In Search of the Magic Number
By Frank Hurtte
Returning from a hurried lunch at the Golden Lantern Asian Buffet, I notice a fortune cookie sandwiched between the tablet and cellphone in my briefcase. Comfortably seated at my desk, I rip back the plastic and pull out its crusty contents. Snapping the cookie into a dozen random bits, I fondle the message within. One side contains a half-baked (couldn't help the pun) Chinese lesson; the other a powerfully compelling thought: "Look for magic in Numbers." Perhaps it was the double dose of pickled ginger, maybe it was the Thai Chili platter; I was in the after lunch zone. Then my computer "pinged", I had email.
In amongst the normal stuff occupying my inbox was a fresh set of data from a new client. In an effort to better know my clients, I often ask for several months' billing laid out by product, salesperson sale price and gross margin. This data allows me to surgically peer into the distributor. Based on the turnaround time, I can gage distributor's capacity for generating analytic data; I love when data can be set into spreadsheets quickly and easily. Most importantly, it exposes an unadorned view the distributor's sales effort.
Opening the spreadsheet and giving the whole thing a once over for data errors, poor descriptions and rows filled with unreadable characters, I typically begin my work by searching for the magic number. What I have discovered is simple; most distributor sales teams somehow settle on a comfortable margin for orders where they lack solid pricing information.
Using the power of Excel, I quickly build a formula to determine gross margin percentage, copy it throughout the sheet then sort the data. Scanning through the spreadsheet, I quickly notice a couple of noteworthy trends. The first third or so gross margin percentages are relatively random; a few transactions in the single digits, many more in the teens. Then the magic number hits; row after row, page upon page of margins set at precisely 20 percent literally jump off the screen. Pushing on, I notice a number of random orders set at higher margins with the whole thing ending in a flurry of 35 percent margins. Could this be another magic number?
Letting the Magic out of Magic Numbers
Let's make an assumption. I don't believe the magic number necessarily reflects the market price for all of these products. First, my review indicates products from a wide variety of suppliers all carry the same magic cost up margin. Secondly, the products represent a diverse groups of technologies. Juxtaposed, the suppliers originate from a wide range of industries; one might wonder how they arrived upon the same pricing structure. And finally, the customer list points to customers scattered across a wide region representing a couple of states, rural and urban locals and various sizes of companies.
How is it possible that such a wide variety of customers, suppliers and market conditions could have so easily settled on cost plus 20? Simply thinking about the supplier side of this, what are the chances every distributor received the same pricing from a wide variety of suppliers? Today's channel landscape is a patchwork quilt of programs. Sometimes driven by competitive situations, other times through tiered distribution systems and special into stock deals, rarely does every distributor have exactly the same price.
Looking at the magic number, one quickly concludes there is no magic.
If not Magic, what happened?
Over the past three decades, I've had a front row seat to the spread of magic numbers in distribution. Here's the short story.
Pre-1985 most distributor sales teams operated from paper. Pricing was done manually using either individual supplier price sheets (which often did not include the distributor price) or via a pricing service. The pricing services basically published three column prices for a number of vendors. Again, most sellers were only privy to list and a couple of discounted price levels. Any price cutting or special deals were usually based on the price sheet. Terms like "third column price less five" were the lexicon of the wheeler and dealer. Magic numbers in the form of cost up pricing didn't exist.
The wide-scale employment of computers gave birth to Magic Numbers. Throughout the 1990s and into the turn of the Twenty-first Century, most distributors struggled to maintain the quality of prices shown on their order entry screens. To give you an indication, the term "price not maintained" became a common message within customer service groups. Simply put, this meant the suggested prices displayed on the ERP system were not to be trusted. Sellers were forced to determine their own pricing strategy. These broke down to one or more of the following:
- Manually look up the price using the old paper method - which was time consuming.
- Establish pricing based on the history or last sale of the item - but sometimes there was no real pricing history.
- Use a margin they felt reflected the market price - often soliciting guidance from a more experienced seller.
Over time, safe margins developed. As in, if you don't know where to price an item use cost plus 20 percent. With time and without research or much real thought, these numbers were held to be the actual market price. Add new sellers who mostly lacked formalized price training and the number proliferated.
Today, some distributors will attest to the numbers being passed down on stone tablets from a high.
What's wrong with Magic Numbers?
Nothing, if we aren't concerned about growing your business, maximizing gross margin or providing a deal to customers which is fair to them and equitable to the home team. Mostly, magic numbers give away margin.
In this particular case, let me ask this question. Why 20 percent, as opposed to 21, 22, or maybe even 22.5 percent? Pushing even further, does it really make sense to tie anything to your cost? Many distributors find themselves paying for inbound freight on at least some of their product lines. Is freight considered before or after adding the magic percentage number? And what about special deals? Distributor management teams work like crazy to boost profitability with special into stock prices. But as quickly as extra profits are created on one end, guys armed with a magic number give the potential profit away with sloppy pricing.
If all this doesn't scare you, consider this point. The magic numbers used across entire lines of wholesale trade are tracking downwards. Who's ever heard the comment, "Your price is too low"? Every time an order is lost at the magic number level, at least someone wonders if they should use cost plus a new (and lower) magic number. We believe this line of reasoning is ruinous to an otherwise healthy distribution business.
Magic Numbers are hard to Kill…
Remember the 1991 summer classic movie Buffy the Vampire Slayer? It was a comedy spoof and Paul Reubens of Pee-wee Herman fame was the monster. Near the end of the movie, Reubens gets a stake through the heart and goes into a ten minute death scene. The Pee-wee monster was hard to kill, but magic numbers are even harder.
You can't cheerlead your team into using a better plan. We've seen it tried. Management comes out with a message to discourage the use of the magic number, and things move underground. Instead of using a straight 20 percent, the team resorts to 19.5 or 20.1 percent. The practice becomes invisible to all but the best trained eyes. And the march to mediocre continues.
The only real way to create substantial and sustainable results is to put process into your pricing system; remembering this point. A real process has three key components: documentation, metrics and management. Documentation includes details for keeping system prices current, when and where price concessions might be considered and procedures for addressing competitive information. The list of measures necessary is lengthy. However, good things to measure might include percentage of price overrides by seller, gross margin by customer segment and the overall block of business which uses the system prices. Management points are generally served up by the metrics delivered and individuals going outside of the process.
If all of this sounds a bit complicated; it is. The sheer number of products and customer groupings at most customers quickly complicates any attempt to strengthen the way prices are handled. Further today's market conditions are too complex to successfully attempt what many refer to as standardized pricing. Price sensitivity varies by specific product, customer groups, competition and market conditions. To carry the whole thing off, distributors need analytics ahead of the process.
We have discovered one company stands out from the crowd in pricing analytics and process development. David Bauders and his Strategic Pricing Associates (SPA) team employees a scientifically developed proprietary computer algorithm to analyze purchase information from your company's historical data. Armed with the results, pricing data files are created which can be easily ported into your ERP system. SPA assists in building confidence with your sales team through ongoing training and detailed explanation of the scientific approach. The prices aren't just management opinion, they're applied science. Pushing forward in the process, SPA provides the tools required to mentor and monitor the progress of your company; on an individual by individual basis.
Is the whole thing worthwhile?
Reviews of dozens of Strategic Pricing Associates clients points to marked gross margin improvement. They typical distributor adds two full points to their gross margin scorecard. For most distributors this two point pickup falls mostly to the bottom line. And, in an industry where three and four percent bottom lines are common, the resulting profit boost is huge.
Nearly adding this final comment as a post script, allow me just two more sentences. If you happen to be a distributor concerned with the valuation of their business, remember distributors are typically purchased as a multiple of earnings before interest, taxes and amortization (EBITA). Increasing earnings by 50 percent increases the value by a huge amount.
I used 20 percent as the magic number. In the case of this particular client the number was actually lower. It varies by industry, business and selling personalities. However, I have yet to discover a distributor without a pricing process who doesn't have a magic number.