Take the First Step to Optimize Pricing and Improve Profitability
Marketplace pressures continue to evolve and change the competitive landscape, ranging from commoditization to eCommerce to the changing workforce. These factors are beginning to negatively impact the bottom line for many distributors. Distribution is traditionally a thin-margin business to begin with, so these new pressures are challenging many distributors. What is your company’s profitability outlook for the years to come?
Rest assured, you can maintain and grow profitability no matter what is happening in the market. In this article, I’d like to share a simple and innovative solution that solves a long-time profit problem.
Understand the Complexity of Unique Costs to Serve
Having worked with hundreds of distributors’ transactional data in recent years, it is always interesting to find some of the same challenges in so many companies’ datasets. An amazing diversity of companies serving different markets in various industries somehow tend to arrive at surprisingly common problems impacting their bottom line.
The average distributor loses money on 40 percent of invoice line items when the actual costs to serve are factored against their gross margins. Essentially, the wholesale-distributor industry average of 4 percent net profit is the outcome of a struggle among invoice line items that make money, break even (more or less), or lose money. The higher the percentage of orders that lose money, the lower the operating profit.
Let’s say a distributor sells 5,000 products (SKUs) to 1,000 customers. These items naturally have radically different costs to serve: average order quantities, inventory turns, handling costs, customer service needs, and many more. Unfortunately, the average distributors’ pricing matrices don’t reflect these highly variable costs to serve – particularly at the SKU level. It’s a problem created by the complexity of the situation.
As you might imagine, the profitability of a given line item on a given order will depend heavily on its unique cost to serve factors. As such, invoice line items with high costs-to-serve end up being unprofitable at the net level.
Identify and Resolve What Drains Profitability
When you factor in all of the costs to serve, which line items typically drag down the profitability of an order? You might be surprised to learn that the long-tail of ancillary, add-on products are the ones most likely to drain profitability, on average by 50 percent or more. This is ironic, given that these products are often seen as convenience products for customers, which should build margin onto the primary, competitive SKUs on an order.
The reality is, companies rarely account for the cost to serve variability of these items and standard gross margins applied to these items result in compromised profitability. As a simple example, products sold in bulk quantities (think paper towels) carry a lower per-unit cost to serve than products sold individually (think brooms). Identifying, and remedying, these profit drains on products with unique cost to serve challenges is a path to a much better bottom line. In fact, companies that successfully address this problem can predictably increase net income by 1 to 2 margin points ($100,000-$200,000 per $10M in annual revenue).
Remediate the Behavioral Patterns of Your Sales Force
Downstream, distributor sales reps generally lack visibility into each product’s true cost to serve and how that compares to the margins at which they are selling.
Set the Right Price at the Right Margin
In their quest to fully serve their customers, sales reps say yes to selling practically anything a customer wants. That’s not necessarily a bad thing; selling what the customer wants is their job. However, it’s the company’s job to ensure that the right guidance and boundaries are provided to inform those sales decisions, so that the right products are sold at the right margins.
Pricing that Meets Market Levels
Sales reps commonly have significant pricing latitude and/or a cost-plus approach to pricing, setting the stage for a high number of money-losing orders. This compounds the already complex cost to serve problem.
When sellers apply a favorite margin percentage (usually ending in 0s and 5s, as we’ve found) on the vendor cost of a product, it may prove adequate for the high-volume, high-efficiency products that receive most of the profitability attention. However, when they do so on low-sensitivity, convenience products, they sacrifice critical margin points that offset higher costs to serve and the lower margins typically carried by core products.
Correcting Wasteful Discounting
When sales reps underprice long-tail products through cost-plus habits, that drives up the percentage of money-losing orders and drives down net profitability. A similar phenomenon happens for reps doing list-down pricing, as they apply blanket, peanut-butter discounts across products with radically different costs-to-serve.
Distributors have been trying for ages to break these sales force behaviors, but old habits die hard. Any proposed solution to remedy profitability on long-tail products needs to face these issues head on and meet the sales force where they are, not where companies wish they’d be.
Apply a New Solution to an Age-Old Problem
A solution to this complex problem for distributors must be one that:
- Can quickly and accurately identify the problematic SKUs
- Can make the necessary adjustments directly into daily workflow (in the ERP)
- Effortlessly transitions salespeople to more profitable outcomes without requiring behavioral change (which is notoriously difficult to accomplish and/or sustain)
A potential solution would struggle to succeed in a case where any of these three requirements was not met, which is why this problem is simple but solving it is not always easy.
As you consider tweaking your pricing structure to capture margin in this fast-moving economic cycle, consider how you might tackle this challenge. Properly adjusting your price basis on these low-sensitivity products ensures the gains reach your bottom line.
Need help? SPARXiQ has worked with hundreds of distributors to help them better understand and solve pricing challenges like these for nearly thirty years. Find out the impact SPARXiQ pricing analytics can provide for your business.