Mispricing product is a dangerous practice

BY RICH SCHMITT
Management specialist

This month I will continue my three-part Principles of Pricing series. As I started on this topic, I thought I would be able to complete it in two parts. As I have gotten deeper into the subject, however, I believe it is best to spread the information over three parts. I guess that is good for those who want to learn more about pricing. 

I know that many of you are experiencing a downturn in business. Economic cycles are now -- and have always been -- a fact of life in our industry. Remember that some wholesalers do stupid things when put under pressure. You must resist the urge to blindly follow these wholesalers into the toilet. My strongest recommendation in these tough times is to stay in the black. This may involve some difficult decisions, but many things are possible when you are not bleeding.

When you are bleeding, your primary focus must be to stop the bleeding. Your second most important action must be to manage your pricing so you are generating the maximum gross profit possible on the sales that you make.

This is the reason for my three-column focus on pricing. The following subsections continue my list from last month (you may want to scan last month’s column as I will refer to some of the concepts I discussed in that issue).

Many customers will say your prices are too high

One client observed that contractors’ first words are, “Your price is too high.”  They say it for many reasons:

• To obtain additional discounts  -- These five little words cause some salespeople to immediately cave in and drop their price. Mission accomplished. The worst part of this is that you have trained your customer to challenge every price. If you give your dog a treat for soiling the carpet, get yourself a carpet cleaner because the “fun” is just beginning.
• Negotiation -- It puts the salesperson on the defensive, which helps in all further negotiations.
• They’re bluffing -- Of course your customers would never do this to your sales team, but in some areas, lacking competitive data, customers use bluffing as a way to test a supplier’s pricing. They have no real data, but if the salesperson immediately responds to the challenge with another “five” or “ten” off, it is obvious that the supplier had more to give in this situation. When you respond with an automatic concession, you just gave him a “treat” and you know what to expect. The contractor also assumes that the wholesaler probably had more to give in past sales and probably has more to give in future sales. Your concession trains them to test your pricing on every sale. 
• Your price really is too high -- In our experience, in looking at a significant number of pricing challenges, the wholesaler’s normal pricing was really fair and competitive. In some cases, though, you may actually find that your price is too high. (While you never want to be high on benchmark products, you want to be pushing the upper end of the fair-pricing range on the non-benchmark products. If you are doing proper pricing and testing the upper end of the range, occasionally your pricing does get too high. Being low on everything is often an end-game strategy.) When you are, in fact, high, you should gather data, adjust your price appropriately, apologize to the customer and move on.

In addition to a price manager, you need a pricing gatekeeper

Since dumb giveaway-pricing decisions are hard to take back, it is best to review price adjustments and concessions in advance, to understand their implications and intelligently determine whether the concession is truly prudent. This also helps to create consistency in your pricing from customer to customer. Some companies, who do not have gatekeepers, have considerable variations in pricing between customers largely based upon the strength or weakness of the assigned sales person as opposed to real market issues. Ideally your gatekeeper will ask questions like, “Why does your customer need this pricing when similar customers, in the same market, do not.” Post-concession analysis is also good for learning from your successes and mistakes. This can be your pricing manager or it can be a separate person, but you must have someone who applies the brakes as your customers -- and, often, your sales team -- take your pricing downhill.

Get your “normal” pricing set properly

Your “normal” price is the price a customer will get for the product without negotiation.  He walks into your counter, you enter his customer id and a part number.  The price that comes up on the screen is his “normal” price. The price should take into consideration the type of customer, the size of customer, the market and the customer’s pricing hot buttons. Some wholesalers have ridiculous “normal” pricing and thousands of overrides to provide customers with fair pricing. 

Ridiculous “normal” pricing sensitizes customers to your pricing which, in turn, causes them to challenge every price so your people constantly hand-price each product. When your normal price is market-based and credible, you can insist that your people use it. When it is not, every price is negotiated.

Limit price changing authority to people who understand gross margin

I firmly believe that a surprising number of pricing errors are caused by people who do not understand gross margin.  We see this problem often in our consulting, but I fear that we are seeing only the tip of the iceberg.

Most of your people don’t understand gross margin

We have tested thousands of people over the years and have the data to prove it. They don’t know how to calculate gross margin. They don’t understand the difference between gross margin and markup. This widespread misunderstanding costs some wholesalers many points of gross profit. Use our gross margin test to see for yourself. E-mail me at rich@go-spi.com.

Limit the number of people in your company who have price setting authority

If you agree with the previous two points, then the logical conclusion is that you must limit the number of people who can change pricing.

First you have to get your normal pricing set properly. Then you must get your people to use that normal pricing so they stop giving away the store. Finally, only allow concessions after your gatekeeper has approved them.

Always, always, always discuss pricing in terms of gross margin

Never use markup pricing unless your computer system gives you no other choice. (If this is the case, talk to your software vendor about getting this changed.) Always use gross margin. The discipline of using gross margin will make you more money. If you want 15% gross margin, the confusion of using a 15% markup results in a 13% gross margin. The common confusion costs you 2 gross margin points. 

To make matters worse, the larger the percentage, the larger the lost margin. At 25% you lose 5 points of margin. At 35%, the difference between markup and gross margin is a whopping 9 points of gross margin lost in the confusion.

Some wholesalers say they have charts to help their people understand the difference. We have never -- I repeat, never -- found a company that was successful operating in a mixed gross margin/markup world. The only reliable solution that we have found is to focus on one and only one number: gross margin.

If you ain’t divid’n you’re wrong

A client passed along the above as their rule for pricing calculation. This is a reminder that the markup calculation involves multiplication, while the proper gross margin calculation uses division.

Simplify your pricing

Most wholesalers’ pricing is too darn complex. Over many years their pricing has evolved into a can of worms that nobody wants to untangle. This complexity also discourages anyone from “touching” it since the last one to touch it normally gets blamed for any problems or, even worse, gets permanently assigned to its maintenance. Plus any prudent changes involve analyzing the situation, which can be difficult and time-consuming when the pricing is a big mess.

Ultimately the complexity causes pricing to be unmanageable and unmanaged. Lack of pricing management is always bad. You must get your arms around your pricing. It may take a year but it will be time well-spent.

Add complexity to your pricing only when it makes you more money

After you get your pricing simplified and under control, you add new facets of pricing where they will give you a market advantage or improve your profits. The added profits cover the additional efforts involved in managing more complicated pricing.

Keep good pricing records

Each price change must be recorded. This should include the changes,  the person who authorized the change, the reason for the change, the expected results and the actual results (after the fact). This information must be saved for future analysis and review. 

Manage your profit dollars first and percentages second

The old saying, “You can’t spend percentages” is true.

There’s an old joke about a wholesaler who priced boilers at 80% gross margin. Someone asked him, “Isn’t the price quite high?” He replied, “Yes, but if I can sell just one, I’ll make a ton of money.” 

Use turn and earn (T&E)

This combination of gross margin and inventory movement helps you manage the compromise that often occurs in our industry. People sometimes ask whether dropping their margins 10 points on a product makes sense if it will generate additional sales. T&e shouldn’t be the only consideration, but I think it is a very good measure for answering the question. I like to see the t&e for the company, each division, each branch, each product category and each sku.  The information helps determine where adjustments can and should be made.

Pricing must be understandable by management, by sales and by the customer

When your pricing is confusing, management can’t manage it, sales can’t effectively sell it and customers don’t trust it.

As we work with companies, we often find that everyone is on a different page. Even the terminology that they use in discussing pricing does not have commonly understood definitions. This leads to meetings where everyone leaves thinking that there was a universal understanding, but the implementation is a mess.

Uses electronic price updates

Delays and mistakes in cost management can eat away margins, too. Most suppliers will provide cost update files to you and most computer systems have ways of using those files to electronically perform the updates quickly and accurately. 

In many cases, the problem is that the wholesaler’s team has not taken the time to learn how to do electronic updates and then to configure their computer to allow the system to work. (I think buyers have a much higher purpose in a company than acting as a data-entry clerk to update pricing.) 

Manufacturers should get their electronic price update files in order

Make sure that you, as supplier partners to wholesalers, are really providing usable data. If you think sending your price update as a .pdf file represents an “electronic” price update to your wholesalers you are mistaken. Pdfs require significant extra work by the wholesaler at the very least and many are completely useless for updating pricing.

Most wholesaler software systems readily accept a comma-separated-value (.csv) file or a delimited text file (.txt), ideally with a header line describing the format. Sending an Excel file (.xls) will work but often requires the wholesaler convert the data to a .csv or txt file before it can be used. 

Some manufacturers provide Excel files that are formatted to print pricesheets. Often this formatting requires that the wholesaler significantly rework the data to perform price updates.

Industry associations should define a simple price update format for their manufacturers

One of the key roles for associations is to define standards. They have been effective in establishing fundamental standards for EDI and other information so creating a simple, common format for price updates ought to be a priority.

I will finish up my Principles of Pricing series in next month’s column. I know there are a lot of suggestions. Never implement these suggestions without fully understanding how they apply to your company because one-size does not fit all. Also remember nobody does pricing perfectly, but you must work to get your pricing act together.

Every mispriced product either creates a negative pricing perception in the customer’s eyes or represents a lost profit opportunity for the wholesaler.                   

Rich Schmitt is president of Schmitt Consulting Group Inc., a management consulting firm focused on improving the profitability of distribution and manufacturing clients. Rich is also the co-owner of Schmitt ProfitTools Inc. (SPI), a business producing print, CD-ROM, web and palm-based catalogs as well as pricing management and analysis software for wholesalers.