June 2, 2015
The situation: Brent crude oil costs have more than halved since mid-2014, causing the PPI inflation rate for chemical products to fall from 1.7% year over year in November 2014 to -2.1% year over year in December. This generous reprieve is expected to hold for the next 12 months.
The question: Should chemical companies drop their prices?
Customers say “yes,” while chemical companies are well advised to have sound defenses ready before cost reductions.
Here are insights to help you manage for profit, even as customers demand to share the savings from lower raw materials costs:
All “pockets” are not equal: For companies that experience little variation in the cost to serve, pocket price may adequately measure price performance. It’s the invoiced price less payment terms discounts and annual volume rebates. As companies seek to differentiate themselves, pocket price becomes a misleading metric. For these “high-touch” companies with costs that fluctuate transaction by transaction, another level of analysis – pocket margin – is needed to reflect the varying costs associated with each order.
All customers are not equal: Even if you are amenable to offering price concessions, do not grant them, or at least grant them uniformly, across the board. It is better to segment customers by how much price increase they have historically tolerated; then, decide on price concessions accordingly.
Implicit in “all customers are not equal” is an initiative we strongly recommend: take a thoughtful, data-based approach. Create granular analyses by customer to enable detailed and tailored conversations. Here’s a guide to get you going:
First, consider your current price, margin and projections. How much have your margins grown over the last three to five years? How have your cost and price trends behaved over the same period? When do you expect the cost of raws (oil included) to rise?
Secondly, consider your historical pricing practices. Have you raised price targets in the past to coincide with rising costs of raws? If so, how quickly did you initiate these price increases and how effective were they?
Finally, consider your exposure to cost volatility by product and segment. Which of your products are materially affected? Which customers are affected? As noted above, which customers have accepted previous increases?
When protecting your margins, it is equally vital to know how your competitors’ products have been affected by volatility and if they are more, or less, dependent on oil. For import/export equations that might impact your margins in this environment, know how changes impact the competitive landscape in highly affected regions. Lastly, understand your market dynamics regarding the state of supply and demand. Are competitors exposed to volatility in the cost of raws? Are competitors disciplined about defending their prices in the face of fluctuations?
Formula-based (or index-based) pricing can be implemented to mitigate your risks. It’s a process by which the buyer and seller agree to a formula which takes third-party published price or cost data and adds or removes some component to capture factors accounting for the supplier’s processing costs, any market advantages, and other variables.
But know that there are downsides: reliance on manual data maintenance will expose your company to mistakes in formulas and calculations that could spawn significant invoice errors. This could easily reduce your pricing conversation to a cost-plus negotiation aimed at defensively protecting a point-in-time margin — not an ideal position from which to protect margin long term.
In my experience, formula-based pricing makes the most sense for commodity-like products that offer limited pricing power. However, where you have a specialty product that is unique or enjoys competitive advantage, formula pricing may leave money on the table.
For price-setting actions to serve you well in all situations, consider taking a tiered, data-driven approach:
- Consider dropping prices just partially if you eliminated or reduced your 2015 annual increase; if you can credit portions of past increases as reasons beyond increases of raws; or if oil prices are projected to rise in 2015.
- Consider delaying your price drop at least as long as you took to raise your price in the past.
- Consider selective price drops, applied only to products materially affected by raw material price cuts, and only to customers who have accepted prior increases.
- Consider temporary price drops, initiated in the form of 90-day price relief on select products. Prices would revert to current levels unless you choose to extend the relief.
Most of all, know that the game has changed: because margin volatility is now the new normal, leaving price to correct itself is no longer a viable option. The most responsible way to manage pricing in this environment is to create a plan based on clear, defensible, data-based rationale. Only then will you protect margins without antagonizing customers — an outcome that captures the best of both worlds.