Handling Price Increases
Let’s start with this premise: Nobody totally enjoys change. And when the change involves a price increase, most of us hate the change. Yet in most cases, we accept the change and move forward. For instance, on a recent trip to the grocery store, I discovered eggs have nearly doubled from my expected price. In a nanosecond, my brain spun through the avian flu impacting poultry farmers across the Midwest, healthy egg alternatives and buying something else. But Sunday morning omelets were on the menu, and the eggs quickly joined the other goodies in the shopping cart. I accepted the price increase and moved on to the real issue at hand; cooking breakfast.
Driving home from the store, I contemplated what might have happened if the local grocer employed the same pricing strategies as many distributors. Here’s a short list of the notions crossing my mind:
- Distributors insist on providing their customers with a 30-day notice of price increases.
- Distributors fear a price increase might send customers speeding off to new suppliers.
- Distributors often absorb price increases in order to avoid potential customer conflict.
- The grocer understands price sensitivity and uses what they call the “Bread/Milk loss leader” approach to maintain margins that distributors don’t.
As I pondered these few thoughts and made further contrasts, I came to this realization: Price perception is probably just as important to the grocery business as it is to the sale of HVAC equipment. Competition is everywhere. They face the same issues with national chains (Wal-Mart). At least a sector of their customer base cherry picks, buying only on price. But the vast majority shop for convenience, brands and bundled services.
In our industry, we face an epidemic of margin erosion via absorbed price hits. The underlying reason for the margin erosion is relatively simple. We are making “good margin” on one of the products we sell. This number varies from company to company, but for the sake of argument, let’s says it is 25 percent. A price increase of 2 percent comes trickling down from a supplier. And we reach a magic moment. We can follow one of three paths: (1) absorb the price increase and therefore lower our margin from 25 to 23 percent; (2) immediately pass the increase along to the customer and maintain our current margin; or (3) pass along a slightly larger price increase, which incorporates the supplier’s increase and a small margin increase for the distributor.
Most distributors leave the choice to their sales team. And for some mysterious reason, salespeople fear price increases. Many would choose to go down the first path described above based on the fear that a price increase, no matter how well justified, might irritate the customer. Others avoid the price increase because it creates a distraction from their day-to-day selling activities.
They assume, quite incorrectly, that losing a couple of margin points is not a major deal. Unfortunately, industry standard compensation structures based around gross margin only encourage their thinking. Using our example of a drop from 25 to 23 percent gross margin applied to $10,000 in business results in a gross margin drop of $200 (from $2,500 to $2,300). If the seller receives a commission of 5 percent of gross margin, the impact to their paycheck is a measly 10 bucks (on a regular commission of $125). Let me ask you, would you risk the whole commission for 10 dollars? At the same time, the seller’s company risks losing a whole lot more.
In an industry where the typical net profits hover near 3 percent, giving away 2 percent of margin makes about as much sense as a “football bat.” Repeat the process enough times and the organization will need to make radical cuts in people, service or something else important, just to produce a reasonable return for the company. None of these options makes sense on a strategic basis, so clearly we need to establish a plan for making price increases work without damaging our business.
Let’s explore three situations where you might consider a price increase.
A supplier raises their price to you
Periodically, every manufacturer publishes some kind of price adjustment. In many industries, the increases come near the end of the calendar year. Others come irregularly, in relation to commodity price movements — things like copper, steel, oil, plastic or other raw materials. Many suppliers give the distributor a 30- or 60-day notice of the price adjustment. Customary distributor practice dictates that distributors give their customers a similar notice. Stop doing this. For all but a handful of your most important customers, this practice does not make solid business sense. The extra gross margin generated during this short time will allow you to recoup a portion of the costs associated with loading new prices into your ERP system.
When this happens, it’s not unusual for the company to publish a justification, but rarely is an actual increase percentage noted. We like to see distributors add a little extra for the “home team.” For instance, a manufacturer’s price increase comes in at 2 percent, and the distributor provides the customer with a 3 percent price increase. If you want to assume a more advanced approach and have the proper discipline, increase items not purchased in the past six months by an even larger percentage. Again, referring to our 2 percent increase from the supplier, a 2 percent price increase might become a 4 percent increase on items no one bought for six months or more. Any product the customer has never purchased should be set at the “normal market price.” And whenever possible, normal market price should be established based on a discount from list rather than as a mark-up from distributor cost.
Re-evaluate where customers are on your discount schedules
Nearly every distributor on the planet applies some kind of matrix pricing. Depending on the company, prices are typically broken into a few groupings. Categories like contractor, industrial, institution and reseller are common. Further, many distributors break each of these customer categories into customer sizes: small, medium and large. The price levels are broken down based on the cost of doing business for each customer type and size.
The problem arises when sellers migrate their customers to categories with better pricing levels. I have seen distributors where 80 percent of their customers resided on the ERP system as large contractors, mostly because those classes had the greatest discount.
I recommend that you begin reviewing your customer list for miss-categorizations. Expect to see many that you have upgraded to the maximum discount. Set them back to the proper discount level. Further, if customers are massive organizations but have chosen to buy just a few pick-up items from you, when their favorite supplier has a stock out, put them into the small category.
Incoming freight is the same as a price increase
Strangely, many distributors don’t consider freight the same way they consider other costs. However, the impact of incoming freight can be massive. Recently, we had the opportunity to review the freight costs for products a distributor added at a customer’s request. They equated to 6 percent of the total cost. Yet, the distributor handled all of these products at a margin level similar to the typical products sold. The net result was disastrous to the profitability of the distributor.
Typically, a good many of these high-incoming freight purchases come when a good customer asks you to step outside the bounds of your normal product offering from an established supply partner and purchase a couple of oddball items on their behalf. Because the customer realizes many pitfalls exist to buying from this type of supplier, they ask if you will acquire the product and sell to them.
Being a nice guy and wanting to lock in the customer, you assign someone from inside sales to research and purchase the product. This is time consuming. You’ve dedicated inventory to a single customer. You have no leverage with the supplier. Your margin needs are much higher. There is a chance you are not being fully compensated for your work anyway, but incoming freight only adds insult to injury.
Don’t buy into the salesperson argument that doing this business builds great customer relationships so making anything more than the “normal” margin is counterproductive. Instead, understand this service saves your customer a bundle in time and effort headaches. I suggest reviewing these orders for incoming freight.
A final few thoughts…
A pricing process should be part of your overall strategy. I regularly study the work of Strategic Pricing Associates. Their process allows you to raise the prices on the products without a great deal of price sensitivity. Customers don’t notice. Salespeople push back, but they always do. By the way, price increases done correctly impact profitability like no other activity. A two-point improvement in gross margin can add 50 percent to the bottom line.