Monday, March 14, 2011
How Suppliers Manage Pricing
From the time a new product is conceived, companies begin to establish their pricing strategies. If you ever worked in a product development atmosphere, you know that there is always a push to bring the product to market as early as possible, but did you ever wonder why? It all comes down to money. If you are first to market with a product with new features and new functionality, you have effectively created your own market where you may charge a premium price. If you are first to market, your strategy may be to get designed into your Customer’s products, which then gives you an advantage on pricing. For example to change from your product to a competitor may require a re-design, or re-qualification. If you are first to market, you will also enter the market at the high end of the price curve where you will make the greatest amount of profit.
Most products have a form of price curve. When there is only one company selling the product price will be high if there is demand. As competition enters, the pricing is usually driven downward. As the market becomes flooded with competition the price is usually the lowest it will be. As companies exit that market because of the lack of profitability or to focus on higher margin products, the price will tend to increase. Supply and demand impacts the slope of the curve. Excess demand can cause the curve to be flat or even increase. Excess capacity will cause the curve to increase at a greater speed and slope. Over time, as long as you have competing products you will have a price curve. In Industries that experience rapid changes in technology or performance, the individual product price curves may only last a matter of months before the next technology comes in and starts a new price curve.
Every day as a consumer you see pricing strategies in operation. For example, companies may offer promotions to get you to buy. Sometimes it’s an instant rebate, or mail in rebate. Their goal is to motivate you to buy. It’s also a pricing strategy. For example, with mail in rebates they know that only a small percentage of purchasers will actually do what is required to receive the rebate. If they reduced the cost, it would impact their return on all sales. If they provide a rebate, the actual number of rebates claimed impacts their return. This is really a pricing strategy designed to increased sales at the cost of only a portion of the promised rebate.
Companies may have pricing strategies to sell their initial product at or below cost to get you to buy them, counting on the fact that they will have an annuity business where you will have to purchase their supplies, and parts, which is where they will make their profit. A great example if this is computer printers. Today you can find many computer printers for under $100.00, but when it comes time to buy the replacement ink cartridge, that costs $30.00 each. The Suppliers are probably selling the printer at cost or even for a loss because they know that they will make their profit on all the annuity business it will generate. This is not a new phenomenon. Gillette has been doing it for many years with razors and razor blades. Companies like Simplex who made time card machines made most of their money not off the machines they sold, but off the time cards which had on-going consumption. This is a classic example of a pricing strategy intended to get the customer locked into using their product, and then make their money on the annuity business.
In Procurement it’s important to know where the Product you are buying is at on the curve. The closer you are to the beginning of the curve, the greater the margin the Supplier has to work with and the more value they may place on locking you into their product. The closer to the bottom point you are, the less likely they will have large margins and the less value they may see in your business. If you are buying toward the low point on the price curve and expect to have on-going demand, you should be more concerned with trying to lock in pricing for a term as when other suppliers exit the market, it can shift back to an excess demand situation driving the prices up.
Pricing is an art form. Suppliers who have mastered the art of effectively pricing goods or services will use their pricing in a number of ways.
§ Pricing can be used to send messages.
§ Pricing can be used to help drive you to make certain decisions they want you to make.
§ Pricing can be used to improve their margins.
§ Pricing can be used to help them more effectively manage their business.
§ Pricing can be used to help force you to do a better job of managing your business. Most premiums charged for rapid turn around deliveries don’t reflect the real cost, they’re a pricing strategy that earns them extra profit on your inability to plan or forecast.
If a Supplier has a substantial amount of business, the Supplier can use pricing to send a message. They may decide that they don’t want to alienate you by not providing a proposal, so instead they will provide a proposal that is deliberately priced high. The message is “at this price I’m interested and will find a way to take on the additional work, but for anything less I’m not interested”. If the Supplier wants you to purchase new rather than upgrade your old item, they will make the price of the new product attractive and the price of the upgrade unattractive. If the Supplier doesn’t want to perform a specific service, such as out of warranty repairs, they will make their repair cost prohibitive. If you want them to perform a special service or activity that they don’t want to do, they will price it high enough so you will either not want to have it done, or they will make enough profit for providing the service for it to be worthwhile to them.
I can’t tell you how many contracts I’ve seen that has the Supplier obligated to have products, spare parts or repairs available for an extended period and not have anything that locks in the pricing. Without that lock on pricing it’s easy to avoid those obligations by simply pricing them so they will be cost prohibitive.
If the Supplier wants to provide you with something that is different than what you specified, they may use pricing to help you make the decision they want. They will price what you want high and will offer the alternative or option they want at a significant enough discount so that it will be attractive to you. If you take the option, they get want they want. If you don’t, and still want to buy from them, you will pay their premium price.
For any production requirement there is always uncertainty in the total volume requirements. To deal with this, Buyers will always ask for different prices for different volumes. Suppliers will use the volume pricing to their advantage. For prototypes that they know you probably have underestimated your requirements, and they will price those higher than needed to improve margins. For low volumes that they know you will have at some point, such as end of life, they will also price those high to improve margins. They know that the tendency of Buyer’s is to want to buy quantities of 100 at the 10,000 unit price so they will provide pricing that already takes that into account.
Frequently Suppliers who have good sales people and who have been on the account for any period may have a better idea of what to expect in terms of volumes than the Buyers. If they do, they may offer extremely competitive pricing on the highest volumes (which they know are unlikely to be achieved) so that they will get the business as your decision will probably be based on the cost at those highest volumes. They will then charge a higher price for the lower volumes that they know you are more likely to achieve. I once was involved in negotiating a contract for providing parts for a repair center and the same Supplier would win the business year after year. On investigating, what I found was that our estimate of requirements was consistently inaccurate and the Supplier would use that to their advantage, as they knew the real demand. They would price higher on those items where the estimated volumes was less than what they knew the real demand would be and they would price lower on those parts where the estimated volumes far exceeded the real demand. When the evaluations would be done based on extended their pricing to our estimate they would always be low. If the evaluation was performed with more accurate demand numbers, they would clearly be high.
If a Supplier is extremely concerned about end of the quarter demands exceeding their available capacity or requiring substantial premiums in overtime to deliver product, they may use pricing to try to more evenly balance the load during the period. They could offer special incentives or pricing to buy during the first two months of a quarter so that you will buy then and they can then use their capacity in the last month of the quarter to deal with un-forecasted customer demands where they know they can charge a premium as customers scramble to meet quarterly production shipments.
In providing a price a Supplier will usually put a number of conditions on the pricing. As long as those conditions are met, the price is as quoted. If the conditions aren’t met, then that represents a change for which there will be an additional charge. The reason why every sale has an end date is the Supplier is trying to force you to act within the time frame. Many times the conditions may be just another way of making additional margin, or the prices charged for incidental items may be one of their major profit centers. For example, many times copying charges by Lawyers and Consultants are one of their most profitable cost centers.
List Price or Manufacturer's Suggested Retail Price (MSRP) will usually be set at, or just slightly above, the average Buyer's maximum acceptable price if the expectation is that there will be negotiations. The Buyer's maximum acceptable price will vary from Buyer to Buyer based upon influencing factors such as perception of the market, discounting practices, available budget, and the product or service need, etc. The Seller’s lowest acceptable price will vary usually depending upon the constraints they have (such as channel constraints on pricing), the market, competitive pressures, and business pressures such as inventory levels, fiscal period close, etc.. Seller's may try to drive up Buyer's maximum acceptable price by taking the focus away from price. When companies try to sell based upon cash flow (such as leases) or return on investment, what they are trying to do is get Buyers away from negotiating the price.
Another pricing tactic is to drive the price up through options or additional items such as follow on service or maintenance. For example, who really believes the cost of all the options that Car Manufacturers try to add on top of the base price of the car? All that does is give them more margin to work with.
While Seller's may have established a lowest acceptable price beyond which they are unwilling to reduce their price further, there may be a number of non-price concessions that may be negotiated further. Suppliers will also have a number of tactics focused on trying to drive you away from negotiating costs:
· Prestige or distinctiveness of the Product
· Life cycle cost, Product reliability
· Service, Support, Guaranteed satisfaction
· Uniqueness (Aesthetics, Safety, Simplicity)
· Value based selling (where they try to tie price to the value or ROI you will receive).
There are also other Supplier tactics in their terms that closely link to pricing and revenue. Why would a Supplier of a piece of major equipment that has substantial reliability only offer a 90 days warranty? Why would a software company whose product shouldn’t break offer the same 90 days warranty? The answer is simple. They established a price to win the business and they want to force you to purchase a maintenance contract as quickly as possible so that they can increase their revenues and profits. There are a number of other Supplier tactics that are designed to increase revenue or margins and all that is taken into account in the way they price their product. The length of the warranty period is a great example of a pricing strategy. For software it is also the definition of what is a revision (which is included as part of the maintenance cost) and what constitutes an upgrade for which there is an additional charge.
Another pricing term tactic is lead-time. Suppliers may deliberately offer extended lead-times on products or spare parts. The goal is then to charge an incremental cost for deliveries in shorter periods that they know customers will need with “RTA”(Rapid Turn Around) changes. What constitutes a change is another pricing tactic. Suppliers may look to define a minute change as something that requires an additional charge.
For things like capital equipment there is frequently a separate charge for special crating for certain types of shipments. I’ve seen some Suppliers have the audacity to want to charge a percentage of the product cost for such crating. Think about it. A four foot by four foot crate costs no more to make whether you put something worth a hundred dollars in it or something worth thousands of dollars so why would you ever pay based on a percentage of the product cost, but some Buyers do. Its’ just a pricing tactic.
When Products are quoted “plus shipping and handling” that’s just another pricing strategy as it may make the cost seem lower. You can pretty much guarantee that the Supplier plans on making an additional profit on those shipping and handling costs. There are many pricing tactics and the more the Supplier knows your behavior, the more they may want to use that against you in the way they price things. The key in negotiating all of these pricing tactics is to make sure that when there are added prices, those prices are consistent with the actual costs they will incur. You also need to keep track of any added costs as part of understand the total cost of the supplier relationship to determine if they are competitive not just on price but on the total cost of the relationship.