Learning to Love Price IncreasesWritten By Dr. Albert D. Bates
Article Date: 12-01-2004
Copyright (C) 2004 Associated Equipment Distributors. All Rights Reserved.
Supplier price increases should be viewed as a profit opportunity.
Most AED dealer 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, AED dealers 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 all, of the price increase. The profit results are disastrous.
Two key issues with regard to the relationship between price increases inbound from suppliers and those outbound to customers are 1) the price pass-through challenge and 2) making price increases stick.
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 everything works out in the future. The truth is that from a profit perspective, things will not even come close to working out. This reality is demonstrated in Exhibit 1.
Exhibit 1 looks at the operation of the typical AED dealer. According to the most recent AED Cost of Doing Business/Profit Opportunity Report (CODB), this firm generates $25,000,000 in sales volume, operates on a gross margin of 22.0 percent, and produces a pre-tax profit of $375,000, or 1.5 percent 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 the firm can conduct business. They include rent, maintenance and related expenses. They also include 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 CODB. For a typical AED dealer, variable expenses would be about 4.0 percent of sales or $1 million. All of the remaining expenses, $4,125,000, are fixed.
The first column in Exhibit 1 indicates where the typical firm is at present. The second column demonstrates the impact of a 5.0 percent product price increase from suppliers. Half of that price increase is passed along to customers in the form of a 2.5 percent price increase and the other half is absorbed. As can be seen, the change in profit is dramatic. The firm that was producing $375,000 in profit is now generating no profit at all for the same amount of effort. It is a 100 percent decrease.
Exhibit 1 looks at one specific example of many possible responses the firm could make. The following table starts with the same 5.0 percent supplier price increase and examines seven different outbound price responses and their resulting impact on profits.
If the supplier price increase is matched in percentage terms by an increase in prices charged to customers, profits are actually increased dramatically (60.0 percent). However, even a 1 percent difference either way in outbound pricing has the potential to dramatically impact overall profits.
Excerpted from December 2004 Construction Equipment Distribution.
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