Ensure Your Contracts Are Profitable in the New Year – Intelligent Sales and Profit Acceleration #2
It’s no secret that contracts are a great way to secure valuable business for distributors. For many companies, they account for a significant portion of annual revenue and are critical in bringing in key customers. Unfortunately, if they are not managed carefully, contracts can become an area of business where profit leaks or slips through the cracks.
There are two main culprits that undermine the profitability of contracts, or customer-specific pricing agreements (CSPs): inadequate contract price management and customer cherry-picking behavior. These commonly drain profitability from distributors’ contract business. Remedying and preventing these issues require a structured process, which we’ll explore in this article.
Formalize a Contract Management Process
One of the major challenges in contract management is the significant administrative requirement. After all, hundreds of CSPs might have hundreds or even thousands of line items each. Because many distributors do not have dedicated resources to drive the process, they resort to reactive measures. When it comes time to renew, the easiest path is simply rolling over CSPs as is. Doing so, however, creates costly profit erosion over time. There are several reasons why, including:
- Rolling expiration dates of CSPs that are challenging to manage over time
- Fixed net pricing causes margins to go down as costs increase in the market
- Broadly applied discounts to low-sensitivity products and customers commonly sacrifice one to two whole margin points
It’s best to review CSP performance throughout the year instead of waiting to do so in the last quarter. Incorporating a formal review process for CSPs allows you to adjust accordingly, as needed, before it’s too late.
When you review your CSPs throughout the year, segment customer and product combinations based on price sensitivity. Larger customers with high-visibility products, which are highly sensitive to price increases, commonly account for about 60% of revenue and 20% or less of line items. Apart from keeping pace with the market increases, there is generally not much to fix here.
Low-visibility products that are sold to smaller customers typically represent the 40% of revenues and 80% of line items. This is where it’s worth some effort to prune wasteful product additions and remediate excessive discounting. These customer-and-product combinations should be priced closer to typical non-contract pricing, making your contracts significantly more profitable overall.
Many low-revenue contracts where customers purchase low-visibility products began with higher performance expectations which they’ve not lived up to. When you look at the revenue and profit generated from them over time, it becomes very clear that the aggressive pricing available on them is often unnecessary or even inappropriate. These are areas where adjustments can make a big difference in your bottom line.
Watch Out for Cherry-picking Behavior
A common contributor to underperforming CSPs is cherry-picking by the customer. This occurs when the customer chooses to purchase certain products from your contract while choosing to buy others from your competitors, resulting in a contract not delivering the intended results. In these cases, the products actually purchased often don’t provide the distributor with a diverse, profitable market basket.
To remedy cherry-picking on a contract, distributors must uncover its root cause. It could be that the wrong product is specified, the price is wrong, or product availability is poor — all of which may prompt the cherry-picking behavior. Another reason for this behavior is the CSP may have been set up with across-the-board aggressive pricing, and the customer is only using your contact to buy the specialty, hard-to-find items.
It’s important that your sellers facilitate a conversation with these customers to understand why cherry-picking is happening. This helps you understand your customers’ purchasing patterns and allows your company to better serve them. To get the most out of these conversations, equip your sellers with data-driven targets and recommendations for remediating the cherry-picking issue. It may be a matter of expanding the products sold on the contract or adjusting the pricing to align with its actual sales volume.
Cherry-picking happens because a customer’s expected purchasing patterns aren’t understood and CSPs aren’t closely monitored. Work to address both root causes.
Recover Contract Profitability
Distributors who are proactive in managing their CSPs with a structured process benefit when their contracts meet revenue objectives while remaining profitable. Work to fix existing issues while also building a process that will prevent them from happening in the future.
If you’re interested in a deeper dive into this topic, you can view a recording of our recent webinar, Ensure Your Contracts are Profitable in the New Year.