Here, in the American Midwest, the common skunk (mephitis mephitis) thrives despite urban sprawl. Skunks send dog owners berserk as Fido, in just about any breed, can’t avoid cornering the animal. Skunks have poor eyesight which makes their jaywalking dangerous.
They are also, mostly, nocturnal scavengers and when jaywalking at night, they lose to the automobile tire. The result, on humid Midwest summer days, is a dead skunk that stinks to high heaven.
Our work in distributor pricing over the past two decades finds persistent and common dead skunks in the discipline. In general, while the discipline has become better funded and managed over the years, there’s still plenty of needed improvement and just plain poor practice. Pricing is crucial to earnings, which are the bedrock of valuation.
In short, if you want to sell your distributorship for more, you should price well. If you want a sub-par valuation, dead-skunk price.
To help distributors decide if they price well – or not so well – I list the more common dead-skunk practices in the remainder of this article.
Fixed or point pricing is simply a price, stuck in the pricing file, such as $21 for an out-of-round widget. The problem with a fixed price is that it is fixed—it’s not connected to anything and hence doesn’t move as cost moves. Because distribution is a buy/sell business and costs tend to rise over time, fixed pricing compresses margins. We’ve found pricing that is years old, where costs have risen 10% or more since the last price update and the price to the customer hasn’t moved.
Distributors often tell us they have a fail-safe in that they review individual customer pricing files when a vendor increases price. But, with hundreds of thousands or even millions of prices in the pricing file, this is an impossible job. There are better ways to price for a buy/sell firm, and they avoid inspecting quality into hundreds of thousands of prices.
Our suggestion is to nix fixed pricing in its totality; stamp it out, burn it, bury it deep, and have a zero-tolerance policy for it for as long as you own the business.
Cost Plus Pricing
Pricing captures value added by the firm. Distributors, mostly, add value in services surrounding the product. Value can be added through basic services or higher level, less mature service offerings. The closer a firm is in touch with their value, the better they capture said value in the price. Cost plus pricing, on the product cost, circumnavigates value-based pricing. It has little to do with where and how the distributor adds value.
Cost plus pricing also yields low margins. Why? Costs are penalties applied to longstanding customer relationships. We illustrate with a common customer price objection.
Customer: “I think $45 is too high for gray-green thingamabob.”
Distributor Seller: “Well I can make it cost plus 25% rather than cost plus 30%.” (Note: This never happens, but it might as well because that’s what does happen to reduce the price.)
Instead, we offer:
Distributor Seller: “I can give you 30% off list and get you to $42.”
The upshot is that cost plus prices are penalties whereas discounts are gifts. The behavioral mechanism is called prospect theory, which states that the fear of losing the order is greater than the desire to make more margin. The use of list and discount reframes the pricing decision from a penalty and loss mindset to a discount and win mindset. Finally, pricing objections can’t be optimized from product cost as the base for the pricing is not the value the distributor adds.
Manufacturer List Prices as List Price for Distributor Customers
Manufacturer list prices are developed for the manufacturer’s use and reflect their profitability needs. Trying to use them for distributor pricing is an almost impossible job. Why? If a distributor has 1,000 stock vendors, there are 1,000 major variations on list price that must be dealt with. Furthermore, and a much more odiferous outcome, is that there is no consistency in discounting. For instance, if you want 35% gross margin on a group of 100 manufacturers, you will likely have 100 different sets of discounts and probably discounts within individual manufacturers. The upkeep in labor and accuracy is an impossible job.
We recommend using replacement cost times a multiple for a corporate-wide list price logic. We advise distributors use a 2.5X to 3.5X logic for list price determination and the list floats with replacement cost which helps preserve margin. An example, for a $100 cost SKU to get a 35% margin, is a list price of $300 less a discount of 49%.
Using a corporate-wide list and discount ensures product cost increases are captured in real time. It also avoids prospect theory and the impossibility of managing thousands of vendor lists. There are some pricing software programs where the de-facto logic still uses manufacturers’ lists in distributor pricing. We can’t imagine a more costly, labor-intensive and odiferous practice.
Pricing Software is Good Pricing
Pricing software is important for management of pricing. It forces a system logic on the discipline and allows the distributor to manage thousands of SKU prices. Pricing software, however, means little unless the distributor has good marketing management behind it. This includes transaction-type pricing, segmented pricing, services pricing and statistical variation of prices for optimization. Without good, trained marketers who can offer market definition and statistical analytics, having pricing software means you have pricing software, but it does not mean you have good pricing.
The pricing discipline needs a structure or roadmap before you can build out pricing software. Structure includes building blocks such as segmented pricing for stock items, non-stock pricing logic, services pricing, cost-recovery pricing and contract management. Without a structure, the pricing system and its results are often off the mark.
Pricing structure often conforms to market definitions of customers including segmentation by application, customer size, etc. But we find, far too frequently, that distributors often don’t use segments, or they are poorly defined. Cost-recovery pricing is recovery of costs (think freight, special packaging or handling etc.) that are not fully covered in the contracted price. And non-stock pricing is a unique type of pricing as transaction cost and price sensitivity are different.
We often ask distributors about their pricing structure or the building blocks of their pricing discipline. The answers leave a lot to be desired. Without a good pricing structure, the pricing results are all over the place and often poor.
For good analysis, data needs structural definition before the analytics. We recently entertained a prospective client who wanted us to “torture the data (with analytics) until it confesses.” Following our experience in the long-term relationships with B2B firms, torturing data, without market definitions, means next to nothing. Whereas with well-defined segments and transaction-type definitions before analytics are started, great results can be yielded.
Overrides are where the system-based price is overridden by order-takers or sellers. Overrides should have a history or archive file including information on customer, SKU, system price, override price, order-taker, seller, etc. When this data is captured, pricing management, sales management and executives should counsel those whose overrides are too many and deviations from system pricing extreme.
Too often, we find distributors catalog overrides but don’t manage them including excessive discounting. If you don’t limit discounts or challenge the excessive use of overrides, then don’t be surprised if your earnings stink.
Contracts are off-matrix pricing reserved for, usually, larger customers who are heavily solicited. In our consulting, we find contracts that are, unfortunately, legacies of sellers long past and have not been reviewed, sometimes for years. Most software pricing prioritizes contracts above other means of pricing determination. The result is that poor contract review yields sub-par pricing performance.
Distributors should consider contract management which includes pricing review cycle, review standards for margins, pricing mechanism and contract length. We often find Nuke Laloosh1 pricing in contracts where the pricing, like the famed hurler’s fastball, is “all over the place.”
Dead-skunk pricing in wholesale distribution is surprisingly common. Too often distributor execs move a former seller or operations person into the pricing discipline without proper vetting or development. Often, distributor execs assume the purchase of a popular pricing software package means optimized pricing. Nothing could be further from the truth.
Pricing is a discipline, which means it has a core set of principles and is continually changing. It requires significant investment in software and management. It demands time, attention and funding of the first order, or distributors give away their value in a thin-margin business while risking dead-skunk returns on equity.
1 Nuke Laloosh is a leading character in the film Bull Durham, produced by Orion in 1988.