Don’t Let Leakages Erode Your Pricing Strategy

In nature, erosion can create something great. In business, price erosion won’t do much good.

You have hopefully a good understanding of the overall trends in your industry and how they will affect pricing. You are prepared for fluctuations in raw material costs, understand how new technologies shape the business and have considered long-term capacity issues.

If everything is well, you have selected the right market position with respect to your competition. You have also segmented your customer base and use price discrimination to charge for the value every customer segment perceives.

You might still suffer from less visible leakages that eat into the prices you try to manage carefully. These leakages, unless consciously managed, greatly erode net prices while not necessarily making a big difference for better or worse in customers’ eyes.

Such leakages, exemplified by bonuses, costs of trade terms, discounts and allowances, often have the following characteristics:

  • Their size varies significantly between markets, customers and orders.
  • Some customers value the benefits conveyed by these leakages while others could not care less.
  • The sales force and product managers feel relatively little responsibility for these costs.
Leakages are often analysed in a waterfall view. Waterfall charts can be drawn at any level of detail e.g. customer, segment or region.

A leakage management agenda is usually quite an easy way to improved profits. It consists of four steps:

  1. Identify the leakages relevant in your case.
  2. Understand the size and variance of the leakages.
  3. Starting from the most significant leakages, assess their importance to your customers. Whenever possible, remove a leakage or start charging for it.
  4. Ensure that your business performance metrics include the leakages to make this a sustained improvement.

What might be a relevant leakage then?

Annual rebates.
• Description: A bonus paid to a customer, typically at the end of the year, if predetermined volume thresholds are met.
• How to improve: Annual rebates are typically corporate-level. Does the behaviour of a project/branch manager change if the head office receives a bonus? If not, try to get rid of the arrangement. Alternatively, if a volume threshold is met, the bonus calculation should be based on exceeding volume, not total volume. And lastly, the customer should be reminded of the annual rebate scheme during the bonus period so that additional purchases would be encouraged.

Payment time agreed.
• Description: This is the cost of the payment time granted in the payment term. The working capital tied to accounts receivable carries a capital cost. This cost of the payment time agreed equals (1 + WACC) ^ (days / 365) x amount, where WACC stands for weighted average cost of capital.
• How to improve: There might a surprising variety of different payment terms applied. Aggregate line level data to understand reality. Start charging for exceptional payment times. Ask the sales force to renegotiate excess terms further to company policy.

Late payments.
• Description: The working capital tied to accounts receivable carries a capital cost. Companies that are relatively slow in acting to overdue payments may be used as “banks” by customers that look for extended financing.
• How to improve: Start charging interest fees and reminder fees. As long as late payments do not lead to credit losses, some companies make good profits on these fees. Consider teleoperators that get to charge 5-euro reminder fees for invoices worth just a few euros.

Cash discount.
• Description: Some payment terms (e.g. 30 days net, 14 days -2%) allow a deduction from the invoice amount if payment is made quickly.
• How to improve: In general, this sort of payment terms should be avoided completely by the seller.

Cost of credit card payment, electronic invoice discount, electronic order discount.
• Description: Some companies give discounts for cost-efficient order placement and invoicing. Accepting credit card payments carries a cost.
• How to improve: Consider if your discount/fee structure is up to date. It might have been a great idea to give an electronic invoice discount in the first place. Now it might be time go ahead, and remove the discount, and start charging extra for paper invoices.

Delivery terms.
• Description: Incoterms (and unofficial agreements) determine who pays for transportation and who carries the risk associated to it.
• How to improve: Do not give premium service for free. Your team should be willing to go an extra mile – you decide under what circumstances that should be done. You cannot always trust ERP records either – they do not show unofficial arrangements taking place in the field.

Safety buffers or consignment.
• Description: Supplier-funded consignment stocks to a customer carry a cost.
• How to improve: Be aware of the cost vs. the benefit you provide.

Advertising allowance.
• Description: There may be an allowance (% of sales) paid to a retailer or a wholesaler to support local marketing.
• How to improve: Remove overlapping and inefficient marketing activities.

Claims and SLA penalties.
• Description: Customer claims lead to credit notes and lost business, both significant costs. Service level agreements (SLAs) may force a supplier to pay a penalty in case a predetermined service performance level is not met.
• How to improve: Any organisation should strive to avoid mistakes in the first place. However, some customers are more likely to get disappointed than others. Determine whether you can (afford) giving service to the most demanding customers. Try to raise their overall prices to compensate for higher costs, or lower the SLA requirements.

Any other leakages out there?

Charts like this may be useful in understanding the size and variance of leakages. A dot may stand for a customer or a project, for instance. Concerning smaller volumes, it seems to be possible to maintain business at low levels of leakages. High leakages might be wasteful. Concerning larger volumes, are extra services necessary to win business? Would it not be more effective to give a genuine volume discount as opposed to leakages that gain less attention in the buying decision?