It’s Time to Fix Your Contract Pricing
In the world of pricing and profitability, contracts and special price agreements (collectively known as “CSPs”) can create challenges for many companies. As sales teams negotiate with prospects and customers to secure, expand or rescue relationships, they make decisions and establish pricing designed to both win the business and ensure profitability.
If the process is managed well, contracts can help bring in key customers that can be quite profitable. Unfortunately, maintaining these CSPs can create an administrative burden, and the resulting mismanagement can drain profitability.
CSP Management Challenges
The devil is in the details. As sales reps establish CSPs, they often work in Microsoft Excel, Word, or even email to develop and communicate pricing to external customers and their internal sales or pricing teams. After internal or external negotiations, spreadsheets are imported into ERP systems to sit within the pricing hierarchy. Once uploaded, these pricing structures take precedence over matrix or other general pricing structures.
Over time, many companies discover that they have thousands of individual CSPs, each with dozens, hundreds or even thousands of line-items to review. Between quantity, complexity, file structure, and timing, CSP management becomes a truly daunting task for most companies.
If we think of a company’s pricing architecture as a house, CSPs represent the cluttered attic with a random accumulation of odds and ends brought and forgotten, year after year.
Where CSPs Can Unintentionally Drain Profitability
This cluttered attic becomes costly over time. While CSPs may have been appropriately set up, several factors eventually begin to creep in to distort this otherwise benign source of sales growth into a black hole that consumes profitability.
Cost increases: When costs go up, but CSP pricing is fixed (net pricing), margins go down. A critical CSP metric is what percentage of CSP revenue is on fixed versus adjustable (margin- or discount-based) pricing bases.
Inactive or Underperforming Customers or Customer-SKU Combinations: Customers who underperform versus volume, cost-to-serve, or other profit levers can quickly convert money-making CSPs into money-losing CSPs.
Wasteful Discounting: Broad-brush, peanut-butter discounts are indiscriminately applied to low-sensitivity products, customers, and customer/product combinations.
Customer Lifecycle Considerations: Pricing that was established to secure the business, sometimes from competitors, may have been aggressively low in the first place.
Continuous Addition of New Products: In an effort to equalize all pricing to a given customer, the assortment of products in the CSP keeps growing, expanding CSP share of revenues, while the additions are likely to fall in margin over time due to expanded discounts or absorbed cost increases.
Rolling Expiration Dates: The CSP library becomes increasing complex and daunting to manage, review or remediate. Many commercial teams simply extend the deadlines of expiring CSPs.
Looking across these issues, it becomes obvious why CSPs can snowball into a profitability black hole. Over time, between increasing CSP percentage of revenue and decreasing CSP margins, the margin collapse becomes costly. Let’s look at an interactive example to simulate the significance of the profit drain.
Here are the relevant details we’ll use for this example:
- A distributor with $100 million in annual revenue
- An average gross margin on non-contract sales (including overrides) of 28 percent
- As a starting point, contract sales make up 20 percent of total revenue
- Average gross margin on contract sales is 22 percent (compared with 28% of non-contract)
Move the sliders below to see how net profit is compromised when the percentage of revenue on contract increases due to clutter and bloat. At the same time, reduce the average margin slider to reflect the company’s inability to keep up with cost increases.
Bring Structure to Your Contract Pricing
Recovering contract profitability can seem like a daunting task for all the reasons discussed above, but there is a path to solving this problem. It all starts with segmenting the problem. Out of the thousands of CSP line-items that exist in your ERP system, there are predictable patterns and choices that can simplify the task of segmentation.
We know that bigger customers with high-visibility products (shown in red and yellow in the figure above) are where customers and sales reps want to have the most engagement and discussion. These combinations commonly account for about 60 percent of revenues, and 20 percent or less of line-items. Remedy most of the line items with the simple steps below:
- Remove unnecessary products, customers or product/customer combinations from the mix.
- Move the prices to prescribe capped (phased in) or uncapped (immediate, whole) increases.
- Hold prices or identify a higher price that is short of the prescribed price.
- Convert static net prices to dynamic discounts or margins to pass through cost increases in the future and prevent margin erosion.
With appropriate sales performance data, sales and pricing teams can quickly and efficiently build integrated, market-sensitive plans.
Low-visibility products that are sold to smaller customers represent another 40 percent of revenues and 80 percent of line items (shown in green in the figure above). The goal here is to prune wasteful product additions and discounting and remediate inappropriate net pricing. Applying low-margin discounts to these products to be consistent with high-volume, high-visibility products generally isn’t necessary.
Instead, these products and product groups can often be priced closer to typical non-contract pricing. When that’s the case, contracts can become significantly more profitable. Unfortunatley, applying logical rules and adjustments to this large number of low-visibility products is where many companies get tripped up and ERP systems struggle to provide answers.
We developed ContractGPS™, a simple cloud-based tool to quickly and efficiently take control of your CSP business, to help companies take control of these situations. With this tool, you can safely use automation with built-in analytics to correct contract pricing without wasting valuable sales time.
Contract business may be a sore spot or a challenge to your company, but there are paths to success that enable you to recover profitability while maintaining competitive price points for some of your most important customers. Incorporating these approaches to recovering margin can increase overall CSP net profitability by 50 percent or more for your business.