Book Excerpt: Price For Success

Price for Success: A Practical Guide for Improving Margins in Wholesale Distribution, a joint effort between Advanous, a consulting firm specializing in margin enhancement for the distribution industry, and NAW/DREF, is a resource for distributors looking to find new ways to drive higher margins.
Complete with an introduction on the basics of pricing, the book’s 14 chapters and subsequent case studies provide an easy-to-understand and valuable tool for any distributor making a conscious effort to better his or her bottom line.
The following is an excerpt from Chapter 11 of the book:

Throughout this book, we’ve written a lot about the need to improve your systems, create reliable default pricing and build an effective pricing organization. This chapter will provide some concrete steps that you can take today to make immediate and significant improvements to your margins.

We believe the best place to improve margins is to go directly to the source where the margins are set — the field. Here’s what you need to teach your sales reps about margin.

1. Avoid the “Divide-by-.75” mentality
First and foremost, you need your sales reps to get away from simple, reflex responses to pricing. Being profitable isn’t that easy.

Suppose a sales rep walks into an existing customer’s office. The customer places an order. One of the items on the order has never been purchased before. What should the sales rep charge? A common answer is to look at the cost of the item, take out a calculator and divide by .75 — calculate the price of the item by using a GM% (gross margin percent). Is this a good strategy? Absolutely not! But what else can and should you do? Keep reading.

2. Charge a higher margin on lower-cost items
In an ideal situation, sales reps will have a recommended list price that allows the company to make an adequate profit with a realistic price. If this isn’t provided, the sales rep should look at the cost for the item. In general, lower-cost items require higher margins. A distributor’s costs are typically about the same amount to warehouse and handle any small box, whether that box holds an expensive product or an inexpensive component. To cover the company’s cost to order the item, receive it, store it, sell it and ship it out, a sales rep will need to capture about the same amount of revenue … which means a higher margin for the low-cost item. Therefore, a general rule to follow when pricing items is

• Higher margin on low-cost items

• Lower margin on high-cost items
Following this rule, GM$ (gross margin dollars) will vary considerably by product. For example, a typical purchase order might be priced as shown in Figure 3-12. Each item has a quantity of one.

3. Understand the 80/20 rule
The 80/20 rule as it applies to a customer’s purchases states that 80% of the dollar volume of a customer’s purchases comes from 20% of the items bought.

If a customer purchases 100 unique items, on average the top 20 items (those items generating the highest sales revenue) represent about 20% of the total sales (dollar volume) for that customer. The 80 items that represent 20% of the total sales are the best opportunity for price improvements. A sales rep shouldn’t target all 80 items, but pick and choose from this list based on other factors.

A sales rep is reviewing the purchases of ABC customer. The rep wants to raise the average gross margin for this account from 22% to 23%. How should he do it?

Rather than attack all the items, identify those that are less sensitive (typically lower-dollar-volume items) and are underpriced. Look for items that aren’t very expensive, aren’t purchased frequently and aren’t highly visible. Let’s say that 30 of the 80 items represent 10% of the customer’s dollar volume. Rather than implementing a 1% price increase for all 100 items, implement a 10% price increase for the 30 low-price sensitivity items. The predicted impact on the account’s profitability is the same with either strategy: 100% x 1% = 1% and 10% x 10% = 1%.

But the second option carries a significantly lower risk, because the customer isn’t jolted by an across-the-board increase that includes high price-sensitivity items.

4. Balance risk against profitability
There are two goals when managing margin: 1) Maximize profitability. 2) Minimize risk.

This means that sales professionals must constantly balance individual and corporate goals of high margin against the possibility of overcharging … and possibly losing a customer.

Too many sales reps focus only on risk. They keep margins low to avoid any chance of losing business on pricing. This reduces their own earnings potential and creates a shortfall in profits for the company.

Some sales professionals sometimes inflate selling prices to an extreme. When this happens, and if the customer compares the price of an item from you (say $100) to the price of the same item from another company (say $25), your company may lose that customer.

Again, the key is to seek balance between profit and risk. A sales rep must not be afraid of making an honest profit, but should also be aware the problems inherent in big variances in price between your company and the competition.

5. Diversify your selling margin by item
The system recommended here involves a highly diversified pricing strategy, as opposed to a simple, across-the-board approach.

You can see that strategy at work if you study successful distribution salespeople. A sales professional who writes at a high average margin typically differentiates her margins by product. For example, if a customer purchases 100 items, some items will be sold at a very low margin (typically the more sensitive items to that customer) and many more will be sold at higher margins (the less sensitive items to that customer). Sales professionals who write at lower margins will have little product pricing differentiation.

Take a look at Exhibit 3-13. It illustrates the GM% of 100 items that a typical customer purchases.

Sales rep with higher margin
Notice that the higher-margin sales rep established prices on some items at a very low margin and others at high margin. This rep’s pricing practice is based on a combination of what the market will bear and the cost to serve for those items. In addition, the rep is pricing the 20% of the items that represent 50%-90% of the dollar volume at a competitive price. These typically are the more price-sensitive items (higher dollar volume and frequency of purchase).

How does this minimize risk? The customer decides to shop for lower prices. What are the items the customer will focus on? Typically they are the higher-volume, more frequently purchased items. And what will the customer find? Not a lot of difference, because this sales rep is competitive on those items.

A competitor offers to give a quote to a customer. What items will the competitor quote on? Typically the most visible, more sensitive items. And what will a comparison show? Probably not enough difference to warrant a switch.

Even if a price comparison is made on an infrequently purchased, high-margin item, justification can and should be made as to the costs involved to service that item. In addition, the customer must understand and be casually reminded that he is paying for premium service.

Now let’s look at the pricing practices of the lower-margin writer (Exhibit 3-14). He, too, will typically be competitive on a select group of items. However, when it comes to the balance of the product portfolio, the low-margin salesperson will flatline and typically cap out at a predetermined margin (25%).

Sales rep with lower margin (“divide-by-.75” mentality)
The reason that some salespeople do this is a combination of fear of overcharging, inability to articulate value to the customer and/or pricing laziness (it’s easy to divide by .75).

The obvious result of this action is lower margin for the company. In addition, because of the simple divide-by-.75 approach, you also face the risk of your competitor’s discovering your price point. Once he does this, he can confidently quote against you.