New Pricing Paradigms
Published June 16, 2008
Prices for automation products are traditionally based on manufactured cost with target gross and net profit margin multipliers which are rapidly shrinking because of fierce global competition. New pricing paradigms are needed.
Global Price Differentials
Today's world has three business/technology models:
- U.S. businesses develop products with 60 percent to 70 percent 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, products developed in the United States are more complex and are targeted for large markets that can justify high investment and subsequent high overhead.
- Developing countries (other than China) are growing rapidly through products that have intermediate complexity with smaller revenue growth and medium (40-50 percent) gross-profit margins. In India, Brazil and other developing countries, there are exciting technology companies growing to $5 million to 10 million within three to five years with medium complexity products, quickly developed. This level of success attracts high levels of investment.
- China is unique in that it is largely government controlled, with target gross-profit margins of only 5-10 percent (margins that are considered too small anywhere else). It is this – not reputed low-cost labor – 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 2%. That is the essence of global pricing differentials.
China low-ball pricing
In the early 1990s, China was seen as simply a low cost place to make basic, labor-intensive products. But now China’s universities are producing large numbers of engineers who are relatively inexpensive to employ. Today, China is advancing quickly up the value chain, adding state-of-the-art production capacity in cars, specialty steel, petrochemicals, and microchips. Indeed, we are rapidly approaching a time where America and Europe cannot compete with China purely on a technology basis.
Prices for Chinese manufactured goods are typically half of comparable U.S. products and this continues to give China a strong competitive advantage. It’s important to recognize that the low-price comes NOT from the cost-advantage but rather the way manufactured products are priced. Because they target primarily high-volume products, typical gross-profit of as low as 5-10% is acceptable, and net-profit is often zero.
Zero net-profit? This astounds most outside observers – how can a profit-making enterprise survive (capital and cash-flow) with no profit?
In China, short- and medium-term operating deficits are acceptable since capital is manipulated and controlled by the government. Chinese planners recognize the demand for short-term profit as the key Achilles-heel of Capitalism. The primary objectives are rapid local employment and long-term market share.
Here’s the far-sighted key objective: China mandates disclosure of all intellectual property, demonstrating its long-term perspectives. By contrast, outsourcers are giving away intellectual property and knowledge for short-term financial gain. Many U.S. and European companies find this acceptable, because they consider that the IP is already obsolescent, and they retain primary ownership. However, the Chinese see this as a long-term priority, which will help them attain long-term technology and global market leadership goals. Their ongoing economic transformation continues to have a profound impact not only on China but on the world.
It’s evident that to succeed against China and other countries that accept lower profit margins, there are just two logical pricing alternatives:
- Utilizing technology and automation that provides value beyond anything competitors can supply. Sell differentiated products that cannot be manufactured by others. Stop giving away valuable intellectual property for short-term cost-benefits. Use IP to stay ahead.
- Pricing based not on cost and profit margins, but on performance.
For most automation suppliers, 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 is lower, but because global companies are prepared to compete with lower profit margins.
Western 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.
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 profit overall margins. My contention is that 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.
Performance-based pricing is answer. The seller is paid based on the actual performance of its products and services. In the advertising industry, agencies have traditionally been paid 15% of the cost of the media they buy for a client. These days, agency/client relationships are moving to performance-based pricing – payment based on achieving measurable advertising goals. Other industries as diverse as consulting, trucking, and industrial services are seeing the same trend. Usage-based pricing (price-per-click) is common on the Internet.
Performance-based pricing is “insurance” that 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 that it will not overpay – they pay only for the amount of performance that is actually delivered on a measurable basis.
Of course, this means that 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 allows up-front cost to the buyer to be relatively low. Further, it must include service & 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.
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.
Risk Versus Reward
It is useful to consider the risk/reward tradeoff embodied in various pricing approaches. Pricing for services based on costs plus a predetermined profit margin, often referred to as "time and materials," involves no vendor cost risk or price risk. The customer pays for all cost overruns and the supplier's profit is established before delivery. 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.
Some suppliers of very large systems are moving to profit-based pricing – sharing in the profits (and savings) achieved over past performance. This gets the supplier directly involved, making suppliers and customers truly business partners.
Performance-based pricing moves both 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 involved with that customer to generate additional profits for both sides. With the risk comes added opportunity. The vendor who uses performance-based pricing must be willing to accept greater risk for added reward opportunity.
Traditional cost-based pricing is seriously flawed in the competitive global business environment. Performance-based pricing should be examined as a viable alternative.
Whoever makes things better, cheaper, faster – wins! America must continue to be the leader, or slide backwards into mediocrity.
The remedies proposed require significant attitude changes. Our society must recognize that manufacturing and job creation are not just political or business manipulations, but the building blocks of society. Manufacturing is the nation's backbone. It's important to keep investing in jobs, to upgrade factories, to be competitive in global markets. Entrepreneurship and talent should be encouraged and stimulated to thrive in the manufacturing sector.
Jim Pinto is an industry analyst and commentator, writer, technology futurist, angel investor. You can email him at: [email protected]. Or review his prognostications and predictions on his website: http://www.jimpinto.com/. Review the contents of his new book “Pinto’s Points – How to Win in the Automation Business” at: http://jimpinto.com/writings/points.html</