Many industrial companies face a complex new array of challenges today, including a global pandemic that has driven radical shifts in demand, buying patterns, cost to serve, and perceived value across sectors and value chains, which in turn have led to sharp spikes in commodity prices.
Inflation in the cost of raw materials is forcing industrial companies to take swift action on pricing. The price increases required to offset inflation and maintain constant gross margin could greatly exceed the 2- to 3-percent hikes many industrial companies make at year-end. In our discussions with leaders across industries, many have voiced concern about this issue (see sidebar, “The response to inflation”).
As an example, a business with 30 percent gross margins and 40 percent of cost of goods sold (COGS) exposed to raw materials, assuming inflation of 20 percent, will need to implement and capture an 8 percent price increase just to keep gross margin unchanged. Even higher increases may be necessary with more exposure to raw materials or higher inflation.
In a highly volatile environment such as the one we are experiencing now, in which prices of raw materials can quickly swing by double digits, capturing pricing upside is more challenging than ever, especially if pricing and procurement organizations are not working hand in hand.
Indeed, nearly all pricing and procurement teams operate in silos with different calendars and operating rhythms, and they generally lack formal processes to communicate effectively and orchestrate decisions. As a result, margin leakage is common, and the volatility in prices of raw materials exacerbates the issue. A few examples follow:
- Sales teams base discounting decisions on standard costs that they update only once a year, while actual sourcing costs could change as often as daily.
- While they may update standard costs more frequently, lack of communication between pricing and procurement organizations often means that procurement savings are passed on to customers—for example, when a salesperson sets prices based on gross margin instead of value, granting customers hard-earned procurement savings.
- Many pricing and procurement teams hedge risks independently and without coordination—for example, by using spot pricing on the purchasing side and fixed pricing on the commercial side, inadvertently raising the company’s exposure to inflation risk.
Now more than ever, procurement and pricing teams need to work together to understand pricing opportunities across products and agree on priorities to pass through cost increases and protect—or expand—margins.
While procurement teams should continue efforts to fight material-cost increases and creatively reduce sourcing costs (topics beyond the scope of this article), adjusting prices is essential in today’s inflationary environment to improve margin position and align the prices of a wide range of industrial goods to their value to customers.
Industrial companies typically face several challenges in capturing the full pricing potential from their range of engineered products:
- For standard and configured equipment, hundreds of product configurations and accessories make it extremely hard to link performance and capabilities to price. Having limited win–loss data and competitive insights is a typical blind spot that curtails value capture, and channel incentives are often out of sync with the true value brought to the table (for example, demand creation versus fulfillment).
- For custom equipment, significant variations often arise between budgeted versus actual margin due to front-end gaps (for example, insufficient cross-functional review during budgeting, budgeting errors, or scope changes) and execution (for example, skill gaps or inefficient installation). In addition, pricing for change orders usually does not capture the complexity of postdesign spec changes—if change orders are charged at all.
- For engineered components, including spare parts, poor segmentation or taxonomy data (for instance, insufficient detail on IP, part life cycle, cost to serve, or attributes or complexity of base units) often makes it impossible to adequately price thousands of SKUs, and discounting across customer segments, regions, or product segments is often unexplainable or inconsistent. The typical approach reverts to “one-size-fits-all” annual price increases of 3 percent, leading to poor price realization.
- Across the board, a lack of clear price-performance mechanisms, such as tracking tools, process price realization, delegation of authority, and central quoting teams, can lead to additional margin leakage.