Passing Cost Changes on to Customers: When, Where and By How Much?

June 16, 2016

This is the third post in a four-part series by Zilliant Senior Vice President of Products and Science Pete Eppele on how best respond to cost volatility vis-a-vis price. Read the first and second posts for a primer on the topic.

After a thoughtful diagnostic, there are a few key considerations to roll into the strategy. First, companies should consider if the cost increase or decrease is isolated to their organization, or if it’s industry-wide. Their strategy is likely to vary if the company and its competitors are all experiencing the same cost swing, versus if they are experiencing it alone.

Most industry-wide cost swings are tied to commodity prices, and in those cases, customers are likely to anticipate a price adjustment as a result. For example in the oil and gas or metals industries, customers have high visibility into cost decreases and are expecting cost savings to be passed along.

If it does make sense to adjust prices as a result of cost volatility, next consider the amount, or the “how much?” part of the equation. Here company leadership should determine if the percent of cost pass-through should be large or small. In some cases they may want to pass through 100 percent of the cost increase or savings to customers. In others, it may make sense to pass through a smaller percentage to some customers.

Next is the timing, answering the question “when should price be adjusted in response to a cost change?” Or, “when should the price change with respect to the effective date of the cost change?” (Date of the cost change is defined as the actual date at which new costs will be experienced by the seller.) It could be before the change, for example, effective date minus 90 days, to begin selling existing inventory at higher prices to provide extra cover of the upcoming cost increases. In some cases, it could make sense to wait until after the date of the cost change, perhaps with some fairly long lag times.

Finally, knowing where to pass along costs is critical. As noted above, an across-the-board price change in response to cost won’t suffice. It’s well known that price segmentation is the key to capturing the maximum margin-dollars available to a company in the marketplace. And the basic equation is pretty straightforward: The more price segments a company can scientifically identify, measure the sensitivity of, and make operational, the more margin that company can capture through differentiated pricing.

Consider, for example, a large distributor with thousands of products and customers and millions of transactions. How many price segments could exist in its market? Hundreds? Thousands? The answer is that this type of market actually contains tens-of-thousands of discrete pricing segments – each with a different price sensitivity. Once sales reps have visibility into each segment’s relative sensitivity they can discern that it may not be necessary to reduce prices as costs decline in low sensitivity segments of their business. Yet it may be essential that in high sensitivity segments companies pass along those cost savings in order to maintain volume and wallet share. A smart and effective pricing strategy should not only address the “how much” and “when” parts of the equation, but also the “where” across these discrete micro segments. 

Stay tuned Tuesday for Pete's final post in the series which will share how to set smarter strategies to mitigate cost volatility.

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Experts and Equations Lead to Smarter Strategies to Mitigate Cost Volatility
Experts and Equations Lead to Smarter Strategies to Mitigate Cost Volatility

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