Is too much discounting preventing you from meeting profitability targets?

A brief guide for building fast, low-cost and effective margin analytics platforms in-house. Especially in a prolonged inflationary environment, you’ll be glad you did it.

Price leakage is a big problem for most Manufacturers and Distributors and can have a large adverse effect on their Operating Profits. At its basic level, price leakage occurs because our customers often pay for our products below the published List Prices and receive other monetary benefits. The difference between the amount we receive (the Invoice Price or Net Price) and the amount we initially charge (the List Price) is usually the largest source of Price or Margin leakage. A host of other customer benefits further reduce the Invoice Price to a Pocket Price, which ultimately causes too many discounts and rebates to price leakage occurring in companies?

We often like to proclaim that the biggest driver of margin leakage is an overzealous sales organization giving away too many discounts and rebates to customers, often irrespective of any guidelines. But the problem is not simple, nor is the characterization to blame the commercial organization fair.

When I work with organizations that have a significant margin leakage problem, the main drivers are usually the following:

1. There is no clear, well-structured, well-proselytized, and easily understood pricing, discounting, and rebate strategy.

2. Discounting guidelines do not exist, are too complex to digest and follow (think giant matrices with dozens of columns and rows), or are too high level and don’t account for the pricing nuances of critical customer segments or geographies.

3. If you are using automated, dynamic pricing, there are too many manual overrides either by the pricing team (pressured by sales) or by sales executives with pricing override authority.

4. Rebates and discounts are not based on pay-for-performance. In other words, customers that contribute a disproportionately lower share of our company’s growth receive a disproportionate allocation of price discounts.

5. There is no effective margin analytics platform used across the organization. This means no effective measurement systems track discounts and rebates versus guidelines or strategies.

In this brief guide, we will focus on #5 and discuss how to build a robust in-house solution, leveraging standard technologies you are familiar with. Most executives in charge of Pricing/Margin are hesitant to go down the margin analytics platform path, thinking it will take 12-18 months and $1-5MM to implement. That is usually the case for well-known, industry-specific turnkey solutions, which fail most of the time – primarily due to a lack of solution flexibility and adoption issues.

Similar to my article on Dynamic Pricing, building an in-house Margin Analytics solution using existing tech you are familiar with - popular BI stacks (Power BI, Alteryx, Tableau, Domo, etc.) or open-source frameworks - can be done cheaply and in a relatively short amount of time (2-3 months). Most importantly, it will achieve 85-90% of the value realization of expensive turnkey solutions and will likely drive greater adoption with your Finance and Commercial teams (since they are brought along the development journey).

What are the biggest drivers of price leakage?

The most significant drivers of revenue erosion are price discounts, which can decrease your list price by 10% to 70%. This includes standard, volume-based distributor or end-customer discounts and other on-invoice, pre-negotiated price discounts. This price leakage between your list and invoice price typically represents 40-70% of your total margin erosion, so focusing on rationalizing discounting behavior is paramount to driving operating profit improvements.

Some other critical drivers of margin leakage, in decreasing order of profit impact:

1. Customer rebates: rebates are a considerable expense in three-tier systems, where the product flows from manufacturer > distributor > retailer (and to the end consumer). They typically take place in the form of quarterly or annual volume rebates. However, it’s not uncommon for sales to offer rebates on every sales order (in addition to on-invoice discounts) to a customer for a future promise to deliver on specific volume commitments. The source of price leakage here is two-fold:

   • often, the rebates are too high and not structured for pay-for-performance (i.e., based on delivering volume growth) and

   • customers don’t meet promised volume commitments.

2. Freight discounts: sales teams often offer reduced freight costs (sometimes free freight) to customers based on specific order thresholds (e.g., $50K min. per order). Price leakage becomes prevalent when:

   • freight discounts are given irrespective of order thresholds and

   • customer orders start concentrating around the minimum order threshold (to get discounted or free freight).

3. Off-invoice promotions are special customer rebates that don’t appear on the invoice and are usually given seasonally to accelerate sales of specific products. The lack of clear strategy and guidelines often makes the ad-hoc nature of off-invoice promotions a sizable price leakage problem.

A dozen other drivers of price leakage include marketing development funds, slotting fees (also called merchandising allowance), cash discounts, and other customer payments. This McKinsey article, “The power of pricing,” does a great job describing them in detail, and I encourage you to read it.

How can advanced margin analytics help you?

Building a margin analytics platform doesn’t have to be complicated, expensive, or take up a lot of time and resources. In-house solutions developed by internal or temporary external experts can typically be deployed in 2-3 months at a fraction of turnkey software costs and can drive 80-90% of total value realization.

It is vital to keep the following two things in mind when building your in-house solution:

1. It needs to be part of a visible (CEO-sponsored) collaborative analytics solution development process, for example, a key Pricing Transformation initiative. It helps to have a catchy project name that is familiar throughout the organization (as opposed to just “Margin Analytics Platform”).

2. Key stakeholders from the Pricing, Finance, Sales, Category Management, and sometimes Supply Chain organizations must be involved from the onset. You need to identify key members from each group who will be involved in crucial stages across Concept Design, Minimum Viable Solution, Pilots and  Full Launch, and ongoing training. Involving key partners early on ensures that you build an analytics solution that captures cross-functional requirements and makes others feel like they are part of the build process (i.e., the Margin Analytics solution is just as much their work as it is yours).

Whether you build it in Tableau, PowerBI, or some other self-serve BI or open-source tool (e.g., R, Python), you want your Margin Analytics solution to address the following questions:

What are the most significant opportunities in our sales practices?

• Is there a clear pattern between customer size (e.g., annual revenues) and our sellers’ discounts?

• Is there a similar pattern between customer size and margin profiles? (i.e., do our smallest customers typically generate the best margin % and our largest ones the smallest margin % - since they make it up in volume? Or is there an illogical pattern here?)

• Where are the discount outliers (account, product, sales rep), and what is the incremental Sales or Margin $ opportunity if we close the performance gap?

• Is there a strong, positive relationship between Sales Commissions and Margin $ generated at the account level?

• Is customer or product mix adversely impacting Revenue or Margin $ growth (i.e., selling a higher share of low profitable products to customers or selling to a more significant percentage of price-conscious, low-profitability customers this year vs. last year?)

Below is a sample visual of Net Sales vs. Gross Margin % performance, enabling you to quickly determine where your most significant pricing opportunities are. Let me give you a couple of examples:

• We must first attack “Dead Zone” customers: these are the smallest customers by volume, comprising less than 20% of cumulative Net Sales, and their Margin % is in the bottom 25th percentile. Let’s evaluate their price leakage ASAP and determine where we need to make some quick adjustments on price discounts, freight discounts, payment terms, etc. If the customer threatens to defect for the competition, let them: your Income Statement will thank you.

• Top Sellers – Bad Margins: these are our largest customers (cumulative 80% of net sales), but margin % profiles in the bottom quartile (similar to “Dead Zone”). We must pay attention to these customers given their scale but recognize that each 1% Net Price improvement will yield significant Operating Profit benefits.

Another visual to evaluate sales rep discounting behaviors using the standard stack ranking method. You can set what your discounting outliers are based on: statistical outliers, performance groups (i.e., highest discounting quartile), or based on discount guidelines. Highlighting the biggest offenders gives additional details on the sales reps, down to the Account or Product level.

Where do we need to tighten up our pricing policies?

• Are customers given rebates, despite not meeting rebate volume or growth targets?

• Are customers given payment term discounts despite clearly violating payment terms?

• Do list prices reflect our desire to move customers to fewer orders but larger order sizes? (we are looking for logical list price bands here)

Where should we create/change our off-invoice discount policies?

• Are sellers charging customers for expedited shipping or giving too much free shipping away irrespective of order patterns?

• Are customers getting too much free product, and does this practice extend beyond new customers?

What are the key components of a robust margin analytics solution?

I recommend starting with the list below of critical metrics and KPIs to include in your Margin Analytics solution. This will answer the majority of the questions you have on Pricing and Margin diagnostics:

• Pricing and margin trends: ASP, COGS, Shipping Costs, Margin %, and Margin $ per Unit trends over time.

• Revenue and margin $ performance decomposition: breaking down revenue and margin $ growth into price, mix, and volume impacts (plus exchange rate if you are dealing with consolidated results of multiple countries; and cost if you are explaining Margin $ variance). Understanding whether positive customer or product mix shifts have offset negative price realization is fundamental and can encourage your sales team to know.

• Price discounting behaviors: % Discount off list price vs. Annual sales revenue; % Discount by Volume Bins – show 10th and 90th percentiles, along with median, to see if any logical step-up curve exists as volumes grow.

• ·Price bands: net price distribution by Customer Segment/Type for the identical/similar Product; or Net Price distribution by Product Sizes for identical/similar Customers.

• Order patterns: Number of Orders vs. Median Order Size. You’ll want to use this to encourage customers to order fewer times in higher order quantities.

• Sales commission vs. Margin $ by Sales Order: use this to quantify whether your commission structure supports your business goals. Most often, I have found that companies’ commission plans are in misalignment with business/profitability goals.

• Unit Volume distribution by Price Bins (for same product/product family): use this to understand where your commercial organization tends to price products and as a coaching tool to price up over time. I.e., if 70% of the volume is priced at $10 but 30% at $15, there’s an opportunity to create additional price bands between $10 and $15 to raise margins.

• Price and Margin leakage waterfall: this is the familiar decomposition of Price and Margin leakage into critical categories. Clicking on each type (e.g., off-invoice discounts) will reveal additional details such as Customer Segment, Account, etc., helping you diagnose issues and formulate strategies to resolve them.

Quantify the opportunities

With each analytical view or dashboard included in your Margin Analytics platform, aim to quantify the business value of closing performance gaps. This is important for your Pricing and Finance organization and serves as a motivating factor for your sales reps (i.e., this is how much your commission can increase if you decrease discounting on this Customer from X% to Y%...).

When presenting incremental opportunities, offering options, such as Low/Med/High-end opportunity estimates, is essential. After all, perfect execution depends on dozens of factors, so presenting different outcome ranges incorporates executional uncertainty and respects the nuances of your business.

Suppose we know which accounts are outliers regarding the Price Discounts they receive. This outlier definition could be based on either being above a statistical outlier or simply above the maximum allowed Discount thresholds. Your incremental business opportunity is defined as bringing those outlier accounts back into the “normal” range. But since you don’t want to overshoot your benefit estimates, you will present some outcome ranges:

• High-end estimate: we will bring all outlier accounts with aggressive discounting practices down to their statistical norm or discount guidelines.

• Medium estimate: we will decrease price discounts for all outlier accounts halfway between current levels and guidelines / statistical norms.

• Low-end estimate: we will decrease price discounts for 50% of the outlier accounts halfway between current levels and guidelines/statistical norms.

Summary

Price leakage, especially excessive discounting and rebates, are the most significant source of Operating Profit misses for Manufacturers and Distributors. A common misconception is that it takes a long time and heavy capital expenditures to build robust measurement systems to track pricing execution, diagnose root causes and recommend quick actions to improve Margin performance.

Building in-house Margin Analytics solutions and critical cross-functional stakeholders can often be done at a fraction of the cost and timeline compared to well-known turnkey Price Management solutions. They can yield significantly greater adoption and outcomes.

Suppose you are an organization in need of robust Margin Analytics solutions to combat suboptimal pricing and sales practices in an extended inflationary environment. In that case, I encourage you to explore the above as a fast, effective option to drive data-informed Net Price improvements.