As a young operations manager, I always just assumed that the sales people in my organization put tons of effort and analysis into optimizing pricing on our products to maximize profits. It wasn’t until I was well into my career working for what had grown into a medium sized parts distribution company that I realized that sales people really don’t use much math in their professional lives. Here I was, scratching and clawing to cut every dime, nickel, and penny of cost I could out of the operation for the sake of profits just to watch the sales folks give that profit away with lazy pricing decisions.
That was the impetus for forming the pricing and analytics team for our company. But, in the beginning, it was just me and Excel. I did a bunch of analysis to determine which customers and which products were not particularly price sensitive and came up with recommendations to not treat everyone and everything with a one size fits all pricing method. The result was a bottom up approach to price low volume parts and infrequent customers appropriately. I had a plan to significantly increase our bottom line profits with no capital investment, no new hiring, and no extra work.
When the plan was implemented, profits for those customers and parts doubled with single digit percentage attrition. By starting from the bottom up, we were able to impact profit without generating any angry phone calls from customers. The truth is that until you get at least a single call from a customer about a price change, you haven’t even approached the break even point where your profits are optimal.
What About Equipment Manufacturers?
Parts sales are generally the highest margin segment of the manufacturer’s business, but there is usually no one singularly responsible for developing the part pricing. Far too often, either an annual calendar reminder or below budget sales results trigger someone to go find the spreadsheet from last year, enter a formula to add 3% to last year’s list price, and email it out to their authorized service company and equipment dealer network.
Knowing that pricing changes are something that organizations needs to dip their toe into rather than diving in, there are some simple yet effective strategies that can be implemented without a lot of controversy. Each of these common sense approaches can be logically explained to the sales organization in a manner that will minimize pushback.
Double the Profit on the Bottom 10% of Your Parts
If you ever get invited to a meeting and told that you need to increase profits on parts sales by 10%, would your first instinct be wage cost cutting or a new comp plan for the sales team? There is a much easier way. Just double the profit on the parts that make up the bottom 10% of your parts merchandise profit.
Before doubling the profit on the bottom 10% of your parts, your profit is the following: 90% + 10% = 100%
After doubling the profit of the bottom 10%, your profit increases by 10%: 90% + 10% + 10% = 110%
If you significantly raised the price of the slowest selling part on your price list, would anyone notice? Probably not. You can do a bunch of analysis to determine the exact price sensitivity of each one of the parts you sell in order to determine which ones can take a significant price increase without losing sales. But if you want the quick and dirty answer, it is likely that parts that you sell less often are less price sensitive.
There are not generic equivalents or other options for most slow moving parts. They may likely be used on the oldest equipment models that are still in operation for the couple of customer holdouts who have not upgraded. Even if the price increase triggers an equipment upgrade, you still win in this case.
Until you get at least a single call from a customer about a price change, you haven’t even approached the break even point.
When I say double the profit, that does not mean double the list price. If you are selling a valve for a list price of $100 that you sell to your service network for $50 and costs you $30, your merchandise profit as the manufacturer is $20 ($50 network price minus $30 cost). To double the $20 profit, you only need to increase the list price by 40%, not 100%.
The list price goes from $100 to $140. The service network price goes from $50 to $70. Your cost is still $30, so instead of making $20 of profit you are now making $40 of profit ($70 network price minus $30 cost).
The headline message of this method to your sales team and customers is that you are holding the pricing of the top 90% of parts by volume on your parts list. The only change customers will see is to slower selling parts that are more expensive for you as a manufacturer to provide. You can’t buy or handle slow sellers in bulk so there is no economy of scale for the wages required to purchase and receive the parts. You are also more likely to get hit with surprise price increases for parts you buy only sporadically. Increasing the prices on the slow movers only makes sense.
Don’t Sell Cheap Parts
You cannot make a profit selling one $0.25 screw even if your supplier gave them to you for free. There is no margin big enough for something that cheap to overcome the cost of processing the order. The same goes for the parts distributors downstream of you. By allowing that $0.25 screw to be sold, not only will the manufacturer lose money on the transaction, but so will the downstream distributors and dealers.
All manufacturer parts order will require some or all of the following tasks to be performed:
- Answer the phone and give the customer price and availability information on the parts they want to order
- Read the email with the purchase order sent by the customer
- Enter the order into the ERP system
- Respond to the customer’s post order phone or email requests for order confirmations, estimated shipping dates, tracking numbers, etc.
- Print the order in the warehouse and distribute it to the picker
- Pick the order and deliver it to the packing area
- Pack the order and deliver it to the shipping area
- Ship the order and load it on the carrier’s truck
- Invoice the order
- Collect and apply the customer payment to the invoice
You can lower the labor costs by automating any of these elements of the order process. However, if we make the rough assumption that it takes 20 minutes of applied labor to complete all of the above tasks for an average size parts order by employees who have a fully loaded cost of $30 per hour with wages and benefits, then each order has a variable labor cost of $10.
You cannot make a profit selling one $0.25 screw even if your supplier gave them to you for free.
In addition to labor, the packaging for an order (box, void fill, tape, staples, etc.) has a variable cost of about $1.
If the customer pays by credit card, the manufacturer will pay around 3% of the total order amount back to the credit card processor. If the average credit card order is $500, that is another $15 of variable cost for credit card orders. If 10% of your orders are paid by credit card, that is an average of $1.50 for all parts order.
If your freight recovery strategy does not take in more shipping revenue than the outbound shipping costs for parts orders, then that is another variable cost.
You could also calculate the total cost of purchasing, receiving, putaway labor, and inbound freight and distribute that across all customer parts orders to come up with the total variable cost of processing an order.
Rather than spend the time to get the exact answer, I would just make the conservative assumption that it costs $15 on average to process a parts order for a manufacturer.
The Answer to the Question “So What?”
If it costs you $15 to process an order, every order that does not make at least $15 in merchandise profit loses the company money. Margin is important, but average order value is more important. If your merchandise profit margin is 50%, then the customer needs to order at least $30 of parts for you to break even.
An enlightening exercise is to look at the list of a day’s worth of orders descending by total dollar amount and see how many of your daily orders are processed at a loss.
As a manufacturer, you can dictate large order minimums to your network to protect yourself against the profit drain of small orders. However, this just pushes the problem downstream to your dealers, distributors, and service companies who sell small quantities to a large number of customers and are more vulnerable to the profit impact of cheap parts.
Remove Cheap, Slow-Moving Parts from the Price List
The goal should be to minimize unprofitable orders and discourage the purchase of cheap hardware and fasteners that can be purchased at Home Depot or Grainger. If a part is not sold more than a few times per year and it is not profitable because of its low price, making it obsolete on the price list will remove those unprofitable transactions from the business.
There is an argument that can be made for keeping a part active on the price list if you are already holding stock. However, these parts are by definition cheap, so throwing the stock away to clear up more space in an already crowded warehouse for profitable inventory probably makes more sense financially.
To make it easier for your customers to find these parts once you make them obsolete, make sure that the part descriptions detail all the necessary specifications for the fastener (thread, material, length, etc.). Even go so far as to list the Grainger or McMaster-Carr part number in the description so the customer can buy their screws one at a time from someone else.
Set a Minimum Part Price of $10
For parts that are close to the $15 profit margin goal, make price adjustments to get them there.
For parts that are farther away from the margin goal, setting a minimum network price of $10 is a little harder to swallow on the surface, but can be enacted in a way that will also bring value to the customer.
If it is a cheap, but fast-moving, part, you should eliminate the option of buying it by the “each” and replace it with pack quantities that make sense for a price and margin that generates at least $15 of merchandise profit. For a screw with an annual sales quantity of over 10,000 each, a network price of $0.25 and a standard cost of $0.03, the minimum pack size should be a box of 100 screws. The manufacturer can charge a network price of $20 for the box of 100 screws at a standard cost of $3 and make it cheaper per screw to the customer, make it a profitable transaction for manufacturer to sell one box, and still meet the margin goals of the company.
Margin is important, but average order value is more important.
If you want to keep the option to order the “each” part number due to the need to process warranty orders (which are ultimately free to the customer regardless of list price), raise the list price to $10 for the “each” part number to discourage sales but give the customer the option to buy a box of 100 for $20 if they complain about the “each” price.
The elevator speech bullet points that the customer service people should be armed with are:
- These are parts you can get from the hardware store and we encourage you to do so.
- We lose tons of money selling screws and nuts one at a time, so we want you to get them from Home Depot or Grainger if you do not want to buy in quantities of 100.
- If you really want to buy one screw from us, we need to charge at least $10 (plus freight) so we don’t lose our shirts moving one screw through our warehouse.
- We don’t want to have to enforce a minimum order amount or charge a minimum order service fee, so we need to charge at least $10 to make it possible.
One of my favorite complaints is the price of freight relative to the price of the product. You have to explain that UPS will charge you $7 to ship an empty box. The value of the product inside is irrelevant. Nobody is getting rich selling $0.25 screws one at a time and charging the minimum UPS charge. Pointing out the fact that you would have to put an order minimum in place and make customers buy $50 worth of screws in order to discount the freight generally works well.
The benefit of not having an order minimum but paying the freight is demonstrably more valuable to the customer than the alternative. The same explanation applies to having a minimum parts price. You can clearly explain to the customer that the $10 each price with the option to buy a cheaper pack quantity takes the place of a wasteful order minimum policy.
Every order you process with a profit margin below the variable cost to fulfill the order has a negative impact on your company’s bottom line. If you remove the low value transactions, you can remove the costs associated with processing those orders. If you increase the price, you will grow both the top and bottom line of your business without doing any more work than you are already doing.