Preserve Your Profits by Plugging Price Leaks: 3 Key Actions to Take Now
The shifting economy resulting from COVID-19 has created a challenging business environment for distributors in many verticals. Distributors face an unprecedented challenge to their profitability, cashflow, and even survival. In electrical distribution, where the typical distributor’s net profit averages less than four percent of sales, a 20 percent drop in revenue equates to a complete loss of profitability (or equates to breaking even).
A natural response to the current economic uncertainty is to cut costs where possible to preserve your business. Many distributors are doing exactly that, cutting their selling, general and administrative (SGA) costs, and the following table shows why.
As the table demonstrates, by implementing a 20 percent SGA reduction (e.g. cutting staff, reducing pay, or both), a typical distributor can maintain 80 percent of their profitability, shrinking from 4 percent earnings before interest and taxes (EBIT) to 3.2 percent EBIT. Many of those reading this article have probably taken similar steps to protect profitability, cashflow, and to ensure survival.
Three Problematic Pricing Areas to Address
Cutting costs is a necessary step for distributors to take, but it is unlikely to be a sufficient solution on its own. More importantly, distributors suffer from a few perennial pricing leaks that drain profitability and are likely to accelerate and become more critical during the economic downturn. With falling market demand, increased competitive pressure, and outdated pricing systems, distributors face the distinct possibility of both shrinking volumes and shrinking margins.
There are three pricing leaks that are common to all distributors, varying only in their prevalence and magnitude. Companies that build their own pricing matrices often struggle with these, as well as those that use more stripped-down pricing solutions on the market. Considering the current economic state, addressing these is more important than ever.
1. Pricing Overrides
When salespeople override pricing matrices, or structures, they commonly sacrifice about 10 margin points versus matrix values. For many distributors, overrides represent 20, 40 or even 60 percent of their revenues. This reduces EBIT by 2.0, 4.0 or 6.0 percentage points, effectively shrinking EBIT by 33 percent or more. In a weakened economy, with increased competitive pressure and customer haggling, these losses can quickly grow, chipping away at the revenue intended to be recouped.
Reducing overrides requires focus and a continuous-improvement mindset. In addition to working to influence seller behavior to reduce these, there are specific tools available in Epicor and Infor pricing modules which can help. We’ve worked with numerous companies to reduce overrides with a variety of solutions and are here to help if you would like to explore your options.
2. One-Time or Rarely Sold Products
When salespeople price one-time or infrequently purchased customer/SKU combinations, they frequently price outside of their established pricing matrices or customer-specific pricing agreements. Instead, by using cost-plus formulas, they predictably produce unprofitable orders on rare-event sales. Having an ERP pricing tool that accounts for rarely sold items helps plug this leak by providing the prices that maximize profits.
According to decades of profitability research by Waypoint Analytics, the typical distributor loses money on 40 percent of their invoice line-items. For a typical distributor, one-time or rare events can represent a significant chunk of these. With a 10 or 20 percent true-margin delta versus common, everyday sales orders, the net impact can easily be 2 to 4 margin points. To succeed at stemming these losses, it is critical to have default-pricing matrices in your ERP system that assign appropriate pricing standards and guidance for these rare events. Our integrated pricing solutions built for Epicor and Infor ERP platforms are designed to allow you to do exactly that.
3. Peanut Butter Pricing
Just as you would spread peanut butter evenly across a slice of bread, many distributors take the same approach to spreading a single margin evenly across a broad category of items. Instead of applying the peanut butter approach, there is an opportunity to better price an individual item by applying a pricing matrix that reflects the market value of any given product. By doing this, you would differentiate an item within its product class or sell group.
Many distributor sales reps are fond of using cost-plus approaches to pricing, specifically using margins or mark-ups commonly ending in 5s and 0s. This age-old practice, while comfortable and straightforward, fails to extract critical margin premiums on less-sensitive, costly-to-serve products that commonly represent 30 percent or more of revenue. When sellers fail to extract premiums on these products, to offset concessions on more competitive products, they commonly sacrifice one to two whole margin points.
To resolve this issue, distributors need smarter pricing matrices that guide sellers away from margin targets towards market pricing. A smarter pricing matrix also critically differentiates high-sensitivity products and low-sensitivity products within product families. Each of the SPARXiQ pricing solutions provide this level of detail, ensuring that margin opportunities within individual families are not overlooked.
For companies who already have a sophisticated matrix that allows for this, now is a time to consider building in small slivers of additional margin on the insensitive products within families.
How Price Leakages Affect Bottom Line
The three price leakage points can each, individually, produce a one-point (100 basis points) EBIT drop. For many organizations, all three issues can coincide, producing a 300 basis-point drop in profitability. The common effects of the three issues playing out for an already-stressed distributor are demonstrated below.
As we can see, our typical distributor, despite having cut SGA by 20 percent, now faces a profitability that is 40 percent below baseline. To make up for each 100-basis-point pricing leakage issue, the distributor would have to cut SGA by a further 6 percent (to 26 percent). With all three price leakage issues present, the distributor will have to cut SGA by a further 19 percent (total 39 percent), just to get back to profitability levels of 80 percent of baseline.
Imagine what can happen if the distributor improves their performance in at least one of these price leakage points, and stabilize the other two. A one-percent gain in pricing can restore profitability for the company to baseline levels prior to the COVID-19 economy.
Prepare to Plug the Price Leaks and Protect Revenue
The good news is your pricing leaks can readily be plugged. The challenge is having your management team focus on the analytical, behavioral and systemic causes of these issues. Quarantines and economic lockdowns on a rolling basis will likely persist for the foreseeable future. Now is an ideal time to dedicate resources to making foundational improvements to your pricing practices.
In future posts, I’ll examine how remedying each of the three common price leaks can contribute to a stronger bottom line during the impending recession, as well as during an eventual rebound. During this time of unique economic challenges, your company can sharpen its approach and address these pricing leaks to maintain profitability and not just survive but thrive. Then, when the economy begins to recover, you will be in better position than before with a new pricing strategy in place.