The Stockholm Syndrome
In 1973, a bank robbery went very wrong in a suburb of Stockholm, Sweden. The two robbers took four people hostage and held them for nearly a week. During that time the hostages began to identify emotionally with the hostage takers rather than the police who were trying to free them. Social scientists have named such a transfer of allegiance the Stockholm Syndrome.
A more recent and better-publicized version of the event took place in the United States when Patty Hearst was kidnapped by terrorists from the so-called Symbionese Liberation Army. She demonstrated classic Stockholm Syndrome behavior by identifying with the terrorists and assisting them in their activities.
Currently, virtually every sales force in distribution demonstrates almost identical behavior by cutting prices for customers. They do so, not because they have been physically kidnapped, but because they are swayed by a strong identification with customers. The negative financial impact on distributors is nothing short of enormous.
Sources of the Syndrome
The pricing problem arises from two factors, one positive and one negative. The positive factor is that distributor salespeople are customer-oriented. Their role in life is to help customers have a great purchasing experience. Normally, this is an extremely beneficial perspective for salespeople to have.
In practice, though, the most common complaint that the sales force receives is that prices are too high. When the sales force is hammered with this perspective day after day, they begin to believe it. Slowly, allegiance shifts from the distributor to the customer.
The negative factor is that the sales force does not fully appreciate the importance of margins in driving distributor profitability. As a result, the sales force is not aware of what margins are needed on individual items to meet profit needs. Inevitably, they begin to believe that “our prices are too high.”
Interestingly, the Stockholm Syndrome is not a factor for faster-moving, commodity-type items. These are already priced on a market basis. Prices are almost always assumed to be fair.
The problem manifests itself on slow-moving items—the classic C and D items in a matrix pricing arrangement. These items have high margins because they are slow selling. However, the sales force sometimes loses sight of the fact that the item may have sat in inventory for a year waiting for the customer to need it. Instead of the current price being fair, it is often stated that “we are overcharging our customers.” Such a perspective is a significant margin drain.
Impact on the Bottom Line
Oftentimes management is not fully aware of how serious the pricing problem can be. After all, it simply affects slower-moving items that are a small part of the sales mix. Further, the margins after the price cutting are still “pretty good,” so why worry?
Exhibit 1 reflects a pricing matrix for a representative MHEDA member. It may not follow the exact pattern of every firm, but it demonstrates the fact that the A items are low-margin, tonnage products. The C and D items are at the high-margin, slow-selling end of the matrix. Overall, the margin for the entire firm is 29.0 percent, which is typical according to the Distributor Performance Benchmarking Report.
The top part of Exhibit 1 demonstrates the impact of a 10 percent price cut on D items only. The impact as shown is on the sale of all D items during the entire year. Each individual transaction involving D items would have the same sort of impact. Looking at the aggregate of all sales is simply quicker and easier.
As can be seen, the price cut lowers the total firm gross margin from 29.0 percent to 28.6 percent. For a firm with $15,000,000 in sales, this is a gross margin loss of $75,000, because the sale of these items will not be influenced by the price cut. Since expenses for the firm are the same, this comes right off of the bottom line.
The bottom part of the exhibit looks at the same 10 percent price cut, but on all C and D items. Here the results are much more dramatic. The firm has suffered a gross margin loss of 1.4 percentage points, or $300,000.
Margin Enhancement Opportunities
It is important to remember that the typical MHEDA member only has a bottom line profit of 2.5 percent. From that perspective a reduction of 1.4 points is a major issue to be addressed. Of equal importance, it is probably a reduction that could be avoided in its entirety.
Slower-moving items are ones where there should be huge opportunities for margin enhancement, not margin degradation. Generating the needed margin requires education, monitoring and discipline.
Education must focus on the fact that a 55.0 percent gross margin on a D item is not high, but extremely fair. Again, this item may have been held in inventory for one or two years waiting for a specific customer to need it. Product availability on slow-selling items is not just a good value-add, it is a great value-add. Salespeople must be convinced of that themselves before they can convince customers.
Monitoring requires systems to ensure that irresponsible price cutting is not taking place. Virtually every management system has the ability to trigger exception reports on pricing activity by salesperson. Such reports must be monitored with vigor.
Discipline reflects the reality that every salesperson may be trained and believe that prices really are fair, but not all of them will follow through in the proper manner. Discipline can be implemented by setting minimum margins on individual D items. If sales are made below that margin level, then commissions are not paid. Discipline can also take the form of fixed pricing on non-commodity items. In that case, pricing issues are removed from the sales environment.
Gross margin management continues to be the main profit driver for MHEDA members. There is no gross margin opportunity that should be overlooked. Outside margin pressures are a reality and pricing must be fair and honest. However, if the problem is an internal one where the staff thinks “our prices are too high,” it is a perception problem that must be addressed firmly.
|Meet the Author
Albert D. Bates, Ph.D. is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado, and on the Web at www.profitplanninggroup.com.