December 2004              return to newsletter contents page

Reversal of Fortune: Learning to Love Price Increases

by Dr. Albert D. Bates

Most AVDA members have acclimated themselves to a price-sensitive world. The thought of raising prices has become almost foreign. However, for a variety of reasons, the economy is moving back into an era of price increases. A few price increases, such as for steel and oil, have been sudden and dramatic. For most other items, though, it is an increase of a couple of percentage points in supplier prices here and a couple more there.

At the same time AVDA members have been very hesitant to raise prices outbound. There is the very understandable concern that even the smallest price

increase may lead to sales declines. As a result, firms often eat a portion, or even all, of the price increase. The profit results are disastrous.

This report will examine two key issues with regard to the relationship between price increases inbound from suppliers and outbound to customers:

• The Price Pass-Through Challenge—Measurement of the profit implications faced by the typical AVDA member if supplier price increases cannot be translated into commensurate price increases to customers.

• Making Price Increases Stick—Suggestions regarding specific procedures for maintaining price integrity in a rising market.

The first of these is extremely quantitative. It demonstrates quite clearly the fact that absorption of price increases is not a viable strategy, even in the short run. The second is much more strategic in nature. It probes the areas of action that are needed in a world that is seemingly always price driven.

The Price Pass-Through Challenge

Far too many decision makers are not fully aware of the impact that absorbing price increases tends to have on profits. When this lack of understanding is combined with the relentless pressure on margin faced by firms every day, there is a natural tendency to follow the line of least resistance. Simply maintain existing prices and hope that everything works out in the future. The truth is that from a profit perspective, things will not come even close to working out. This reality is demonstrated in Exhibit 1.

Exhibit 1 looks at the operation of the typical AVDA member. According to the most recent AVDA PROFIT report, this firm generates $120,000,000 in sales volume, operates on a gross margin of 20.5% and produces a pre-tax profit of $2,400,000, or 2.0% of sales.

In addition, the firm has both fixed and variable expenses as part of its financial profile. Fixed expenses represent the commitments that have been made so that the firm can conduct business, and include rent, maintenance and related expenses. It also includes virtually all salaries and associated fringe benefits.

In sharp contrast, variable expenses represent the incremental costs of generating additional sales. Typically, these will include sales commissions, bad debts, bankcard charges, overtime and some interest expense.

Fixed and variable expenses can be estimated reasonably from the AVDA PROFIT report. For a typical AVDA member, variable expenses would be about 4.0% of sales, or $4,800,000. All of the remaining expenses, $17,400,000, are fixed.

The first column of numbers in Exhibit 1 indicates where the typical firm is at present. The second column demonstrates the impact of a 5.0% product price increase from suppliers. Half of that price increase is passed along to customers in the form of a 2.5% price increase and the other half is absorbed.

As can be seen, the change in profits is dramatic. The firm that was producing $2,400,000 in profits is now only generating $510,000 for the same amount of effort. It is a 78.8% decrease.

Exhibit 1 looks at one specific example of many possible responses the firm could make. The following table starts with the same exact 5.0% supplier price increase and examines seven different outbound price responses and their resulting impact on profits.

As can be seen, if the supplier price increase is matched in percentage terms by an increase in prices charged to customers, profits are actually increased dramatically (41.3%). However, even a one percent difference either way in outbound pricing has the potential to dramatically impact overall profits. The firm must have a commitment to price integrity.

Making Price Increases Stick

Pricing will always be an emotional issue. No firm can afford to be priced out of a competitive market. Nevertheless, supplier price increases create a ready-made opportunity to improve profits. Candidly, the need for a price increase can be shifted to a third party. However, success in passing along price increases requires four concerted actions:

• Full Disclosure—Firms should be open, honest and direct about the need for price increases and the fact that price reductions when they occur are passed along to customers as well. Firms that are afraid to discuss their pricing are doomed to poor results.

• Sales Force Controls—Inevitably, pricing always gets back to the sales force as they are continually bombarded with price complaints. Ideally, pricing responsibility would be removed from the sales force. In a more realistic world, precise controls are necessary to help maintain price discipline. Such controls usually come in the form of absolute minimum price levels or sliding commission scales.

• Price Balancing—Most of the severe price competition is focused on the commodity end of the product line. At the slow-moving end of the assortment there are numerous opportunities to build margin back. However, given that slow sellers, by definition, generate only modest volume, price increases must be substantial to offset price increase absorption on faster moving items.

• Employee Education—Most operating managers do not understand Exhibit 1. That lack of understanding is costing the firm profits every day. They are losses that no accounting system can track. Every employee needs to be aware of the margin issue. Failure to provide proper education on pricing is impossible to overcome.

Moving Forward

Supplier price increases should be viewed as a profit opportunity, not a challenge. To continue to be successful, AVDA members must make sure that every decision maker in the firm understands the need to maintain price integrity. Failure to pass along price increases is a road map for disaster.

About the Author:

Dr. Albert D. Bates is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado.

©2004 Profit Planning Group. AVDA has unlimited duplication rights for this manuscript. Further, members may duplicate this report for their internal use in any way desired. Duplication by any other organization in any manner is strictly prohibited.

A Managerial Sidebar on Evaluating Pricing Pass-Through Options

Participants in the 2005 AVDA PROFIT survey will have access to a Microsoft® Excel template that will provide a tutorial on the economics of absorbing supplier price increases. Each participating firm can use its own numbers in a tailored training program.

It is also possible to use the formulas behind Exhibit 1 to calculate exactly how much of a price increase is required to exactly offset a supplier price increase. Using the numbers from Exhibit 1 for the typical AVDA member, the results are: