How to get customers to pay more
by Frank Hurtte
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 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 in the sale of industrial supplies. Competition is everywhere. They face the same issues with national chains (theirs is 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. At the same time there are some notable differences.
Margins are different. The typical grocery chain operates with a grocery aisle margin in the 1-2 percent range. With this point in mind, any thoughts of absorbing the increase come to a screeching halt. In our industry, we face an epidemic of margin erosion via absorbed price hits. In this case, 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 two 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 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 five percent of gross margin, the impact to their paycheck is a measly ten bucks (on a regular commission of $125.) Let me ask you, would you risk the whole commission for ten dollars? At the same time the sellers company risks losing a whole lot more.
In an industry where the typical net profits hover near three percent, giving away two 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. Because none of these options makes sense on a strategic basis, clearly we need to establish a plan for making price increases work without damaging our business.
Let’s explore four situations where a price increase should be applied.
A supplier raises its 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 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 two percent and the distributor provides the customer with a three percent price increase. If you want to get advanced and have the proper discipline, prices for items not purchased in the past six months might be increased by an even larger percentage. Again, referring to our two percent increase from the supplier, a two percent price increase might become a four percent increase on items not purchased for six months or more. Items never before purchased should be set at the “normal market price” which is established based on a discount from list rather than a cost up approach.
Reevaluate where customers are located 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 OEM, Industrial, Contractor, Institution and Reseller are common. Further, many distributors break each of these customer categories into customer sizes; like small, medium and large. The price levels are broken down based on the cost of doing
business for each customer type and the customer 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 were established on the ERP system as large OEMs or Contractors, mostly because those classes had the greatest discount. The whole thing might have been believable except we discovered counter customers placing $100 orders categorized as large OEMs.
I recommend you begin reviewing your customer list for miss-categorizations. Expect to see many that have been upgraded to the maximum discount. They need to be set back to the proper discount level. Further, if customers are massive organizations but have selected to just buy a few pick-up items from you, when their favorite supplier has a stock out, put them into the small category.
Review your list of Resellers purchasing from you. Are some of those companies competitors? Review the products they purchase. Increase the price to these “customers” as well. It makes no sense to give a competitor a sweet deal; especially when they may be using it against you.
Review special pricing agreements
Customers, especially those with professional purchasing types, negotiate prices based on high volume purchases and future growth. Somehow the promised volumes don’t happen. When this occurs, distributors should put the opportunity to good use by reopening the negotiations. Price may play a part in the negotiation. However, the original price agreement was based on volumes which never materialized.
Rather than just allow for the old price to stand, offer a rebate if the quantities become close to the original estimates. Typically, this results in a price increase for at least some of the items on your list. Further, if the customer vehemently pushes to maintain the old price, this presents the perfect opportunity for a quid pro quo trade for additional purchases. The new products should be fairly priced, hopefully at an improved margin.
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 six 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 for the customer.
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 odd-ball items on their behalf. Because the customer realizes there are many pitfalls 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. Inventory is dedicated 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’s 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, effort and headaches. I suggest reviewing these orders for incoming freight. If my assumptions about incoming freight are correct, now might be a great time to chat with the customer on the topic.
Three final thoughts…
- Expect sales pushback. Be strong in your conviction that you must be paid for the work you perform.
- It is better to establish an expectation that your company passes along price increases on a regular basis. Many distributors get into trouble because they hold the line for years and then discover they must present one massive price increase. Massive price increases are troubling to customers, small incremental increases are not.
- A pricing process should be part of your overall strategy. I regularly study the work of David Bauders and his team at Strategic Pricing Associates. Their process allows you to raise the prices on the products without a great deal of price sensitivity. Customers rarely notice. Salespeople push back, they always do. By the way, price increases done right impact profitability like no other activity. A two point improvement in gross margin can add 50 percent to the bottom line.
Contact Frank Hurtte of River Heights Consulting via email at email@example.com or via phone at (563) 514-1104.
This article originally appeared in the July/August 2015 issue of Industrial Supply magazine. Copyright 2015, Direct Business Media.