher-service, lower-volume item."

Traditionally, one of the best ways to determine how much it costs to serve a customer is Activity Based Costing. The method is effective but it is also complex and time-consuming. F.W. Webb already used the ABC method. But Krishnadevarajan says A&M wanted to develop a simpler methodology to provide the same information for distributors who had not yet taken that step.

The A&M researchers in their cost-to-serve model used variables such as average days to pay after an order is shipped; the ratio of products a customer brings back after buying; the number of line items per order; the percentage of C and D products the customer accesses; percent of orders picked up or delivered; and so on.

Using a scoring method (1-5), distributors can assign a 1 to low cost-to-serve attributes up to a 5 for high cost-to-serve. For example, if a customer takes 10 days to pay, he might receive a 1 for that variable, while a customer that takes 65 days to pay may receive a 5. And the distributor can weigh the variables for their importance.

The system essentially mimics the idea behind the ABC method, but does not provide a dollar amount per customer as the ABC method does. Instead, it provides a general guideline for where customers fall on the cost-to-serve spectrum.

Brent Burns, vice president of family-owned ISC Building Materials, Dallas, TX, sees a lot of value in this concept for his company.

The 13-location distributor is dealing with a perfect storm of falling commodity prices (lumber) but rising transport and other costs -one of the reasons the company is re-examining how it does pricing and looking at ways to better manage its cost-to-serve.

ISC has just started adapting the A&M model to its system with the help of its current technology vendors. For Burns, the process is a win-win. "Even if we don’t get to full implementation, we will still have learned a lot about our customer base and where our profits come from. We will be able to base decisions more on facts and less on gut,"he says.

Customer Types
After determining Total Cost of Ownership, distributors are better able to define customers. A&M defines four types: core, opportunistic, service-drain, and marginal.

Core customers have a high sales volume and low cost to serve and comprise on average 5 percent to 10 percent of the total customer base. They are loyal and buy frequently. Without them, a distributor can’t survive.

Opportunistic customers, comprising 2 percent to 5 percent of the total base, buy infrequently and often come to a distributor when a competitor does not have what they needs. This customer is willing to pay a higher price, and brings in higher margins.

Service-drain customers have loyalty and a high volume of sales, but are hard negotiators. They have a high cost to serve so result in low gross margins. They comprise about 5 percent to 15 percent of the customer base. "At the end of the day you are paying them to take the product from you,"Krishnadevarajan says.

And the largest group of customers, marginal customers, makes up about 50 percent to 75 percent of the base. They buy infrequently, present low sales volume but have a high cost to serve. They require low prices and/or high service levels. Krishnadevarajan says it is possible to move customers from one type to another in the matrix. For example, you may want to ask opportunistic customers why they don’t buy from you regularly.

Perhaps you don’t carry a key product line they need. Or maybe they need better pricing. Setting up customers in these categories helps salespeople to determine which targets to spend their time on. Some companies are firing unprofitable customers, but there may be a better way to approach that customer segment. "We don’t want to fire customers,"F.W. Webb’s Mohr says. "What you want to do is adjust how you work with the customers."

For example, consolidate invoices; instead of sending an invoice for each order, agree to send two a month. Or cut down on deliveries and visits by customer employees to the counter.

Each of these moves can save both the distributor and the customer time and money. Mohr says training employees on customer type is important to making this work.

Getting Buy-In
As we published in MDM last year, the "make-or-break"issue in pricing strategies is often an organization’s ability to implement them.

Everyone has to get on-board to implement a shift in pricing strategy. In any distribution business with more than one branch, this requires bringing managers into the loop.

Al Bates recently told MDM that branch managers should be treated as if they are running a "mini-business."They need to be educated on how to run such a business and be compensated for overall performance,"says Bates, author of Profit Myths in Wholesale Distribution.

F.W. Webb seems to subscribe to this philosophy. When asked whether all the employees backed up the change the company made in pricing from the start, Mohr says "No way."Many initially responded with "We’re already doing that,"or "You have never dealt with the personality of this customer."

To avoid pushback, the company approached the managers in a way that gave them much of the power. The more "experimental"managers were approached first, Mohr says. They would try the new concepts at their branches and provide feedback.

After the program was honed, the distributor solicited more participation, using the results from the test branches as an example of the system’s effectiveness.

"It was not a top-down approach,"Mohr says. "The managers adopted the new system when they were ready. We, however, might force them to use new features in the software, like giving managers control over how much gross profit salespeople give away. But this feature was an improvement suggested by the managers themselves."

Mohr recommends involving IT in the process from the start "in a big way."The IT department should work with the other stakeholders in developing the strategy to ensure the company is moving in the right direction and that everyone is on the same page.

In the same vein, Engine Warehouse sent its vice president for sales to the A&M pricing optimization seminar. The next step is reviewing the new pricing framework with Engine Warehouse’s salespeople, spread across six states, at its next sales meeting. The company will reinforce the concepts with Webinars.

ISC’s Burns plans to utilize outside help for training: "I want to get away from the feeling that a parent is trying to tell his children how to do things."A third party with expertise in the area who also knows how to teach is ideal, he says. Burns is optimistic moving forward that ISC will see success. "I have high hopes based on what I am hearing in other sectors of distribution."

One of the benefit’s of A&M’s recent research, according to CSC’s Sommerfeld, is that it can be applied to any business. "Any investment in pricing optimization can pay large dividends,"he says. "Distributors should make a commitment, start simple and then enhance it."
 
The researchers at Texas A&M were led by Krishnadevarajan, industrial program director Barry Lawrence, Sivakumar Sellamuthu and Brijesh Rao. Go to readcenter.tamu.edu for more information on upcoming A&M programs.