News from the Safety Equipment Distributors Association
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March 2007 return to the newsletter contents page Improving Margin with Product Mix: Mission Impossible by Dr. Albert D. Bates, President, Profit Planning Group |
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Most SEDA members are acutely aware of the
need for improved gross margin performance. The challenge is how to
produce higher margins in a highly price competitive-world. Very high on
almost everybody’s list is to change the sales mix to sell more of the
high-margin items. This would seem to have the potential to increase
margins without any reduction in price competitiveness. |
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The Real Impact of Mix on Gross Margin—An examination of the relationships between changes in the product mix and gross margin. In addition, the mix strategy will be compared to the more straight-forward strategy of increasing prices.
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The Challenges in Changing Product Mix—A discussion of the inherent difficulties in changing mix versus raising prices.
The Real Impact of Mix on Gross Margin
The theory behind changing the product mix is commendable. The intent is
to sell more of the higher-margin items in the line so as to increase
the firm’s overall gross margin without having to resort to price
increases.
To understand how this philosophy goes awry, it is necessary to have an
understanding of the margin structure for SEDA members. According to the
most recent PROFIT Report, the typical firm operates on a gross margin
of 26.0% of sales. This is often referred to as the blended gross margin
as the overall result is produced by selling a range of different items
whose margins vary widely.
Exhibit 1 looks specifically at the
variation in item sales and margin. It utilizes a very common velocity
code analysis that divides the product line into four categories based
upon how fast the items sell—A, B, C and D items.
The A items represent the fastest-selling items in the product line.
Typically, A items will constitute 60% of total sales. The B items are
basic items and generate around 20% of the firm’s sales. The C items are
slow sellers and only account for 15% of total sales. Finally, D stands
for dogs. The slowest-selling items in the product line generate only
about 5% of the firm’s total sales.
However, when a gross margin perspective replaces a sales perspective,
things change dramatically. In a typical variable pricing (also called
matrix pricing) arrangement the A items tend to be commodities and have
low margins. In Exhibit 1, the margin on the A items is only 22.0%. At
the other extreme, the D items have a great margin—44.0% of sales.
The combination of a very high gross margin and very low sales leads a
lot of managers on a quest to sell more of the D items. The top half of
Exhibit 1 explores the impact of such an effort. The bottom half of the
exhibit reviews the parallel impact for a price increase.
The projected results on the right hand side in the top section, sales
of the D items are increased by 10%, while the other three categories
remain at their same sales levels. The gross margin percentage on the D
items does not change, of course, but the dollar amount of both sales
and margin does.
The totals for the top half of the exhibit indicate that the blended
gross margin percentage for the total firm increased from 26.0% of sales
to 26.1% of sales. While an increase is an increase, the additional
margin percentage is small. From a dollar perspective, the mix change
took margin dollars from $5,200,000 to $5,244,000, or an increase of
$44,000.
The bottom half of the exhibit goes through the same sort of analysis
for a 10% price increase on the D items. As can be seen, the improvement
is much more dramatic. What is especially important to note is that when
sales increased by $100,000 due to the price increase, gross margin
dollars increased by the same amount. Price increases have a dollar for
dollar impact on margin.
This means that instead of the firm having $44,000 additional margin
dollars, it has $100,000 additional dollars. Furthermore, it got this
higher number without having to sell any additional merchandise. From a
gross margin percentage perspective, the new margin is 26.4%.
There is an important conclusion that SEDA members cannot walk away
from. The impact on gross margin from changes in pricing is much more
significant than changes in product mix. However, many managers continue
to view price increases as extremely difficult to achieve while product
mix changes would appear to be within easy reach. The truth is typically
exactly the opposite—price changes are relatively easy while mix changes
are almost impossible.
The Challenges in Changing Product Mix
D items are D items for a reason. Customers buy them only when they need
to have them. This means that any effort to sell more D items should
more accurately be described as “getting people to buy things they don’t
really want.”
This doesn’t mean it is impossible to do, but it does mean it is really
hard. In the example, the reward for doing something really hard is that
the gross margin percentage is increased by a paltry 0.1 percentage
point.
In comparison, raising prices had a dramatic impact on both the dollars
of gross margin and the gross margin percentage. It can also be argued
that increasing prices on the D items is a lot easier than selling more
of the D items.
The overwhelming motivation of customers when purchasing D items is to
find a specific item as quickly as possible with minimal effort. At this
point distributors provide a sensational level of added value—they
actually have the item available when the customer needs it. This added
value deserves a higher price.
Most purchasers of D items are also purchasing the same exact item that
they last bought perhaps two or three years ago. Their price perceptions
are fuzzy at best. Even if their pricing recall were great, however, the
ease of getting the exact item required as quickly as possible dominates
the transaction.
In short, increasing prices not only has a larger impact on margin than
changing the mix. It is also actually easier to implement. Sometimes the
real barrier to increasing prices is that the firm’s own employees think
that prices on D items are already too high. After all, as shown on the
bottom of Exhibit 1, they now have a gross margin of 44.0%. Going to
49.1% would be unconscionable.
In reality, the price is not too high. It is what is needed to justify
maintaining the item in inventory for two years waiting for the customer
to need it. Availability is essential to the customer and getting paid
properly is essential to the firm.
Moving Forward
Distributors need to think in terms of generating the greatest gross
margin gain with the least gross margin pain. In almost every instance,
that trade-off is maximized by charging fair prices for slow-selling
products. With proper discipline this is actually relatively easy to
achieve.
About the Author
Dr. Albert D. Bates is founder and
president of Profit Planning Group, a distribution research firm
headquartered in Boulder, Colorado.
©2007 Profit Planning Group. SEDA 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 Checklist for Identifying Price Increase
Opportunities
The most commonly used checklist for determining if the price of an item
can be increased without suffering a sales decline has been presented
several times before. It is worth repeating with some sense of strategic
direction.
Items with three or more of these characteristics are virtually
guaranteed to be price insensitive:
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Slow Selling—This is where firms should start. For the typical firm the D items are only 5% of sales, but are about 50% of the SKUs. This leaves lots of opportunities.
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Not Promoted—Generally D items are not promoted. A few items would be excluded if there is widespread price information available.
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Low Dollar Value—Items that sell for $2 are easier to increase in price as opposed to $2,000, or even $200 items.
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Infrequently Purchased—Items that are bought episodically are almost guaranteed to lack price sensitivity.
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Bought Only When Absolutely Needed—Items that are purchased only when a specific need arises are literally crying out to have their price increased.
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Unique Items—Items that are not readily available from other sources of supply represent a very unique opportunity.
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Repair/Service Parts—Small-dollar purchases that allow the buyer to forego a larger purchase are inherently insensitive to price increases.
© 2007 Safety Equipment Distributors Association
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Important links from this article
A Checklist for Identifying Price Increase Opportunities
Notes
The SEDA PROFIT Report helps member distributors benchmark their financial performance against industry averages. Participating firms receive an individual critique of their operation which lays out a specific plan for improving company financial results.