Every distributor believes that they have a unique product and service combination and can serve customers better than their competition. If that’s true, why do distributors still rely on cost-plus pricing and market-based approaches, which can leave up to 450 basis points of margin on the table?
The pricing method a distributor selects is a primary reason for missed margin opportunities. Cost-plus and market-based pricing may be the most widely used pricing philosophies, but their rudimentary approaches typically result in massive margin leakage. Cost-plus pricing accounts for product cost and applies a standard gross margin to all products. Market-based pricing, which is quite popular among the sales force, conservatively prices close to the competition with the goal of safeguarding market share.
Value-based pricing is a vast improvement on these methodologies because it’s based on what the customer values and what the customer is willing to pay. Moving to a value-based approach may require additional time and effort, but attributing value to every customer, product and supplier is a better way to preserve long-term margins. Value-based pricing provides the following key benefits:
- Customer conversations focus on problem-solving.
- Price pushbacks from customers take a backseat.
- Your sales team sells better by concentrating on value.
- You differentiate yourselves clearly from your competition.
- You get compensated better in the marketplace for your value creation.
Moving to a value-based pricing approach does not happen overnight. It begins by creating a value-driven culture internally. To prepare yourself for a value-based pricing culture starting in 2021, we’ve outlined 10 steps you can apply immediately. This 10-step roadmap was developed from hundreds of pricing implementations and our interactions with distributors that adjusted their pricing processes in 2020 across various lines of trade.
1. Create Your Team
The most critical step is to create a cross-functional, strategic pricing team led by a pricing manager or a chief profitability officer. This improves upon the more common, siloed approach in which only a pricing analyst or the salesperson influences most pricing decisions.
I love games, and one of my favorites is the Rubik's cube. Like a Rubik's cube, your customers receive value from six different teams in your organization:
- Sales (including customer service)
- Operations (warehouse and transport)
Creating a pricing team without representation or input from each of these departments is a fundamental mistake many distributors make as they move toward value-based pricing. To get it right, your team should involve individuals from all these areas. Companies are establishing roles such as Chief Value Officer, Chief Profitability Officer, Chief Pricing Officer, etc. to lead their value-based pricing initiative.
2. Set Your Goals
For an effective pricing strategy, you must set specific gross margin and market share goals. Most companies set these goals at a corporate or branch level. However, to focus on value-based pricing, you need to tie your goals to your value triangle: suppliers, customers and products. The role of competitors on your pricing strategy must be established along with long-term strategic objectives. We’re all familiar with SMART goal setting, in which goals must be Specific, Measurable, Achievable, Relevant, and Time-bound. When you set your goals, merge SMART and your value triangle together.
3. Experiment Wisely
Select a pilot location(s) representative of the whole business in terms of volume, product mix, customer mix, geographical structure and profitability. Depending on your company size, you could have multiple pilot locations. For example, we worked with a building materials wholesaler-distributor with 160 locations that chose five pilot locations based on their regional presence and other relevant factors.
4. Assess Your Process
Assess your current pricing process to identify opportunities for enhancement. Include your IT capabilities in this assessment. Document your assessment in terms of the three implementation components: people, process, and technology. In addition, document the reasons for current gaps, which might include:
- Financial constraints
- Traditional rule-of-thumb practices
- Lack of exposure to a value-based pricing methodology
- Change management
When you document these, also identify potential solutions to avoid resistance later in the process.
5. Define Your Price Cube Based on Value
Your price cube is foundational to your pricing process. It helps narrow your view of potentially hundreds of pricing variables to the most primary, influential and quantifiable ones. In our years of experience working with distributors, we’ve found that a value-based pricing cube should account for these six primary variables:
- Customer Value: Who buys from us?
- Supplier Value: Who do we represent?
- Product Value: What do we sell?
- Item Visibility: How often do we sell items to customers?
- Purchase value: What is the cost to buy product from suppliers?
- Realized Margin: How much do we make?
6. Customize Your Rules
Your strategic pricing team should adjust or set pricing rules and price multipliers. Think of it as setting boundaries for your pricing process – a threshold between minimum and maximum margin expectations. Keep it simple by setting the multipliers at customer and item groups. Most companies have three to five customer categories and four to six item categories. Your rules and multipliers should address four different scenarios:
- Existing items sold to existing customers
- Existing items sold to new customers
- New items sold to new customers
- New items sold to existing customers
7. Apply Rules and Observe Results
Develop a specific project plan that includes:
- Project sponsor
- Project manager
- Project team (both business and IT)
- Any external help
Apply the price cube and pricing rules to your chosen pilot location(s). Assess outcomes with your tactical team, which could be inside sales, outside sales, branch managers, marketing managers, or the pricing manager. These are those frontline staff members who typically deal with customers and make pricing decisions hundreds of times every day. Adjust price multipliers if necessary.
8. Implement and Integrate Technology
Next, you must implement your new pricing process in your IT or ERP system and extend it to all your locations. This step involves a technology assessment in which you’ll:
- Evaluate internal IT capabilities
- Identify long-term goals
- Perform a cost-benefit analysis
- Make decisions concerning technology investments and upgrades
This could take two to four months depending on your resource availability and company priorities. You must evaluate third party solutions, new/existing ERP modules, and DIY options to determine the best technology fit. It’s important that the front end (graphical user interface) of the technology is user-friendly and actionable to encourage user buy-in. Depending on the level of sophistication of end users, classifications and pricing information should be presented in an easily digestible manner with an on-demand option for more data-rich dashboards for curious users.
9. Educate Your Workforce
Explain your value-based pricing best practices and why they should be used by your employees, particularly those on the frontline. Provide both technical and business education to help them apply their learning in daily decision making while focusing more on value and less on price pushbacks from customers. This is also a good opportunity to address implementation challenges faced at pilot locations.
10. Review and Improve Continually
Identify metrics, or key performance indicators, to monitor the sustainability of the value-based pricing approach. Devise mechanisms to link user performance to these metrics and apply the appropriate compensation/incentive structure. Dashboards with key metrics for various users, from the front line to top management, can be designed and implemented across the company. Review goals periodically (monthly or quarterly) and adjust according to business conditions. Finally, observe and address any challenges or mistakes to achieve continual improvement and, ultimately, drive maximum growth and success with value-based pricing.
Pradip Krishnadevarajan is co-founder of ActVantage, which helps distributors drive profitable growth through analytics. He has more than 15 years of experience helping hundreds of distributors while co-authoring seven books for the National Association of Wholesaler-Distributors. Before joining ActVantage, he co-founded the wholesale distribution-focused research lab at Texas A&M University's Industrial Distribution Program. Contact Pradip at firstname.lastname@example.org or visit actvantage.com.