Everyone knows that distribution is a thin-margin business, with net operating profit averaging around four percent of revenues. Even elite distributors struggle to attain or sustain double-digit levels (aside from those in certain specialty market segments). With these thin margins, every point counts.
A four-percent company that consistently gets one margin point more across thousands of customer and product invoice line-items becomes a five-percent company while a company that consistently loses one margin point becomes a three-percent distributor. In this challenging environment where small business decisions add up to significant improvements, no other profit lever in the business – not sales, cost of goods, or operating expenses – has as dramatic of an impact on net profit as pricing. Based on the math, you’d think that the average distributor would have the most sophisticated, robust, market-based pricing system possible, with deep analytical rigor and airtight sales discipline.
Amazingly, this is rarely the case. In fact, most distributors take a Do-It-Yourself (DIY) approach to building and managing their pricing architecture, their single most impactful profit lever. Beyond that, many companies allow their sales teams to make important pricing decisions on the fly, essentially tasking them with adding an appropriate margin to the product cost in the ERP system to arrive at a price (Cost-Plus Pricing).
How DIY Price Management Becomes Structured Chaos
In this scenario of inconsistent or non-existent pricing management, the “Wild West” prices quoted by the sales team need to be formalized in the ERP system, usually as customer-specific pricing pages (CSPs). ERP systems are well designed to accommodate this approach, and in the early stages of using them, distributors can see improvements in consistency and reduced customer frustration.
Ultimately, however, this approach presents administration challenges, as the sheer volume of CSP line items grows. No one has the time, the tools or the discipline to carefully review, analyze and correct CSPs. For many companies, CSPs may eventually constitute 50 percent or more of revenue and tend to increase over time as reps add products but neglect to remove inactive or inappropriate products. The result can be described as structured chaos.
Eventually, someone gets tired of creating or updating so many CSPs. They decide to create pricing matrices to apply standard pricing to groups of multiple products and/or multiple customers. Many companies come up short because they task internal employees with creating a pricing architecture, something many have not had experience with previously. And, needless to say, these pricing standards impact the business significantly; for many companies, these matrices may hit 20 percent or more of their revenue.
The Great Conflict Between Pricing and Sales
When a price manager sets up basic matrices, often manually in Excel, the company inevitably finds tension between what the matrix pricing requests and what sales reps believe (rightly or wrongly) to be the market price. This disconnect creates the “Great Conflict” between pricing and sales. For most companies, the result is an uneasy stalemate where each side believes the other side doesn’t know the market or what’s possible. Lacking any clear data to resolve the stalemate, most executive teams ignore this and let the chips fall where they may. It’s usually in favor of the sales team.
When the sales team holds the balance of power in the stalemate, the result is pricing overrides. When quoting or placing orders, each sales rep brings their own opinion of market pricing. And with easy visibility into cost and margin, reps override system pricing down to the margins they deem as approximate market pricing while ensuring that they won’t lose sales by overpricing. The end result is a new form of unstructured chaos, where on-the-fly pricing decisions are unhinged from either CSP pricing or matrix pricing. Ultimately, price overrides start to take revenue share out of CSP and matrix pricing, often hitting 25 to 50 percent or more of revenue.
A company’s resulting blend of DIY pricing structures – ad hoc CSPs, discredited pricing matrices, and on-the-fly pricing overrides – is called the Pricing Methods Mix. The different methods may carry different margins, but the cumulative chaos results in widespread inconsistency and underpricing.
Where Pricing and Sales Hit a Stalemate
For many distributors, pricing progress stagnates at this point of unstructured pricing methods. No one can really resolve the tension between pricing and sales, and the system’s complexity evolves to the point where no one can realistically maintain all the moving parts. Likewise, it’d be difficult to reform or restructure the underlying pricing methods mix. For these distributors, who generally understand the power of pricing to potentially impact their results, they are effectively paralyzed by the complexity and organizational tensions that remain unresolved (or even deteriorate further). At this point, their margins are stagnant, below their industry benchmarks, and their work effort to maintain the system is unwieldy.
Sadly, a big part of the problem companies face is a failure to understand and address the proper role of the various pricing structure layers and associated tools. CSPs and matrix pricing deserve roles in your pricing architecture, but those roles need to be clearly defined:
- Customer-Specific Pricing: For the customer’s planned spend, with core products to managed accounts
- Matrix Pricing: For the customer’s unplanned spend, with non-core products to managed accounts, and for general pricing for house accounts, transient, or unassigned accounts
Don’t Limit Your Most Powerful Profit Lever
Beyond all the analytical and technical limitations of DIY pricing, there is a fundamental limitation of having insights from only your own company. Within a single company, it’s difficult to know what “good” looks like outside of your own experience, and it’s easy to plateau at levels below best in class for that reason. As a company’s most powerful profit lever, pricing is too important to a company’s financial and strategic success to leave to the DIY approach and constant tension between sales and pricing managers.
If you’d like to explore the pathways forward to a sensible pricing structure and improved profitability, please contact us. Learn more about how we help you navigate complex pricing situations. Your sales teams, stakeholders, and customers will be glad you did.