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Pricing Training Steams Up

Nov. 1, 2003
Special nonstock items may be expensive to process, but don't let them derail your profits.Part two of this five-part pricing series also looks at segmented

Special nonstock items may be expensive to process, but don't let them derail your profits.

Part two of this five-part pricing series also looks at segmented pricing.

Trying to cover the spectrum of pricing in a series can be tough. To make this series practical, individual pieces of the pricing puzzle will be addressed because I am more interested in giving pragmatic solutions to pricing problems than in fitting together the pieces of the pricing puzzle.

One of these problem areas is nonstock items. For our discussion, I limit nonstock items to special-order items that are not stocked but ordered as needed. Most often they are processed through the warehouse and shipped on the company fleet to waiting customers.

The basic problem with nonstock items is that they are expensive to process. The typical nonstock item is often ordered separately. It may be added to a stock purchase order, but it still requires special handling throughout the firm. Nonstock items often set off a chain of expensive transactions including a separate purchase order, separate receiver, specialized batch inventory, separate payment and separate freight transaction. They also have a higher warranty risk than stock items and are more difficult to return because of unique vendors. All totaled, most activity costing systems put nonstock transactions as three to seven times more costly than similar stock transactions.

For the economic impact of these extra costs, consider the following example. Suppose that Wholesaler A had an average of $40 sales per line at a 25 percent gross margin. Let's say that the cost per line was $1.25 to process the order. The economics for the line would be a $10 margin ($40 minus $30) less $1.25 processing costs or a net of $8.75. Now consider the nonstock item that costs $30 and is cost-plus priced at $40. The processing cost is, for illustrative purposes, five times the stock item or $6.25 (five times $1.25). The net, after processing costs, is $10 margin less $6.25 or $3.75.

Many wholesalers without activity costing are surprised that nonstock items are so expensive to process. Although the numbers in the example don't reflect every wholesaler's costs of processing, they aren't far fetched. The margin, after processing costs, for the nonstock item is approximately 10 percent (3.75 ö 40) versus a 22 percent (8.75 ö 40) for a stock item. To breakeven with stock margins, the price of the nonstock item needs an additional mark up of ($6.25 minus 3.75 ö $30) or approximately 8 to 9 percent to cover the added cost of the transaction. If you're not pricing nonstock items above and beyond stock margins, you may not be making what you should.

OTHER NONSTOCK CONSIDERATIONS AND PRICING SOLUTIONS The following analysis helps to quantify the cost of nonstock specials. Market realities may or may not allow for an extra 10 percent margin to cover these transaction costs. Most wholesalers cost-plus price nonstock special orders because cost is available to the inside seller exploring the customer inquiry, and a list price is not available or is not used.

The problem is that cost, for some transactions, is a fair and convenient basis from which to price an item, but for other transactions, it's a lousy method. For instance, in a hotly contested "job" bid for contractors, product cost is a floor from which margin is attached by competing wholesalers. In this instance, regardless of how the product is procured, the bidder needs to be competitive to get the orders.

In a simple inquiry about an item, cost is a lousy basis for pricing. Why? Customers aren't always sensitive to item costs, and they often ask for a "quote" on the item to give a price to their customer. In these instances, we recommend several solutions:

- Develop a suitable list and discount mechanism for nonstocks. For instance, if the cost was $30 and the typical cost bump is 25 percent, use the pricing system to fabricate a list and an appropriate discount. A common rule of thumb is to multiply the cost by 2.5 for a list of $70 and then discount 25 percent for a price of $52.50. Discounts are well perceived by customers and inside sellers.

- Use the above mechanism and vary discounts by transaction size. The larger the dollar size of the transaction, the greater the discount needs to be. Why? Pricing research shows that the larger the dollar amount purchased, the more sensitive customers are to line-item price.

- Charge an "Inbound Freight and Handling" fee for nonstock items. The fee recognizes the extra handling costs of a specially ordered item and eliminates matching the freight bill to the customer invoice. A simple percent fee that varies with the cost of the goods is sufficient in most cases. For example, 5 percent under $100, 4 percent from $100 to $250, etc., can be programmed into the pricing system and easily implemented.

Of course, any time you raise prices or have new pricing line items for an order, the greater the fear is that sizable losses will occur. To hedge the risk of this happening, remember the following rules on pricing increases:

- Small incremental increases are better and less noticed than large increases. In other words if you want a 5 percent increase, five 1 percent increases (spread over time) are better than one 5 percent lump.

- Select 30 to 50 random customers by segment and raise the price to the desired levels for four to six months. If volume does not decrease substantially, you can roll the price out to the segment with similar expectations for success. Why? The technique, called statistical approximation of a pricing increase, uses valid random samples of similar customers to approximate the effect of price change to a segment population while diminishing the risk of volume downside because the sample is small.

Whatever you decide to do, don't leave nonstock specials to be cost-plus priced by inside sellers. Most inside sellers don't understand the cost structure behind these items, and they are wary of any pricing upside that would seemingly jeopardize customer relationships. They also perceive that a 40 percent mark up (1.4 over cost) is a "rip-off" for a good customer while a 40 percent discount from a 2.5-times list (1.5 over cost) is a customer value.

SEGMENTED PRICING AND INVENTORY VELOCITY A common method of arranging discounts or cost-plus margins is the speed at which items move from inventory. This method of pricing is commonly referred to as velocity pricing, which translates inventory movement into margin strategy.

For instance, reviewing Figure 1 (page 64), we see five products for Ampere Electric arranged in order from highest sales to lowest. Ohm Stones are the largest selling category at $511, 331 and Joule Jumpers, the lowest with $178,422. We also see that gross margin (GM) percent rises as the category sales grow smaller. The gist of velocity pricing is that as product sales rise, gross margins decline. Research finds customers benchmark pricing on high usage products and don't necessarily review prices on slower moving items. Pricing literature calls price checking finding a reference price; these products are reference products.

Several contemporary wholesaler texts and consultants advocate arranging product usage from highest to lowest and pricing accordingly. Based on research, however, this practice does more harm than good. Why? Look at Figure 2 (page 68), which lists the five products under a customer segment classification. Under the Residential Repair Segment, Amp Stamps are the fastest moving product. According to velocity pricing they would get the lowest margin.

In the Commercial New Construction Segment, Watt Widgets would get the lowest margin and Ohm Stones a mid-level margin. In other words, if Ampere Electric priced by product movement under Figure 1, their pricing would not reflect specific market (segment) realities. Ampere managers would overprice Amp Stamps for Residential Repair and underprice Ohm Stones for Commercial New Construction.

The desire to sort by overall product usage and price accordingly is a common marketing mistake. Instead, the marketer should determine a segmentation logic and then arrange product usage by segment. Products are used at varying rates across segments; what is an A-moving product in one segment is a D-mover in another.

Of course, the preceding analysis assumes a viable segment logic. There are right and wrong ways to segment; for a discussion of the topic, we refer the reader to any of a number of marketing primers. The key point is that customer segments are the bedrock for a market-based pricing system. Many wholesalers don't understand this and fail to capture the maximum profit in their pricing systems. So, when developing a market-based pricing logic, segment first and program velocity analyses second.

And, whatever you do, don't let your sellers pooh-pooh these analyses and tactical moves.

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