
	Current Issue \| Past Issues \| Contact Us \| Advertising \| www.pei.org

Managing Conflict
LCG Advisory Council
Top Distributor Photos

TOPIC ARCHIVE

Alternative Fuels
Best Practices
Business Development
Education
D/M Partnership
Equipment Edge
Human Resources
Industry Forecast
Installation & Construction
Letters
Money Matters
Member Profiles
PEI Committees
Projects of Note
Safety Spot
Sales & Marketing
Service Front
Technology Advisory
Technical Talk

INSIDE PEI

President's Perspective
The Renkes Report
People of Tulsa

Improving Margin With Product Mix

Mission Impossible

By Albert D. Bates, Ph.D.

Most PEI members are acutely aware of the need for improved gross margin performance. The challenge is how to produce higher margins in a highly price-competitive world. Very high on almost everybody's list is to change the sales mix to sell more of the high-margin items. This would seem to have the potential to increase margins without any reduction in price competitiveness.

As desirable as this strategy might seem, it has two very important negative characteristics: It is extremely difficult to do, and it doesn't improve gross margin very much. This article looks at the somewhat hidden negatives of product mix from two perspectives:

The Real Impact of Mix on Gross Margin - An examination of the relationships between changes in the product mix and gross margin. In addition, the mix strategy will be compared to the more straightforward strategy of increasing prices.
The Challenges in Changing Product Mix - A discussion of the inherent difficulties in changing the mix versus raising the prices.

The Real Impact of Mix ON Gross Margin
The theory behind changing the product mix is commendable. The intent is to sell more of the higher-margin items in the line so as to increase the firm's overall gross margin without having to resort to price increases.

The overwhelming motivation of customers when purchasing D items is to find a specific item as quickly as possible with minimal effort. At this point distributors provide a sensational level of added value—they actually have the item available when the customer needs it.

To understand how this philosophy goes awry, it is necessary to have an understanding of the margin structure for PEI members. According to the most recent Distributor Profitability Report, the typical firm operates on a gross margin of 27.0% of sales. This is often referred to as the blended gross margin, as the overall result is produced by selling a range of different items whose margins vary widely.

Exhibit 1 looks specifically at the variation in item sales and margin. It utilizes a very common velocity code analysis that divides the product line into four categories based upon how fast the items sell—A, B, C and D items.

The A items represent the fastest-selling items in the product line. Typically, A items will constitute 60% of total sales. The B items are basic items and generate around 20% of the firm's sales. The C items are slow sellers and only account for 15% of total sales. Finally, D stands for dogs. The slowest-selling items in the product line generate only about 5% of the firm's total sales.

Exhibit 1
Improving Gross Margin Percentage By Product Mix and Pricing
	Current Results			Project Results
		Gross Margin			Gross Margin
Velocity Code	Sales	Dollars	Percent	Sales	Dollars	Percent
Changing Mix--Emphasizing D Item Sales
A	$3,600,000	$756,000	21.0	$3,600,000	$756,000	21.0
B	1,200,000	324,000	27.0	1,200,000	324,000	27.0
C	900,000	378,000	42.0	900,000	378,000	42.0
D	300,000	162,000	45.0	330,000	178,200	54.0
Total	$6,000,000	$1,620,000	27.0	$6,030,000	$1,636,200	27.1

Changing Prices--10% Increase on D Items
A	$3,600,000	$756,000	21.0	$3,600,000	$756,000	21.0
B	1,200,000	324,000	27.0	1,200,000	324,000	27.0
C	900,000	378,000	42.0	900,000	378,000	42.0
D	300,000	162,000	54.0	330,000	192,000	58.2
Total	$6,000,000	$1,620,000	27.0	$6,030,000	$1,650,000	27.4

However, when a gross margin perspective replaces a sales perspective, things change dramatically. In a typical variable pricing (also called matrix pricing) arrangement, the A items tend to be commodities and have low margins. In Exhibit 1, the margin on the A items is only 21.0%. At the other extreme, the D items have a great margin—54.0% of sales.

The combination of very high gross margin and very low sales leads a lot of managers on a quest to sell more of the D items. The top half of Exhibit 1 explores the impact of such an effort. The bottom half of the exhibit reviews the parallel impact for a price increase.

The projected results on the right-hand side in the top section, sales of the D items, are increased by 10%, while the other three categories remain at their same sales levels. The gross margin percentage on the D items does not change, of course, but the dollar amount of both sales and margin does.

The Distributor Profitability Report is based on data that will help participants compare themselves to relevant profit and operational benchmarks throughout the industry. Questionnaires must be returned by June 30. For more information on this industry-wide survey, please contact PEI headquarters.

The totals for the top half of the exhibit indicate that the blended gross margin percentage for the total firm increased from 27.0% of sales to 27.1% of sales. While an increase is an increase, the additional margin percentage is small. From a dollar perspective, the mix change took margin dollars from $1,620,000 to $1,636,200, or an increase of $16,200.

The bottom half of the exhibit goes through the same sort of analysis for a 10% price increase on the D items. As can be seen, the improvement is much more dramatic. What is especially important to note is that when sales increased by $30,000 due to the price increase, gross margin dollars increased by the same amount. Price increases have a dollar-for-dollar impact on the margin.

This means that instead of the firm having $16,200 additional margin dollars, it has $30,000 additional dollars. Furthermore, it got this higher number without having to sell any additional merchandise. From a gross margin percentage perspective, the new margin is 27.4%.

There is an important conclusion that PEI members cannot walk away from. The impact on gross margin from changes in pricing is much more significant than changes in product mix. However, many managers continue to view price increases as extremely difficult to achieve while product mix changes would appear to be within easy reach. The truth is typically exactly the opposite—price changes are relatively easy while mix changes are almost impossible.

The Challenges in Changing Product Mix
D items are D items for a reason. Customers buy them only when they need to have them. This means that any effort to sell more D items should more accurately be described as “getting people to buy things they don't really want.”

Many managers continue to view price increases as extremely difficult to achieve while product mix changes would appear to be within easy reach. The truth is typically exactly the opposite.

This doesn't mean it is impossible to do, but it does mean it is really hard. In the example, the reward for doing something really hard is that the gross margin percentage is increased by a paltry 0.1 percentage point.

In comparison, raising prices had a dramatic impact on both the dollars of gross margin and the gross margin percentage. It can also be argued that increasing prices on the D items is a lot easier than selling more of the D items.

Most purchasers of D items are also purchasing the same exact item that they last bought perhaps two or three years ago. Their price perceptions are fuzzy at best. Even if their pricing recall were great, however, the ease of getting the exact item required as quickly as possible dominates the transaction.

In short, increasing prices not only has a larger impact on margin than changing the mix, it also is actually easier to implement. Sometimes the real barrier to increasing prices is that the firm's own employees think that prices on D items are already too high. After all, as shown on the bottom of Exhibit 1, they now have a gross margin of 54.0%. Going to 58.2% would be unconscionable.

In reality, the price is not too high. It is what is needed to justify maintaining the item in inventory for two years waiting for the customer to need it. Availability is essential to the customer and getting paid properly is essential to the firm.

Moving Forward
Distributors need to think in terms of generating the greatest gross margin gain with the least gross margin pain. In almost every instance, that trade-off is maximized by charging fair prices for slow-selling products. With proper discipline, this is actually relatively easy to achieve.

A Checklist for Identifying Price Increase Opportunities

Items with three or more of the following characteristics are virtually guaranteed to be price insensitive:

Slow Selling – This is where firms should start. For the typical firm, the D items are only 5% of sales, but are about 50% of the SKUs. This leaves lots of opportunities.

Not Promoted – Generally, D items are not promoted. A few items would be excluded if there is widespread price information available.

Low Dollar Value – Items that sell for $2 are easier to increase in price as opposed to $2,000, or even $200 items.

Infrequently Purchased – Items that are bought episodically are almost guaranteed to lack price sensitivity.

Bought Only When Absolutely Needed – Items that are purchased only when a specific need arises are literally crying out to have their price increased.

Unique Items – Items that are not readily available from other sources of supply represent a very unique opportunity.

Repair/Service Parts – Small-dollar purchases that allow the buyer to forgo a larger purchase are inherently insensitive to price increases.

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.