A pricing process should help distributors achieve healthy margins where they are warranted and ensure their cost to serve does not get out of control. This means focusing on a critical set of customers. With the right tools and data to offer customer-specific prices, as opposed to one-size-fits-all prices, a well-educated sales force will capture higher margins. During this crisis, your pricing process can seek to control:
- Over-discounting based on the perceived benefits of volume. (Avoid the classic topline approach.)
- Over-discounting due to fear of customer churn. (No, we do not need all customers.)
- Undercharging for or over-delivering services. (Balance value creation and value capture.)
Pricing can be a complex and multifaceted process. However, if you seek to optimize the information and actions of all influencers with a process that employs the right data, you can achieve clarity, understanding and superior profitability. To help with your margin recovery, we have identified five rules for your success: visibility, control, ownership, focus and balance.
Rule of Visibility: You Cannot Optimize What You Do Not See
Your people cannot optimize what they cannot see. At the same time, it’s not practical to provide them all the cost elements before they gravitate to a price and offer quotes to customers. What’s the solution? Breaking down the price equation. Generally, we only pay attention to the gross margin percentage and dollars. However, there are more ingredients to the price equation. If you try to optimize the result (the recipe) without optimizing the pricing drivers (the ingredients), you are setting yourself up to fail. Let’s break this down:
- What your salespeople see: Price = Cost of Goods Sold + Gross Margin
- What your CFO or pricing analyst sees: Overall Profit = Cost of Goods Sold + Gross Margin – Cost to Serve + Vendor Rebates – Customer Rebates/Discounts
Start applying the rule of visibility by providing information about your customer types with customer segmentation. This segmentation is the first step in getting to a stable pricing process. Use more than sales to segment your customers (sales, cost of goods sold, gross margin and cost to serve). Possible categories include: core, opportunistic, marginal and service drain. Doing this will help you be consistent with price, at least across customer segments, and begin streamlining your pricing process overall.
A container distributor based in Atlanta segmented their customers into four groups: high volume (21% markup), high growth potential (23% markup), low volume (30% markup), and low growth potential (27% markup).
They set up pricing actions that they internally called the 4i plan:
- Insulate (low growth potential and some high-volume customers): Protect and insulate these customers from the competition. They receive the best price — always. Minimal price increases are recommended periodically (1%-3% price increases).
- Increase (high growth potential customers): The sales force will aim to increase business with them. Controlled price reductions are permitted to gain volume and increase market share.
- Identify (high growth potential and some high-volume customers): The sales force will identify five customers who are high growth customers and put a pricing plan in motion.
- Investigate (low volume and some low growth potential): The sales force is requested to investigate the reason for doing business with them. If nothing works, they will receive the highest price, and inside sales will work with these customers.
Rule of Control: You Cannot Preserve Profit If You Do Not Lock Costs
Establishing a cost-lock is a must for pricing discipline. Cost-plus pricing has been a staple approach for distributors, and it will continue to be so, but how it’s applied can make or break your bottom line.
Distributors always complain that there are too many prices in the market that they provide to customers. The immediate reaction is to point fingers at the sales team. We fail to realize that there is as much cost fluctuation (cost of goods sold) as there is price fluctuation. Our value to procure items from vendors varies significantly based on time, allocation, lead-time, volume, payment terms, freight terms and more. However, we maintain a cost in the system that changes, either going up or down. This cost may be called replacement cost, next buy cost, standard cost, average cost, and so on. The price to buy from suppliers may go down because of the purchasing team’s efforts. When that new cost is in the system, the problem begins.
Let’s look at these common scenarios:
- If the cost of the item is $80, the sales team does a cost-plus to markup by 25%. The resulting price is $106.67.
- If the purchasing team makes a huge volume buy and it lowers the cost of the item down to $70, the resulting price with the same 25% markup is $93.33.
What did we just do? The purchasing team optimized the buying cost, and the pricing process just deoptimized it. We gave away the savings and much more to the customer. Unfortunately, this process has been automated for most distributors. Automating a fractured pricing process will take you down. Lock in the cost for a specific period to avoid this breakdown.
Rule of Ownership: You Cannot Achieve Results If You Do Not Create Accountability
Creating accountability and transparency in your pricing process is essential. Only 1 in 15 distributors today have someone responsible for pricing. When we say responsible, it’s not just about having pricing in their job title, as in pricing analyst (most common), pricing manager or director of pricing (less common). This person should wake up thinking about pricing, be able to communicate to sales and operations effectively, and influence pricing at the field level. This person should also help identify and define the variables that drive pricing decisions.
It’s often difficult for pricing analysts to play this role. So, to fill the gap, many companies introduce new pricing software or technology. But distributors also like to be in control and have ownership of every tool and product they purchase, which in effect turns these pricing tools into “black boxes.” Without proper access to and understanding of these tools, their value won’t be actualized, as many people are averse to using tools they don’t understand. Establishing the role of Chief Profit Officer, Chief Pricing Officer and other similar titles has helped companies create accountability for developing others’ understanding of any relevant pricing tools and processes. Such a pricing leader can communicate with marketing, sales and operations to achieve common pricing goals based on strategic metrics.
We all agree that technology, in some form, is required to manage and optimize pricing. However, when technology is left in the hands of untrained individuals, it is not sustainable. Companies must share what is driving the pricing recommendations, exercising transparency and offering education and training or bringing in a new system will not solve the problem.
Rule of Focus: You Cannot Win Big By Not Starting With Your Core Business
Avoiding margin erosion in your core business is a perennial challenge. Value creation for distributors primarily comes from customers, inventory and suppliers. Distributors cannot address one without the other. For instance, when an item’s inventory is reduced by the purchasing team, the sales force might express concern that the reduction will affect their top customers. These teams might work together to fix the issue, but then the supplier management team could express concern that reduced inventory will affect their volume discounts with key suppliers. Commonly, this results in intense negotiations with suppliers and unsatisfied customers. Having unsatisfied customers often drives distributors to lower prices and give up on prioritizing value creation.
To avoid losing sight of value creation and spiraling toward uncontrolled pricing, distributors can consider customers, inventory and suppliers at once, rather than separately. It’s time to separate the value from the noise to stabilize pricing in your core business, remembering that those firms which handle complexity well will be better equipped to maintain healthy business and attain profitable growth.
Rule of Balance: You Cannot Ignore the Role of Autonomy and Management
Sales management and pricing autonomy are two independent influencers of profitability. Pricing autonomy can be at two levels:
- Low-level autonomy, in which case salespeople have less power to change price
- High-level autonomy, in which case salespeople have more control over price.
Sales management has two levels:
- Low-level management, in which case they have little to no access to tools/guidance.
- High-level management, in which case they have greater access to tools and guideposts.
Creating a two-by-two matrix of sales management and pricing autonomy results in four possible “zones.” First, identify your zone by knowing where you reside across these two influencers. Depending on the zone, your investments, strategies and tactics will vary significantly. The majority of distributors fall in the “Competition” zone. The four zones are as follows:
- Consistency (High-High): Process guidelines drive long term pricing sustainability. An indispensable pricing band is provided to guide decisions. Cost-to-serve is kept under control.
- Compensation (Low-Low): Pricing individual or team is present. Customer segmentation is rudimentary (sales-based). Communication with salesforce is through compensation.
- Competition (High pricing autonomy and Low sales management): Pricing practices are inconsistent. No clear value proposition and customer conversations revolve around price. Competitors drive pricing decisions. Most distributors are in this zone.
- Control (Low pricing autonomy and High sales management): Pricing decisions are more disciplined. The focus is on market share growth. Management by objectives (MBOs) is a vital part of sales compensation.
These five rules are the pillars of your pricing strategy. In times like this, a pricing reset is vital for your business survival. As you race for topline (revenue) coming out of this crisis, you do not want to sacrifice margins by not focusing on your pricing tactics.