Contra Revenue: Could it be your easiest way to improve profit margins? (5-minute read)

On the general subject of ‘customer-centric cost reduction’ I would like to discuss an area that many medium to large companies do not examine at all, and the rest do not cover deeply enough. Contra revenue is not in your P&L or in your Balance Sheet. It therefore receives little attention in most companies. After all, if it is not in your P&L, Balance Sheet or cash flow statements, how can it possibly matter?

What is it?

Contra revenue is the difference between your list price and what you actually charge your customers. It is a cost, and most managers never think about it. Here are some examples:

• Corporate discount agreements: standardized price reductions you give your largest customers. They are often subject to negotiation, and there are wide cultural differences in how they are positioned. Some countries, such as China, are ‘high list price, high discount’ countries, meaning corporate customers expect to see discount levels of 80% or more, so companies bump up their list prices to facilitate them.
• Negotiated discounts: most corporate procurement people consider the corporate discount agreement to be a starting point for a further downwards negotiation.
• Reseller rebates: these are the standard discounts you give to third parties who sell your products. There can be sub-types like ‘deal leader’, ‘deal supporter’ and ‘lead payment’, where a partner brings you business but plays no further part in it.
• At retail, price reductions during sale periods are contra revenue.
• Customer returns are also contra revenue, though they tend to attract more scrutiny than other categories.

Contrasting control mechanisms

Taking the retail example, a decision to repaint the walls of a store can take weeks, involve multiple bids from contractors, intense negotiations and have a budget of $20,000. Meanwhile, a department manager can spontaneously decide “We tried 30% off in our sale last summer. Let’s try 40% off this time”, and that difference can be worth far more to you than the paint decision. Yet it undergoes less scrutiny.

Change can be difficult

Once customers have become used to receiving a certain level of discount, it can be really difficult to change it. The least flexibility comes with volume discount structures, where you publish a table that says that purchases of above a particular amount attract a specific price reduction. Such formal structures are particularly problematic in two situations:

1. When your company merges with another company of approximately similar size, customers will try and often succeed in negotiating the lower of the two discount structures for all of the combined business. Procurement managers love supplier mergers!
2. When you decide to launch a new product line with lower gross margins, it can be challenging to communicate to both customers and sales people that the discounts they are used to are no longer available. You may even have corporate master discount agreements that mean your new product line will be structurally unprofitable when sold to your largest customers.

Managing contra downward

No matter what forms of contra revenue exist in your company, driving it downward will always be possible if you have never worked on the subject before. Here are some ways to go about it, without excessive pain:

• Review negotiated discount levels with sales managers as part of your standard sales reviews. Simply inspecting them will have a reduction effect.
• Compare the discounts given to similar types of customers by different sales teams and approval processes. You will quickly find that some managers give high discounts quite easily, compared to others who are in identical management situations.
• While it is worth including downward management of average discount levels into sales managers’ goals, it is quite tricky to get right. You can’t punish those who already have the lowest discounts. They should probably be asked to maintain discount levels while others are asked to reduce.
• There is often a subjective element in partner discounts. Did the partner simply refer the customer to you, which might be worth 5%, rather than assisting you with the sale, which might be worth 15%? Did they simply assist the sale (worth 15%) or actually lead the sale, which might be worth 30%? Ensure the decision criteria do not contain any element of subjectivity. If you have an automated sales system like Salesforce.com, you should be able to tell when you are paying partners and your own sales people for doing exactly the same work. Inspect it.
• More generally in high-tech, customers try to get higher discounts on software licenses than for hardware, at least for on-premise software. This is because they perceive the incremental cost of a software license as zero. If your sales people sell both hardware and software, you may become a victim of the same mentality. Ensure sales people are trained to understand the R&D and other costs associated with developing and maintaining software. If you sell both hardware and software, and your software discounts are higher, you should consider it an attractive contra improvement opportunity.

Culture

Watch out for cultural differences in contra revenue. There is no universal standard discount rate, and your results will vary. There are countries where customers expect relatively high discounts during the negotiation process. Your own experience is your best guide. The most extreme expectations I have seen have been in China and some Middle-Eastern countries. You will probably need to make your list prices higher in these countries to allow the customer to feel they have had a successful negotiation. While the Dutch and Danish have aggressive negotiation styles, they tend to have realistic expectations of what is possible, and reasonable knowledge of the prices you offer locally and in adjacent countries.

Prices and brand perception

Taking contra revenue to the extreme, where exactly do your prices come from? If yours is mainly a product business, there is at least one way of checking whether your prices are based on sound logic, or whether a single individual has decided what is acceptable based on personal intuition. That way is to look at the last numbers in your list prices. $1,299, and $8,999 are almost certainly examples of prices that have been decided without any testing. Intuition can involve thinking like “Our main competitor has a similar product at $699, so we need to match that.” Well, why do you need to match that? It is not possible that the perception of your brand is exactly the same as that of your competition.

Differences in brand perception mean that you can sell exactly the same product at a different price. This is easy to prove. More than 95% of the bananas sold in the USA are a single cultivar, the Cavendish. Go to Aldi, Safeway, Walmart and Whole Foods, to find four different prices for Cavendish bananas. The reason we are willing to pay more at Safeway than at Aldi or Walmart is all about brand perception. Your corner store in Manhattan can charge still more for the convenience it offers. ‘Pink Lady’ apples are another example. Most people think they are a specific type of apple, but ‘Pink Lady’ is a trademark, and is simply used for some ‘Cripps Pink[1]’ cultivar apples. You can buy identical apples more cheaply, with different branding.

Testing

I don’t pretend to be a pricing expert. I do claim to be a testing expert. If you cannot find sound logical reasoning for your current prices, run small tests of higher prices in some markets. Yes, almost all prices are elastic in some way, meaning higher prices may reduce sales. However, every cent you add to your price is an additional cent of operating profit. If your corporate operating profit is 6%, increasing your average selling prices by 2% means your profits rise by a third at a constant sales volume. Will a 2% price rise cause your sales to drop by 2%? Why not test it, and a variety of other increases? Would moving that $829 price to $845 really cause a sales drop, or just a profit increase? Test it and find out.


[1] See this link for the explanation of Cripps Pink and Pink Lady: https://www.orangepippin.com/apples/pinklady

 

As is usually the case, this is a slightly-edited version of a chapter in one of our books; in this case Customer-Centric Cost Reduction. All of our books are available in paperback and Kindle formats from Amazon stores worldwide.