One of the lemming-like constants of business is that when times turn bad, many companies immediately figure that since they aren't making much anyway, they'll drop their prices. It sounds crazy when you state it so simply, but if you've been around for longer than a couple of business cycles, you've seen it. But experts in pricing strategy -- a topic poorly understood by many executives -- will tell you that you might be doing exactly the wrong thing. I recently spoke with such an expert: Matt Johnson, a managing partner with Simon Kucher & Partners, a marketing consultancy known for its work in pricing.
BNET: Semiconductors are one of the foundational products in electronics, and yet the profitability of the industry has gone off a cliff, which is another way of saying that they don't get what they need for the chips. What are some of the dynamics you've seen? Matt Johnson: It used to be that the semiconductor companies could count on driving five percent or so out of costs every year. A semiconductor would be introduced at a given price and there were curves [that described how] pricing would drop. But that cost savings curve isn't keeping up. The cost of developing chips initially as well as the ability to drive costs out has been [negatively] influenced. You have cost pressure to show the same [historic] price decreases, but you have pressure on development costs, materials costs, and even labor in some markets. The result is unprecedented margin squeeze.
In addition, companies on the purchasing side have tools to identify every pricing gaffe. Often we'll find that salespeople can get better information from semiconductor customers or contract manufacturers than their own systems. Customers are incredibly sophisticated. All the procurement people are getting trained twice a year on how to negotiate. I think for a lot of the semiconductor salespeople it's like bringing a knife to a gun fight.
BNET: How does the current economic climate differ intrinsically from others that companies have seen over the last 10 or 20 years? MJ: Historically, much of the hardware market was based on price points. There were magic numbers. The latest notebook was always $3000. The latest cell phone, people wouldn't pay more than $300. Many of those are coming apart. It's a combination of longer lifespan on some, meeting certain performance expectations, and not needing the performance increases that they needed in the past. No one pays $3000 for a top end notebook any more. They pay $2000. They had very high prices on the iPhone. Those went down, but you see the same thing with the new models of Blackberries. The early adopters are paying a pretty high price. We see broad segmentation where there's a premium market but there's a ruthless erosion curve of what's a premium product down into where it becomes a more commoditized product. That affects not only the person selling the handset, but backs up into the semiconductor and component manufacturers selling.
BNET: And then the credit crunch becomes another factor. How does this translate into pressure on the OEMs? MJ: You're starting to [see companies] measure things to the hundred of a cent. You start to see the impact of the terms and conditions of contracts.
BNET: How do high tech companies have to approach pricing differently than they have? MJ: Business is usual is a disaster. Companies have to look for fundamental ways to establish values for their products. What becomes vital for your new products, high margin products, is that you don't allow those products to be sucked down with the rest. When a product becomes commoditized you have to walk away and focus on the newer, higher margin products.
Understand a company's ability to pay you in a [predictable] way; that is, how much can I count on getting paid on a timely basis? Companies that promise me certain volumes -- to what degree do they actually meet their promises, which allows me to run manufacturing better. I can get benefits by selling the same product and getting bigger margin if I can plan better. To what degree do companies work with me on inventory management and actual delivery costs? A lot of these products are being designed in one place, manufacturing in a second, assembled in a third, and sold in a forth. Understanding the complete waterfall of what I invoice a customer for and what I see in product. It's credit risk, delivery risk, operational and manufacturing risk.
The other thing that makes that exceptionally brutal is that it's not just you and the end customer, but you have contract manufacturers in the middle who are able to game the system because they see what people are buying the same product. They often are arbitraging out the benefits you create in the sales process by aggregating those demands and stealing the profits from the component manufacturers. Or sometimes it's downright deceit. Say the contract manufacturer is making things for IBM and HP and Sun. All three of those projects are using the same parts, one [paying] 50 cents, one $1, and one $1.50. The contract manufacturer will go and buy the parts for all three customers at the 50 cent price but still bill back at 50, $1, and $1.50. We had one case where one of the vice-presidents from the big component manufacturers was talking to a counterpart at the contract manufacturer, saying, "You are cherry picking the contracts." The counterpart said, "Yes, we are, and as soon as you can tell us where we are, we'll stop." Normally the OEMs if they find out it's happening will work to keep the contract manufacturers to their contract, but we're talking thousands, tens of thousands of parts, so finding the problem can be a challenge. There are easily tens of millions of dollars in profits being siphoned off by the contract manufacturers -- profits agreed to by the OEMs and the component manufacturers.
BNET: A lot of companies talk about selling solutions and moving up the value chain. What goes wrong? MJ: Getting that [approach] to the salespeople can be a real challenge. Partly it's scale. Most sales forces are incentivized based on gross volume and gross revenue. Profit is rarely a component of their compensation, so even through you're developing a strategy to maximize profitability, if the person actually on the street with the client is trying to move units and gross revenue, those goals can conflict with each other pretty dramatically. They can be making their incentive goals and not the profit goals of the company.
BNET: Should that be obvious to management? MJ: One of the challenges is that most companies can measure gross volume and revenue easily. But it's harder when profit is a factor of delivery risk, exchange rate risks [and other factors]. How do I roll that up on a real time basis and communicate it simply and effective enough that [the salespeople] can have a meaningful level of control? How can we develop the guidance, reporting, and tracking for sales, the tools for them to use, to give them those insights at the point of sale to have some control over profitability and enable us to institute incentives based on profit?
BNET: How does the negotiating process go between component vendors and customers? MJ: When a Nokia or Samsung comes to negotiate a contract, they come in with a lot of data and tremendous volume levers. Companies have always threatened that if you don't play my game, I'll put you on the sidelines and not design you into products for a year. A lot of these threats have been made historically but not acted on. Now I think there are companies actually carrying through -- they have the ability to carry through. Most semiconductor companies lack the sophistication in terms of tools and training to maintain the pricing and be strategic of how they walk out on the tail end. A few companies have begun to develop that sophistication. National Semiconductor has spent a lot to be much better in this area.
BNET: How are companies reacting to the current economic pressures in pricing and buying? MJ: The first thing you have to look at is what happens to a C-level executive's mindset. They want to conserve cash, protect their assets, reduce costs, gain efficiencies, and grow their customer base. Cost is a tough one in this market because those are going up at the same time the crisis is happening. The bias of quality versus price tilts strongly in terms of price, at least in some segments of customs, so lowering price becomes really tempting. But few companies have the cost structure to reduce cost over a long period; it's dangerous to do that unilaterally. Even though it might protect your market share in the short turn, you create a long term untenable position where when the market recovers you might not. Prices are easy to go down, but they're not very elastic. The good [vendors] are trying to tie the pricing decreases to some kind of performance decrease as well. If you reduce price without any performance decrease, you're effectively heading toward commoditization.
And the companies that are very price or risk adverse are the most vocal. Guys building digital imaging systems or missiles for the government need the best components. Fundamentally price is not what they care about, but often we find that procurement people take advantage that there is this perceived price sensitivity for everybody so they ask for price concessions that frankly they don't need. One procurement person I talked to at a company that does medical healthcare devices are notoriously price inelastic. You put a $2 chip into a $10,000 machine. If the chip fails, it's massively expensive for them. He said negotiating with component manufacturers is like being a kid in a candy store. More than half the time people give him concessions because of empathy for the market being bad: "We don't need the concessions, but if we're given them, we're not going to argue."
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