Distribution Pricing: Why Velocity Pricing and Service Fees Won't Necessarily Work in the New Economy
Part 1 of 2
by Scott Benfield
Recently, I was sent new literature on distribution pricing by a client. They were questioning much of the accuracy and assumptions regarding the text, especially in light of current and future economic conditions. I obtained a copy of the release, thumbed through it and put it away. I find that when there are purported experts on subjects who sell a discipline as a cure-all, I am best left to put the material down and cool off.
Distribution pricing is a growing field and, like many growing fields, has new literature that is being generated all the time. As far as I can tell, Jane E. Baynard and I penned the first pricing text for distributors1 some eight years ago. Since then, there have been many texts, seminars, experts and software companies who have come forward to tout their pricing expertise. Some of these companies filter in from other pricing roles including manufacturing-based pricing or software that helps with pricing decision-making. Others are simply trying to “catch a wave” and have no solid pricing management credentials, no formal academic training in the discipline, and no professional marketing background from which to advise on pricing. I would place the recent aforementioned text and its author in the category of a “wave catcher.”
The problem I have with “wave catchers” is that they lack substance and, with a discipline as powerful and dangerous as pricing, they are playing with fire and the client can easily get burned. “Wave catchers” will tell you that you can get easy pricing gains of 2% to 4% and then they will take you through the common areas of distribution pricing including velocity pricing, segmentation, decile or quartile analyses, transaction-based pricing, and various service fees. This was all covered in our release nearly a decade ago and, while it still has some merit, the economic conditions and distribution industry were much different back then, is much changed today and will be very much changed tomorrow.
So, I’ll take on the “wave catchers” who spout the easy pricing advice and relay my concerns. Initially, our work in pricing was to bring the basics of strategic marketing to the discipline including segmentation, product dynamics, and behavioral pricing including blind item or “velocity” pricing. You’ll find the “wave-catchers” tout velocity pricing and use various scaling analyses such as decile or quartile rankings of products and their sales to demonstrate the opportunity for pricing gain. They will go through various service fees such as freight, invoice origination fees, etc., and tell you to increase fees for these services. In years past, with fast growth economies and skyrocketing commodities, velocity pricing, when properly applied, and extra service fees would work rather well. The world today is not so forgiving, however, and distributors who accept velocity pricing as a given may be in for some real headaches.
A New Economy, A New Way to Market
In today’s economy, post-recession growth is forecasted to be tepid at best. In an August 2009 report2 the Congressional Budget Office (CBO) estimated GDP to be at 1.7% for 2010 and not return to normal levels until 2011. The CBO report, however, is getting a lot of flack as it appears far too rosy given the experience of businesses and the unemployment rate which is estimated to be above 8% for several years. On top of the lousy economic environment, the aspect of globalization and falling material prices are weighing heavily on distributors. In the past growth cycle, commodities exploded, often reaching levels three times or more than past long-run averages. Distributors made inventory profits in these years and pretax incomes were at all-time highs for many industries. Our work in foreign sourcing by distributors3 finds that a growing number of distribution companies are sourcing foreign made “off-brand” products that average 30% less (landed cost) than domestic brands. In many instances, the product costs are expected to fall faster than the market grows. Hence, the dynamics for distributors in the next decade are likely to be slower growth, falling product prices, and limited commodity inflation. In turn, this translates to a price sensitive environment where any and all prices will be scrutinized much more than in years past. As the environment changes, so must pricing policy. Recent releases from the pricing “wave catchers” perpetuate the same old logic which was predicated from work done under vastly different economic conditions. In short, pricing policy in the future will take a turn and distributors should be concerned not so much about what prices they can charge and get away with, but how they can win orders in a price-sensitive, limited growth marketplace. In short, the shift focuses to cost, how to get cost down, and win the order.
Enter the Cost to Serve
The cost to serve is located in the distributor’s operating expenses and includes all the standard operations that a distributor does including purchasing, put away, picking, packing, shipping, selling, billing, extending credit, warranties and returns. Most distributors do a fair job of budgeting and streamlining processes and limiting operating expenses. There is still room for improvement in these areas but, from my experience, the vast majority of distributors are in a mode of passing on the increased operating expenses to the customer. In past times, with rising commodity prices and hyper-growth economy, this is a sound position. In today’s and tomorrow’s markets, it can be suicidal.
The cost to serve, in past times, has traditionally not been seen as an area of competitive advantage. The biggest costs are product costs and they overshadow and out-leverage operating costs by a large margin. Product costs are often 75% of sales, whereas operating expenses are 20% or so of sales. Product costs, however, may not be the area of strategic gain in the future that they have been in the past. Why? Simply speaking, product costs can be found 7 x 24 over the Web and around the world, and the availability of foreign-made products is exploding. Two years ago, we reviewed six sources of foreign products that were growing. Today, we find that several of these models, including importers and master distributors, are often growing despite the recession. Hence, checking product prices and sourcing from low-cost producers is easier than before and will become easier as globalization of manufacturing takes hold and use of the Internet to check product prices becomes widespread. With product cost becoming an increasingly level playing field, the cost to serve will become the playground for strategic advantage.
The cost to serve, however, is poorly understood and most distributors use association accounting (PAR) reports to benchmark these costs. Accounting data, however, is a poor substitute in understanding the cost to serve and its link to service quality and pricing policy. New tools and new understanding are needed and are the subjects of the next sections.
Quality of Service and Pricing Policy
Cost to serve is related to service quality. The higher the quality and diffuse the services, the higher the operating expenses. Customers evaluate distributors on service quality and it directly relates to their purchasing decision. Quality does not live in a vacuum, however, and is related to price as operating expenses have to be covered by the price charged. For instance, looking at Exhibit 1 (below) we see that there are two axes on the service/quality quadrant with the X axis being service quality and the Y axis being price.
Focusing on the exhibit, there are four quadrants that plot Relative Price against Relative Service Quality. For instance, a low price/low quality distributor courts economic or price-sensitive buyers. A high price/high service quality courts quality buyers and a low price/high service quality means share gain. In typical high growth economies, one would find that there is room for the high price/high service quality buyer but I expect less of these buyers to be around in the slow growth future. I would also expect the low service quality/low price quadrant of economic buyers to become less of the marketplace. Why? In a slow growth economic environment, many buyers will seek a low price but want high quality. This means that all quadrants will move a substantial part of their buyers to a low price/high service quality platform and the implications for distribution pricing are profound.
When I ask distributors about their quality of service, most tell me that it is “great” or “high quality.” Most have no empirical measure from the customer on their level of perceived quality. Most have no idea that it is entirely possible to measure the customer’s perception of service quality to price paid. And without these measurements, it’s very difficult to know how to set pricing policy and link it to a market strategy. In this environment, and with the current level of understanding, I expect many distributors to tack pricing on to their current operating cost structure and, in an environment that wants low price and high service, they may have a high price and mediocre or low service and, over time, they will lose sales!
In essence, if a distributor can’t empirically measure their service quality in a price-sensitive economy, it is almost impossible, with any accuracy, to set pricing policy and know the market outcome. It is likely that a distributor with high service (operating costs) increases prices and will engender a sales loss strategy and never know it!
The issue I have with some of the pricing “wave catchers” and their current material is that they seldom, if ever, mention service quality and pricing policy. And, in today’s environment, I find this oversight to be preposterous and strategically dangerous. Service quality is how customers evaluate distributors to buy from them. Since most distributor products are commodities, the critical factor in the buying decision is services, and without solid measurement on where the distributor stands in their quality of service, it is strategically dangerous to set pricing policy. Furthermore, this inability, in a slow growth and price-sensitive environment, can easily lead to share loss.
The Complexity of Operating Expenses
If one believes in accounting data or ledger costs, it is relatively easy to manage operating expenses with a budget and determination. As these expenses relate to service quality and service quality relates to pricing, however, new tools and new thinking are needed. The consequences of not engaging new tools and new thinking can be dangerous and, when coupled with yesterday’s pricing policy of the “wave-catchers,” the results can be ruinous. We will review the new tools for understanding operating expenses and services as they relate to pricing policy and market strategy in part two of this series. In the meantime, if you encounter one of the “wave catchers,” ask them if they use service quality measures to set pricing policy, what their instruments are, how they are used, and to give evidence of their usage. If you get a lot of “mumbo-jumbo” or they are dismissive about the logic, consider that they might not be all that qualified to set pricing policy and encourage them to go out and catch another wave.
Scott Benfield is a consultant for distributors and manufacturers in industrial markets. He has consulted with distributors since 1998, worked in Fortune 250 channel marketing and sales roles as an executive/manager, and set long-term pricing policy for dozens of distributors and manufacturers. He has a BA/MBA with concentrations in marketing and operations from Wake Forest University. He can be reached at (630) 428-9311, firstname.lastname@example.org, or www.benfieldconsulting.com.
2 See CBO August 25, 2009 Update on the U.S. Economy at: http://www.cbo.gov/ftpdocs/105xx/doc10521/EconProj_Aug09.xls