Competitive, Profitable, and In-Budget: Pricing Supply Chain Software

There is a science to pricing rooted in microeconomics and behavioral economics. Under a set of assumptions, people respond to pricing in logical, predictable ways. There is also a personal approach to pricing. If a seller knows the prospective buyer well enough, they may choose to contradict the logical methods in favor of a tailored approach. Even when pricing rigorously and scientifically, many inputs are assumptions that derive from an intuitive read of the situation. There is room for art and science in pricing. This whitepaper describes the science side of that equation: how to set an asking price for supply chain software in the absence of some overriding personal understanding of the buyer.

What Typifies Supply Chain Software Purchases?

Let’s make some assumptions about what a supply chain software purchase will look like, namely:

  1. The price will be large enough to be a considered purchase by the buyer. It merits their concentration and effort to evaluate.
  2. The overall market paradigm is low-volume, high-value transactions. For a given market niche of supply chain software there may be a thousand sales per year globally, but not millions.

The first assumption removes impulse or convenience buying behavior from consideration. The second removes sales channels focused on high volume throughput. This leaves a situation where a small group of motivated salespeople are working with a small group of motivated buyers. Now they must discuss price. When they discuss price this is usually called negotiations. But prior to negotiations one party (almost always the seller) has to define its asking price, and that exercise is called pricing. An effective way to find the first asking price for supply chain software is described below.

Supply Chain Software Price

 

How to start finding the right price?

A successful price point will have three factors: the seller’s need for revenue, the buyer’s ability to spend, and the buyer’s perception of the market’s next best offer for alternative uses of their capital. More succinctly, the right price appears profitable, feasible, and competitive. An important caveat is that the price need only appear rather than be these things.  The perceptual frame of the price matters and can be a lever to greatly change the price at which a sale is made.

There is a correct order to how these three factors of a successful price are considered. First, find out the buyer’s ability to spend. Why start here? It should be logical that pricing without the potential interference of a competitor is the same as a monopolistic pricing exercise. And a monopoly’s price is the price ceiling for a competitive situation. A monopolistic approach therefore uncovers the highest feasible price and also allows the buyer to think purely in terms of a buyer reacting to the seller’s price, without the distraction of considering competitive effects.

The buyer’s ability to spend can be thought of as a formula of [Budget + (Perceived Value * Percent of Value That Can Self-Fund)]. This amount is the maximum a buyer can feasibly spend on supply chain software. It’s worthwhile to review each component of the proposed formula in more depth. The term budget refers to the authorized spend limit for the engaged decision maker. This could appear as CAPEX (for asset purchases that will be depreciated over time) or OPEX (for operating expenditures). Typically the granting of authority to spend is quite separate between these two categories, and this impacts the resulting budget mindset of the buyer. With CAPEX, they are prone to larger periodic (i.e. 3-5 year) purchase prices with small annual fees afterwards. With CAPEX, a buyer is authorized to agree to a lower price point but expecting that the same amount is paid year over year.

The term perceived value indicates the amount of discounted free cash that is expected to be generated and attributable to the supply chain software. Because this will happen in a future state, it is an assumption rather than a fact… hence the word “perceived”. Free cash generation means the value must be convertible to capital. Customer service improvement, for example, is a kind of value. However, it is not free cash flow. Higher sales volumes, lower returns, or lower marketing costs to attract and retained customers are examples of free cash flows that are created via improved customer service. This amount must then be attributed across “what changed”. Supply chain software by itself typically does not create free cash flow. Rather, the software is combined with organizational changes such as re-training, supply chain network design, supplier rationalization, and so forth. Every one of these changes has a champion or implementer, and each will expect that a part of the free cash flow that is created will be attributed to them. From a pool of $1 million USD of free cash flow created (via software and other efforts), the software may have an attribution of $500k. This is the perceived value.

Finally, there is the Percent of Value That Can Self-Fund. This indicates to what extent a prospective buyer is willing to share the value created by the software with the seller. This is almost always less than 100%. The important point for pricing is not the percentage but whether self-funding is possible at all. Often, a buyer has zero capability to self-fund their purchase. This then negates the impact of perceived value, full stop. Here is a simple example to illustrate the situation. Imagine a seller approaches you and offers you $100 million USD for a price of $90 million USD. And also assume you have already stated your budget is $100k USD. What pricing calculation are they using? The seller must be assuming you can self-fund this purchase. The price point is $99,100,000 more than your budget but if you could self-fund it would be an obviously good purchase. What’s the problem? Obviously most people cannot generate the $90 million USD to self-fund this purchase, regardless of the value it is expected to create. Convincing the buyer that they stand to make $10 million in value is of no use in changing their ability to agree to this price. Here is the point: perceived value may increase the desire to purchase supply chain software, but not the feasibility to buy unless the buyer has a mechanism to self-fund.

So, a buyer must have either budget or the ability to self-fund from the software’s impact itself, or both. In the absence of these two funding sources, a buyer has no ability to spend and hence the maximum sales price must be zero. The formula also shows the three levers that can raise the price point ceiling. A seller can:

  1. Involve a decision maker or functional area that brings additional budget
  2. Increase the perceived value (assuming the self-funding percentage is > 0)
  3. Structure the purchase contract to enable self-funding, such as later payment terms.

Once we know the upper limit of what a buyer is willing to spend, we should evaluate the seller’s need for revenue. In individual cases, a seller might choose a loss-giving price. But typically the price must at least cover costs. A persistent myth is that software is somehow incrementally costless to produce, meaning that it costs money to build the first copy but then all subsequent copies are free. A review of public software company financials shows how misleading this is. In fact, the cost of sale and delivery (which represent incremental costs) are quite high for supply chain software. The sales process is long, involves high paid staff, and extensive travel. The delivery process involves well paid project management and integration consulting services, engineering, and ongoing monitoring and support. A seller needs to cover these costs on average across all sales, and therefore approaches the average pricing exercise with a target revenue amount. This represents the price point floor, where the seller would rather walk away than transact with the buyer.

With the price point floor from the seller and the price point ceiling from the buyer, there is one factor left to evaluate. It is the most complicated because it is responsive: the market. A successful price is a competitive price. The competition here is not necessarily on the software’s functions and features, but more generally on the buyer’s alternative uses of capital. If the buyer has a budget, and the seller proposes a price beneath it, but there are better uses of that budgeted money, it is clear the logical buyer will decline the deal. The evaluation of market pressure on a price has three components (discussed in detail below):

  1. How comparatively attractive must the price be to overcome alternatives?
  2. How will those competitors respond in this instance?
  3. How will those competitors respond in the longer term?

Buyer’s Alternative Use of Capital

Although hard to do, it’s clear that we need to first assess how attractive our price must be in comparison to alternative uses of capital. It’s worthwhile to simply ask a buyer this question, even though it represents a valuable piece of information in negotiations (their BATNA, i.e. Best Alternative to a Negotiated Agreement) and hence a seller can expect either refusal or deception. Because of organizational factors on the buyer’s side, and differentiation of offering on the seller’s sides, the price points between two options must differ significantly before it becomes a deciding factor. For example, beating a competitor’s by $1 USD at a price of $1 million will not be enough to seal a win. It’s vital to therefore know at what point an offer begins winning, both for the seller and for their competitors. This represents legwork for the seller.

 

Deal-Level Competitive Response

Next, if the seller is winning or decides to reduce the price to a point where they would be selected, they must assess the competitor’s actions. Will they discount as well? Will they change the proposal so as to further differentiate and therefore invalidate the comparison? Will they walk away and let the low priced offer have this deal? There is little point in wasting time, energy, and price firmness by discounting in one round if it’s clear the competition will discount again and the first seller has no intention to match. A very narrow benefit might be an intention to force the competitor to accept a “winner’s curse”, i.e. taking a loss on a deal because the price ended so low. This is short sighted, because…

Market-Level Competitive Response

A seller must also assess the long term competitive response. Price actions on single deals are made in a market context, and that context has high sensitivity to the agreed prices. If a seller participate in pricing discounts today, the seller is forming a market that expects them tomorrow. That market is composed of buyers and sellers, both of which learn rapidly from even a few cases of heavy price reductions. In a very real sense, a seller is competing with itself… the current self vs. the future self. A company known for discounting at quarter or year’s end will find its buyers adjusting to that cadence. What was once an expediency to make a financial period’s numbers becomes an expectation on pricing going forward, with horrible consequences. When adjusting a price proposal based on competitive actions, start with the most immediate (i.e. a competitor option exists but is not responding to this pricing offer), then consider how it would respond to the new price, finally consider how everyone in the industry would respond to the new price.

Then bring it together: the buyer’s willingness to spend (the price ceiling), the seller’s need for revenue (the price floor), and the price action-reaction that is expected from the market. With these three figures it should be clear if there is a workable deal and in what ranges. The rest is negotiations. The rest of this article describes special pricing situations and tips on how to address them.

Supply Chain Software Price 2

Pricing Below Profitability to Gain Market Share

Unfortunately, market forces naturally drive prices to a point where some participants are pricing below the cost floor of other participants. This is natural and desirable market dynamics at work. Therefore almost any seller will eventually be faced with a question of whether to loss-lead in order to gain market share. Conceptually, there are a few reasons to consider providing a price that is a net loss if accepted. First, if the seller feels sure that the competitor will price match and that they too will lose rather than gain profits, this approach forces losses upon a competitor. Second, the increase volume of business (topline growth) may enable structural changes that lower the overall costs of the company and therefore enable a return to profitable operations at a later date. Third, winning at a loss-giving price may enable market penetration in a new sector or region, where future business will make up for the losses of the first sale. Fourth, the denial of market share to competitors may force them in to worse financial condition and eventually to exit or at least a weakening of their proposals, which allows prices to come back up for future deals. All of these four justifications for loss-leading prices are risky and based on assumptions that must be carefully validated. The list below shows each justification for pricing at a loss, and what underlying assumptions should be validated.

  1. Future Competitive Void:
    1. Assumption #1: at least one competitor will exit or reduce investment in this market.
    2. Assumption #2: the weakening of the competitor will not be outweighed by new competitor entrants
    3. Assumption #3: when the competitor options weaken, prices raise in such a way to payback all the losses incurred
  2. New Market Penetration:
    1. Assumption #1: there is no viable option to enter the new market without pricing at a loss
    2. Assumption #2: although entering using low prices, the market will not form an expectation of the entrant as a low price provider and will purchase later at higher prices
    3. Assumption #3: competitive response to the entry will not depress prices and make the market unattractive
    4. Assumption #4: later market share wins, at expected prices, will payback all the losses incurred
  3. Grow and then Streamline
    1. Assumption #1: The cost structure of the company will improve as volumes grow. Typically this means the marginal cost per additional volume will decrease
    2. Assumption #2: future pricing at this level will be acceptable or desirable because the cost base will reduce to make it meet the profit goals
    3. Assumption #3: The losses incurred during the interim phase are both acceptable and will be paid back by later margins
  4. Inflicting the Winner’s Curse on a Competitor
    1. Assumption #1: it is sure the competitor will win this business by matching or undercutting the proposed price
    2. Assumption #2: matching or undercutting the proposed price means the competitor will have negative profits
    3. Assumption #3: The losses experienced by the competitor will not be offset later by market share increases, a better competitive position, or entry to new markets
    4. Assumption #4: the winning price point does not cause market reaction lowering expected prices for future deals

 

How to participate in RFPs

RFPs directly reduce the final sales price: there is overwhelming evidence to back up this claim. This is true even if the winning seller is not the lowest price, because the format and competitive pressure drives all seller’s to submit lower price points than they would otherwise. RFPs have no proven benefits for the sellers. They are time consuming, disclose competitive information, costly, and suppress market and individual deal price points. Statistically, participating in an RFP is the same as giving a discount. Therefore the RFP participation is in fact a negotiated discount: the buyer asks, the seller concedes, and statistically the price is reduced. There are two proven approaches for a seller facing an RFP. The first is to refuse. This has two upsides for the seller: (a) it may stop the RFP (or make them exempt from it) if the buyer considers the remaining sellers unacceptable as their only choice, or (b) it allows the competition to win an RFP at a higher price. Counterintuitively, a competitor winning with higher prices will drive up prices for the overall market because the buying side is anchoring higher and the selling side sees higher prices as feasible and therefore strives for them. If a seller decides to participate in the RFP, the second proven approach is to negotiate a worthy concession from the buyer as their price for participating. These can take the form of payment of their RFP participation costs, additional access to decision makers, to a timeline or process of the seller’s choosing, or the promise to have an option to price match if they are too high in the RFP. In brief, state the RFP for what it is: a concession amounting to a discount. Procurement professionals know this already, and candidly addressing it allows the seller to negotiate directly about their participation.

Blending Fixed and Variable Pricing

Many pricing schemes take the form of a fixed fee plus a variable fee. The variable fee is multiplied by some volume factor and added to the fixed fee to create the total price paid by the buyer. In supply chain software, this could be transport volumes, procurement volumes, factory volumes, revenue, user count, or any other number of dimensions. The variable fee often has non-linearity’s, such as blocks or a declining response as volumes become very large. The details behind this are irrelevant for the point discussed below.

A general rule of thumb for these kinds of two-part tariffs is that the variable fee should match the seller’s actual costs, and the entire profit is made in the fixed fee portion. Why is this so? There are several good reasons. Let’s use an example of a warehouse management system that has a fixed fee plus a variable fee per site, and it’s being sold to a company that targets three sites, but could rollout to more or less. Assume the seller needs revenue of 100k in total, and has 60k in costs evenly divided by the three site implementations. Why is a 40k fixed plus 20k per site pricing offer ideal? As a comparison, why not 25k fixed and 25k per site?

First, notice what happens should the buyer reduce scope by one site. The seller remains profitable while also being able to reduce the cost to the buyer. Second, the seller has made expansion to other sites as attractive as possible (short of loss-leading). Any price above cost would give the buyer additional resistance to adding a new site. The buyer may still feel 20k is too much per site, but at least the seller is genuinely offering its lowest price for expansion. Last, notice that the seller has revenue variability but not a risk of profit variability (in absolute terms). They will make 40k from this buyer, regardless of where site count ends up. For many sellers as publicly traded companies, this is an important deliverable of their pricing strategy.

A sharp observer might ask why not just go 100% variable and load both cost and profit coverage in to the variable fee. Two reasons: first, it’s unlikely that the lower end of the volume possibilities would cover actual costs. After all, almost all businesses (including supply chain software vendors) have some fixed costs they must cover. Second, the two part tariff is viewed favorably by buyers because it make incremental expansion less costly. Here is an expansion of the example above: consider the buyer as they assess the two-part tariff against a fully variable tariff. Notice two things. First, the buyer has more incentive to rollout in the two part tariff. Second, only a buyer who expects shrinking scope would be tempted by fully variable pricing. This is an important lesson: fully variable pricing attracts buyers who expect declining (vs increasing) scope. This is noted in the table by marking in green the optimum pricing scheme for the buyer at each site count. The buyer should be scheme agnostic at 3 sites.

Site Count Two Part Tariff Fully Variable, 33k per Site Buyer’s Perception of cost per site
1 60k 33k 60 vs. 33k
2 80k 66k 40 vs. 33k
3 100k 100k Same
4 120k 133k 30 vs 33k
5 140k 166k 28 vs 33k

 

What contributes to a buyer’s price sensitivity?

In general, buyers become more price sensitive (meaning they are more aggressive in seeking reductions in price points) in these situations:

  1. They believe there are many alternatives
  2. They do not feel urgency to buy
  3. The price is high in absolute terms
  4. They will not share the expenditure with a third party
  5. There is downside risk

This list should be mostly intuitive to buyers and sellers of supply chain software. For example, consider the behavior of both sides during an RFP. The buyer tries to remove urgency, share in risks via fixed-fee implementation, and drum up many alternatives. The buyers attempt to differentiate themselves to avoid being seen as an alternative, to anchor to business pain of urgency, and to remove the perception of risk where feasible to speed up a sale (even if risks are not in fact changed). The last point is worth expanding on. Items such as reference calls and executive visits increase the perceived safety of a software vendor, without having any impact on the actual likelihood of deployment failure. But because of the perceptual change, the reduce price sensitivity in the buyer and therefore are a seller tactic.

In Summary:

This whitepaper provides a brief but dense foray in to setting an asking price for supply chain software.  It explained that the right asking price meets three criteria: (1) it is within the spend-limits of the buyer, (2) it is profitable to the seller, and (3) it is competitive to other uses of the buyer’s capital. These three criteria should be assessed in the order given, in order to discover the price ceiling, floor, and market reaction points respectively. Market response will occur, both at the individual sale and the overall market level. These reactions should be considered in advance, since they can be avoided by electing different pricing strategies. Many classic pricing studies show companies declining to bid on business because they anticipated that doing so simply triggers a competitive response that lowers future price points for the market. The whitepaper concludes with some special cases, such as how to best structure price proposals when there is both fixed and variable fees. The most important theme of this paper is to bring economic science to the pricing decision, as a check upon and multiplier for personal and emotional pricing tactics. While personal and emotional factors may guide a seller to setting the right price, those tactics face a high chance of failure or leaving money on the table when they arrive at a price that conflicts with hard economic principles. Use both approaches together to find the best asking price.

 

 

 

 

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