January/February 2010

Channel Chat

Changing price paradigms

By Jim Pinto

This "Channel Chat" series will cover a wide variety of industrial instrumentation and automation topics. We started with a brief history of automation (www.isa.org/intech/Channel_201001) and will branch out into innovation, standards, manufacturing, systems integration, sales channels, and different kinds of success in this business. Wherever my nose points, and your feedback leads …

Today's world has three business/technology models:

  • U.S. businesses develop products with 60 to 70% gross profit margins, and target revenue growth of $100 million to $1 billion. U.S. investment is simply not available for products with smaller markets and margins. Because of this, U.S.-developed products are more complex and are targeted for large markets that can justify higher investments.
  • Developing countries (other than China) are growing rapidly through products that have intermediate complexity with smaller revenue growth and medium (40 to 50%) gross-profit margins. In India, Brazil, and other developing countries, there are exciting technology companies growing to $5-10 million within three to five years with medium complexity products, quickly developed. This level of success attracts relatively high levels of investment.
  • China is unique in that target gross-profit margins are only 5 to 10%, margins considered too small anywhere else. It is this that has made China the world leader in low-price manufacturing of high-volume products.

It must be emphasized that the profit margins being discussed here are gross-profit, the manufacturing cost related to net selling price, and not net-profit, after sales, development, and administrative expenses are accounted for.

In the U.S., gross-profit margins of about 60% typically result in a target net pre-tax profit of 15-20%. In many other countries, a gross-profit of 40% results in net profit of 5-10%, which is considered acceptable. In China, gross-profit is typically 10-15%, and the net-profit is typically less than 2%. That is the essence of global pricing differentials.

Automation suppliers endeavor to maximize profit margins by emphasizing proprietary products, with design features that can command higher margins. But the global, fast-moving technology treadmill quickly demolishes that lead; few high-volume products cannot be quickly copied.

Pricing alternatives

Conventional cost-based pricing is stuck in a trap. Products manufactured offshore at a lower cost are not the answer-not just because the manufactured cost may be lower, but because global companies are prepared to compete with lower profit margins.

The tactical response by the large automation suppliers is to offer a broad range of products, software, systems, and services. But this still has the effect of reducing overall profit margins. My contention is the problem lies in the obsolescent concept of cost-based pricing.

In today's changing global markets, no other marketing decision highlights the double-edged conflict/cooperation nature of the buyer-seller relationship. Pricing is a zero-sum game in which one's gain is the other's loss. The focus must move to a win-win business relationship, simultaneously providing greater customer value and higher supplier profitability.

It is useful to consider the risk/reward trade-off embodied in various pricing approaches. Typical fixed-price, cost-based sales involve only cost risk for the seller. The price is set before the product or service is made or provided. Pricing for services based on costs plus a predetermined profit margin involves no vendor cost risk. The customer pays for all cost overruns, and the supplier's profit is established before delivery.

Especially for large systems and integration services, performance-based pricing is the answer. The seller is paid based on actual performance of products and services.

Performance-based pricing is "insurance" the seller does not undercharge the buyer; it guarantees that as the seller provides more, it is paid more. Significantly, the buyer also receives insurance it will not overpay; it pays only for the amount of performance actually delivered on a measurable basis.

Of course, this means the performance and expected results of the product must be immediately measurable. With the availability of machine-to-machine (M2M) communications, the system results can be monitored consistently to provide the required performance measurements.

Performance-based pricing must include installation, service, and maintenance because performance is attained only when the product or system is operating. In return, the seller should expect to achieve a high return based on performance.

For example, a $100,000 system typically entails a prolonged budgetary/purchasing procedure. Performance-based pricing can be structured to simplify and speed up the process, providing the buyer with a relatively low front-end cost barrier. The contract can be structured to break-even in less than a year, provided the expected performance is achieved, with further incentives for the supplier to exceed financial results. Of course, the supplier must afford the front-end cash-flow; this is typically not a problem for larger companies.

Performance-based pricing moves the cost and price risk to the seller. Neither is established before the deal is made. But the supplier then gets the opportunity to manage the value to the customer and be closely involved to generate additional profits for both sides. With the risk comes added revenue and profit opportunity.

In today's competitive global business environment, traditional cost-based pricing is seriously flawed. Performance-based pricing should be examined as a viable alternative.

ABOUT THE AUTHOR

Jim Pinto is an industry analyst and founder of Action Instruments. You can e-mail him at jim@jimpinto.com or view his writings at www.JimPinto.com. Read the Table of Contents of his book, Pinto's Points, at www.jimpinto.com/writings/points.html.