Keeping Pricing Gains

Feb. 1, 2003
In this series, we have looked at various aspects of pricing including segmented pricing, pricing a managed inventory agreement and service pricing. In

In this series, we have looked at various aspects of pricing including segmented pricing, pricing a managed inventory agreement and service pricing. In this installment, we will examine common problems to maintaining pricing gains and how to correct them.

The ability to keep pricing gain is part of the pricing control system. A control system, in management, is simply the measures and reviews used to maintain control over processes that can have multiple outcomes.

Wholesalers, for the most part, have simplistic control systems that allow maximum flexibility. This is an evolved style of management that appeals to sellers and the sales philosophy of maximizing top-line growth. The purpose of a pricing control system is to maintain bottom-line profitability while ensuring targeted segment growth.

The proposals in the ensuing writing limit the saleperson's ability to quote whatever it takes to get the order. If you are not willing to get control of your sellers and hold them accountable for pricing decision making, then don't read any further. As long as your competition has a freewheeling style of pricing at "whatever it takes," you will be fine. You can both beat each other into sub-2-percent margins while paying your salespeople big bucks. If you want to get control of your salespeople and pricing, then the following observations and suggestions will give you a good start toward pricing and profit accountability.

Unbalanced vs. Balanced Compensation Systems Most wholesaler salespeople are paid on top-line revenues or gross-margin dollars. Typically the pay scale is some multiple as a commission based on beating the prior year's sales or generated gross margin. For example, suppose outside salesman Al Watt, has a territory that yielded $2 million in revenues and $440,000 gross margin dollars in the previous year. Common compensation systems for Mr. Watt would include the following or similar logic:

- A payout of 1 percent, 2 percent or 3 percent of sales over $2 million dollars. If the payout was 2% and sales were $2.5 million, Al would get 2% of $500,000 or $10,000.

- A payout of 3 percent, 6 percent, or 10 percent of the increase in gross-margin dollars. If Al's territory yielded $120,000 new gross margin dollars and he was paid at 6 percent, he would get $7,200.

There are, of course, numerous variations to the above examples including a "draw" against the territory until a target is reached. Often the payout period is less than a year and is done as a year-to-date versus prior year-to-date. For the most part, however, these or similar options are poor control mechanisms for maintaining bottom-line profits. Why?

Top-line sales targets reward on beating the previous year's revenues. If the economy is soft, sellers will often reduce price to increase personal compensation. Unfortunately, this can spell big trouble for the firm. In a consulting project of years past, I experienced this with a rather large distributor of heating supplies and parts. The company was undergoing a soft economy and management had cut operating expenses, including heads, to the minimum. Even with expense cuts they were still running in the red and couldn't stop the margin degradation.

When I discovered sellers were trying to cut price in order to beat the prior year's (good economy's) sales, I told management to change the compensation plan immediately because they were literally paying their sellers to put them in the red. In short, no amount of price cutting by the sellers could induce enough volume to put the wholesaler over prior year's targets. Sellers had literally dropped margins on the order of 4 percent and never realized it took 16 percent gain at a 25 percent margin to breakeven. The company was running at the bare minimum and couldn't maintain service quality with any less staff.

Many wholesaler managers also reward on gross-margin dollars. Ostensibly, they are familiar with the previous situation and believe that sellers having a territorial gross-margin bogey relieves the desire to cut price and ratchet up revenue. I have found gross-margin dollar targets to be minimally better than top-line targets. Most sellers understand the math behind the loss in margin percent, but they often bet on their ability to cut price and overshoot the prior year's margin dollars. Price cutting to reach a margin or sales bogey almost never works for various reasons.

First, remember that wholesaling is a largely variable cost business and price cuts, if they don't work, cause managers to reduce operating expenses to maintain EBIT. Second, wholesaling is a mature business and growth is somewhere in the range of 3 percent to 5 percent per year. A price cut of 1 percent in a 25 percent gross margin business needs 4 percent growth to breakeven or 7 percent to 9 percent for real growth (3 percent to 5 percent plus the 4 percent). This is quite a feat and means that price cuts must capture significant share. Finally, wholesalers differentiate themselves by services that are located in the operating expenses of the firm. Price cutting on product sales sends the message the products are commodities and so are the services that support them. Ideally, it is better to cut price on products and unbundle them from services where you can charge rates that reflect service quality and value.

Any one measure of compensation is unbalanced. In essence, one measure is too easy to "fudge" or sidestep and doesn't balance growth at the top line with growth at the bottom line. I largely believe that top-line and gross-margin dollar systems are unbalanced control systems and cause wholesalers much bottom-line misery. In short, wholesalers are literally paying for poor EBIT. If you have this problem, then consider the following solutions for getting your sellers to maximize pricing gain.

- Measure on sales gains and margin percent, or on gross-margin gains and margin percent. Review the adjacent matrix bonus layout of Sales Growth and Gross Margin Percent. The matrix begins with a segment at a 19 percent gross margin and $14.02 million in sales. The first square in the upper left hand corner lists the starting points for the bonus. On the left side of the matrix is the sales growth in millions of dollars from $14.02 million to $16.06 million. On the top horizontal axis of the matrix is gross margin percent starting at 19 percent to 21 percent. The bonus is designed as a payout percent of base compensation. If the base salary was $70,000 and the segment finished at $15.5 million and 20.6 percent margin, the payout is 19 percent of base or $13,300.

The matrix balances sales growth with gross-margin percent growth and guards against cutting price to hit a target.

- If you have an activity costing system, consider rewarding on activity profits. Remember, however, in most activity cost systems 50 percent or more of customers are actually unprofitable at the EBIT line. You should plan a compensation target that is reachable based on the prior year's activity margins.

- Use an "open book" accounting system with employees that shares profitability numbers and educates sellers on how the financial statements work. Work with them on understanding how pricing gain helps drive profitability.

All of the above measures used singly or in combination (where sensible), are superior to single measurement compensation systems. They balance the need for growth and the need to maintain profits, which is largely due to maximizing pricing gain.

Elect a Corporate Pricing Manager In my seminars, I ask wholesalers about the appointment of a corporate pricing manager. Most executives look at me as if I am suggesting a worthless position that is not needed. I am most serious, however, about selecting a qualified pricing manager and giving him or her clout over the sales pricing function. Pricing, to be done well, is too different from sales skills. It requires marketing knowledge, accounting knowledge, financial knowledge, understanding of pricing theory and basic statistical theory training. Sellers can be trained, but I prefer authority in one position to maintain focus of purpose.

If you are serious about developing a corporate pricing manager, you should hire someone who is willing to put in long hours of analysis and structure of developing a pricing system. You should be willing to give them clout over sellers and to appropriately structure the reporting system. Don't let them report to a sales/marketing manager who is more of a seller than a marketer. It is better to let them report to accounting or finance than to a sales-driven, top-line maximizing manager. Of course, to get the right individual will cost in salary and support, but in my view there is nothing more important to capturing value and growing EBIT than pricing.

Pricing as a Recognized Professional Discipline Pricing is as important as any of the marketing disciplines and should have a status equal to purchasing, operations, sales management, or any other staff activity. Wholesalers consider that because their sellers can match a competitive price, they can maximize profit through pricing. This thinking is pure fallacy and causes many wholesalers to fail where they could succeed by delving into better pricing management.

I recently ran across a rather large electrical distributor (sales in the hundreds of millions) whose EBIT was 1.7 percent of sales. This financial return (ROE) is probably less than the average index fund and lacks diversification and liquidity of a public stock holding. At these margins, the wholesaler probably has trouble with plowing back any meaningful capital into the business and, with a downturn looming, doesn't have much protection against a decrease in business. If you literally can't get a return out of your business better than an index fund, then my advice is to get out or get better.

Lousy earnings are an embarrassment and unacceptable to shareholders. Just because much of wholesaling is privately held doesn't mean shareholders, and those paid for growth, shouldn't have earnings expectations of the public markets.

I meet far too many wholesaler executives who rationalize why they don't manage their pricing and, of course, they also rationalize their poor earnings. Don't let yourself be caught in making excuses about not having professional pricing management.