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Looking for Gold? Prospect Your Pricing System
by Rick Johnson
May 19, 2006

Looking for Gold? Prospect Your Pricing System

 

In dealing with clients we always try to seek out opportunities to have the biggest impact in the shortest amount of time creating the most value. We call it "picking the low hanging fruit." In almost every case we work with to improve profitability, we find low hanging fruit on all the different branches within their pricing system.


Low Hanging Fruit

Here's where we typically find low hanging fruit:

  1. The pocket price band
  2. Self imposed margin caps
  3. Pricing strategy
  4. The quotation process
  5. Negotiations


1. The Pocket Price Band

 


Source: Managing Price, Gaining Profit; Harvard Business Review, Sept. 1992 

The pocket price band is an exercise designed to create a graphic picture of all your pricing activity during a specified period of time on your "A" items.

Analyzing the pocket price band and taking action based on the results can add as much as two points to your overall margin. The vertical axis shown in the graph represents the percentage of business sold at the particular margin listed on the horizontal axis. In other words, in the above example, 6.1% of the business sold during the specified period was sold at 16% margin, 4.8% at 17% margin, 12.4% at 18% margin, 15.2% at 19% margin and so on.

So What Does This Graphic Tell Us?

First of all, it tells us that the street price margin on your "A" items during this period happens to be between 18 and 21%. Approximately 71% of your sales fell into this category. Your peak street price came in at a 20% margin but you can't change the street price. The street price is set by the dumbest competition in the market place. It is your job to make sure that you are not the dumbest competition. What you can do is analyze those sales that fall on both the upper and lower side of the peak street price margin. In other words, look at those orders that were priced at a margin of 16, 17 and 18%. Determine how that price was calculated. What were the justifications, if any, for pricing at a lower margin? Chances are that most of these lower prices can be justified and were necessary to secure the business. However, chances are just as great that a number of these prices aren't justifiable and were not necessary to secure the business. This is where you learn to improve your margin and increase the price on future business. In fact, in some cases you may decide to walk away from that business. You then apply the same concept to the upper side of the price band and analyze the orders received at 22% margin and higher. What did you do right? Did you charge for value added services that you gave away at the lower end of the price band? If you can shift your price band scale more to the right and get many of your lower band pricing up to the street pricing, you could increase your margins by as much as 2%.


2. Self Imposed Margin Cap

It is a given that if you go through this exercise and create a chart as shown above for each inside sales representative and each outside sales representative who has pricing authority, that most of your graphs will come out as a typical bell curve. However, it is just as likely that one or two of your sales reps will come out with a graph that demonstrates they have a self imposed mental margin cap (MMC), "I can't charge my customers more than a 30% margin. That would be gouging them."

Some sales reps just don't understand that profit is not a dirty word and that unbundling your services is the only way to ensure growth and stability. Of course, you shouldn't gouge your customers, but that doesn't mean you need to give away services for free or give up a purchasing advantage you have gained from critical mass or preferred supplier status.

Educating and monitoring sales staff that may suffer from MMC can add points to your overall margin.


3. Pricing Strategy

So, what is a pricing strategy? What is involved? A pricing strategy is nothing more than determining how you are going to price your product in the marketplace to maximize profitability. That sounds pretty simple. The complexity of the issue comes into play when you start looking at all the factors that may play a role in determining your strategy. Those factors start with knowing your competition. Remember the statement that "market price is set by the dumbest competitor." Knowing your competition and what their objectives are plays a key role in determining your pricing strategy.

Answering these questions will give you insight into building your pricing strategy and determining the components of your strategy and how they will be used. A pricing strategy starts with a defined quotation process with analytical report capabilities. We'll discuss the quotation process in more detail later in this article. Typically there could be three or more components to a pricing strategy as indicated below.

To create a pricing strategy you must understand and identify the internal costs of your organization. In layman's terms, costs are either variable because they change with volume and the activity of your business, or fixed because they remain constant regardless of volume or activity. In reality, very few costs are completely fixed or completely variable.

Activity based costing (ABC) is a tool that can relate costs to individual activities or transactions. Although powerful, it is a complex subject and should be studied independently.

Pricing Decisions Based on Cost of Goods

For demonstrative purposes only, let's assume the average distributor buys an item for and sells it for 0 making 25% gross margin dollars and a 25% gross margin. Twenty to twenty two percent goes into operating costs and the distributor ends up with 3 to 5% pre tax profit.

Price increases are one of the most powerful means to increase profit. A price increase using the above example means selling at 1 while the cost of goods remains at . This increases margin to .00 and pretax profit now becomes 4 - 6%. This is more than a 20% increase to the bottom-line.

Cost Plus Price Increases

Cost

Selling Price

GM$

GM%

$ 75

100

$ 25

25.0%

$ 75

101

$ 26

25.7%

$ 75

102

$ 27

26.4%

$ 75

103

$ 30

29.1%

A increase equates to a 20% increase in the gross margin dollars. If no other factors change and that additional made it to the bottom line, then the increase in net profit is substantial.

A key principle you must not ignore is the protection of your purchasing advantage. If your sales reps are charged with a 20% gross margin target and their cost of goods is , they will sell the product at . However, if you happen to make a great buy at , chances are some of your sales reps will give most, if not all, of that advantage away even to existing customers by selling at .00 X 20% GM = 9.60.

Matrix Pricing

Matrix pricing is nothing more than a pre- determined spreadsheet that enables you to set different prices for unique combinations of customer types and product categories. The key profit leaks that exist in virtually every pricing matrix come from failure to maintain the matrix with current, timely increases. Another leak is generated by the self-imposed authority often assumed by the inside sales reps to shift column pricing in an effort to be more competitive and please the customer. I once had an owner tell me he tried two experiments with his pricing matrix. First, he increased every price by 2% and did not tell anyone. Second, he shifted his pricing one column to the left so when inside sales backed off a column, they ended up selling at the initial desired price anyway. He swore nobody even noticed for six months and his margin went up by 2.3%. Maintain your matrix, review it regularly and monitor the pricing activity. "There is gold in them thar hills."

Unprofitable Customers

It is a good idea to analyze your customer base each year to determine where you are making money and where your expenses exceed the profit you generate independently on each account.

As a distributor, you have limited resources available to service your customer base. Inventory management is critical, cash flow management is critical, cost containment is critical, and a definitive pricing strategy can be your "edge" in creating competitive advantage.

If your organization is not skilled in activity based cost analysis you might try to determine your most profitable customers using a simpler approach. This approach uses basic calculations to give you some sense of where your money comes from and where it goes.

Most of your cash is tied up in inventory and accounts receivable. Consequently, you need to be disciplined enough to ration your cash investments to only those customers who provide a return.

The following steps describe the simple calculation:

· Determine the average cost of processing an order in your business. What is your cost to process an order, pack it, ship it, and collect payment? Each of these stages has internal costs that you assume are covered in your pricing matrix schemes. For most distributors, the cost to process one order completely is between -50 per order.

· Determine key figures for each customer.

1) Total sales
2) Total cost of goods sold (COGS)
3) Gross margin dollars (item 1 minus item 2)
4) Number of orders processed per period

 

 

Not surprisingly, the Paretto Rule often applies here also. You may get to zero and negative contribution after about 20% of your customers have been analyzed. It is this remaining 80% that have some negative impact on your bottom-line profits. Eliminating 80% of your customers based on this exercise is not realistic. However, you certainly might want to analyze how you are doing business with them. Look at all the customers with a negative net profit and determine what their rules of engagement are and what changes can be made to improve profitability.

Pricing Enhancements

Set a new pricing policy that will segment your customers according to Service Output Demands and then reward your large customers.

 

 

 

 

 

Order Value

Gross Profit

0 to 0

$ 30 + 50% GP

$ 100 - $ 500

$ 30 + 40% GP

$ 500 - $ 1000

$ 30 + 35% GP

$ 1000 Plus

$ 30 + 25% GP
 

 


How to make enhancements stick

 

 

o       Proud of new pricing policy

o       Big guys have been carrying small guys

o       Not anymore; pricing will now be more competitive

o       If you're above the threshold, you are exempt from new pricing; others will be charged for some services

 

 

To request a sample price increase letter that your profitable customers may "welcome" since you are taking action against the predominantly smaller customers who are sucking up your resources without paying for them, send us an email at info@ceostrategist.com.

Before you decide to fire any customers, add to the equation their accounts receivable balances and payment histories. What you may find is that not only are you not making any money on their orders, but you are also financing them with your accounts receivable. Look at what products they are buying and make sure you are not stocking products exclusively for their account. Unprofitable customers should not get special services. Once you have determined which accounts are not profitable you have several options:


4. The Quotation Process

"Your customer has no need for you to make a 'fair' profit unless there is no other distributor willing to take your place."

A sobering thought, but one that we should keep fresh in our minds.

If we do not have a vehicle, a scorecard or some methodology to determine how we are doing, then we are driving through a tunnel with our lights off. Not having a formal quotation process increases our chances of becoming the dumbest competitor in the market, giving away the margin.

Quotes have to be recorded with a timeline lifespan. Preferably, your IT system supports this activity and allows you to turn a quote into an order quickly and easily.

If it does, chances are you can create a number of scorecard tools to determine what exactly is happening in your market from a competitive standpoint. These tools include:

Quote kill rates and a trend analysis are two of the most important tools to understand the effectiveness of your pricing strategy.

Are you Market Based?  

Quote Kill Rate =

Total Business Booked

Total Business Bid

 

Month

J

F

M

A

M

J

J

A

a. QKR

12%

30%

20%

22%

24%

25%

18%

16%

b. QKR

12%

30%

20%

22%

24%

25%

29%

35%

  

If your kill rate is high it may indicate an opportunity to raise prices. If it is low you may need to lower prices. Of course you should investigate all factors before coming to that final conclusion. If you track your kill rate by month it can give you an indication as to what may be happening in the market. If your kill rate rises dramatically, again, you may be lagging in a market that is demanding a price increase. Conversely, if your kill rate drops dramatically, it may mean that market prices have dropped and you are not in sync with what is going on. Keep in mind this is an indicator that is telling you to investigate. Do not react impulsively without getting all the facts.


5. Negotiations

Contrary to some beliefs, negotiations in distribution are not about:

Negotiation in distribution is about the exchange of information and action planning that results in a mutually beneficial exchange of resources between two companies. There are five underlying facts you must understand when you are negotiating:

  1. You are negotiating all the time.
  2. Everything you want is owned or controlled by someone else.
  3. There are predictable responses that you can count on in the negotiating process.
  4. There are three critical factors in every negotiation - power, information and time.
  5. The proper mesh of personality types is important to negotiating success.

Negotiating is not just about price. You negotiate many things with a customer including the rules of engagement which is how you are going to do business together. The better your relationship the more predictable the responses both you and the customer perceive. However, you must never forget that the buyer you call on has most likely been trained in the art of negotiations. That is his job; his job has three basic elements:

  1. Ensure a reliable source of supply.
  2. Ensure quality meets requirements.
  3. Without compromising items 1 and 2 above, minimize raw goods inventory and purchase price.

You should recognize that 90% of performance related buyer terminations occur for failure to perform items 1 and 2 and not because of the price he pays. That is a very important fact to remember when negotiating. Remember, the buyer has been trained to develop a rapport with you and then tell you your price is too high. Believe it or not, many professional buyers will keep a log on how you respond to the statement, "Your price is too high." That is why it is extremely important that you not only understand the difference between price and cost but that you also have the ability to educate your customer on the difference between price and cost. There are numerous classes available on negotiations. It is worthwhile to attend one.

Profit Without Pain

Profit without pain is what it's all about. There may be a lot of hidden profits waiting for you to find them lurking within your pricing system itself. The good news is that this can produce tremendous gain with little pain. Go look at what you are doing and how you are doing it. Find out if a customer can call your place of business and get different prices based on who answers the phone. Establish some goals, create a strategy and then execute that strategy. You may be very pleasantly surprised at how much gold is there just waiting for you to sift it out.

Sources:

1)      Pocket Price Band Chart - Harvard Business Review, "Managing Price, Gaining Profit," September 1992.

2)      Underlying Facts of Negotiation - Roger Dawson's Power of Negotiating.

 

www.ceostrategist.com – Sign up to receive “The Howl” a fre*e monthly newsletter and get your choice of "CEO Strategist's Hiring and Interview Guide" or "The Guide to Effective Training Sessions", valuable resources for all levels of management. The Howl addresses real world industry issues. – Straight talk about today’s issues.  Rick Johnson, expert speaker, wholesale distribution’s “Leadership Strategist”, founder of CEO Strategist, LLC a firm that helps clients create and maintain competitive advantage. Need a speaker for your next event, E-mail rick@ceostrategist.com.

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