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Index based pricing
Managing risk and profitability
Today, US companies use Index Based Pricing on more than $100B of products across various industries. While most companies are forced to implement Index Pricing to hedge their raw material cost volatility, not all of them have robust processes to support index exposure and still fewer precisely plan and execute Index Pricing strategy which in turn costs them millions of dollars annually. Index Pricing can be a powerful tool to hedge risk and meet client demands, but be sure you are capturing the value you provide and not stepping down the slippery slope of unnecessarily unbundling your products.
Complexities and challenges
When building or managing Index Price formulas, it is important to understand the various limitations and complexities of Index Based Pricing. From a formula creation perspective, it's essential to carefully consider all of a product's major cost elements. We have observed instances where formula creation was led by focused teams from Marketing that led to creation of formulas using a stack of indices which failed to accurately represent the complete product (and service) configuration for the customer. Often, this may happen due to the exclusion of a specific material index, or perhaps a missing service/labor component. Unfortunately, these exclusions can create the potential for actual cost increases to surpass the formula changes.
From an execution standpoint, one of the biggest Index Based Pricing challenges is the proliferation of formulas and Index-based deals. We have observed that typically once a company gets into Index Pricing with one (or a few) customers for a product line, it adopts a general readiness to enter into Index based deals with all other customers for that product line, irrespective of the customers' size or strategic value. Furthermore, companies embarking on their Index Pricing journey often use inconsistent spreadsheet templates and, as a result, end up with hundreds or even thousands of variations. Although each permutation serves a purpose in its own right, the variety can lead to administrative overhead and potential risks associated with manual errors. It could also reduce company's ability to effectively track formulas' margin performance over time.
Considerations and best practices
Index Based Pricing is typically seen as a cost-plus strategy, and for the most part this is true. However, that does not preclude indexing from facilitating a value-based pricing strategy in some cases. Even though the reference elements of index pricing are not inherently value-based, you should not disregard the value you provide to the customer and build that into the overall price setting and periodic review mechanism. There are two strong reasons why it may be in your interest to quote prices that contain an index:
- When it is in your interest for input costs to be reflected in prices as soon as possible, and certainly no later than they are reflected in competitors' prices. Any delay is likely to cause a gain in sales and share when input costs go up and sales become less, or even negatively, profitable. Similarly, a delay when input costs decline can cause losing sales (as customers wait to get the benefit of inevitable price declines) or losing share (as customers buy more from competitors who have responded more quickly).
- In some markets, companies must make commitments to customers in advance of knowing their costs, exposing them to risks that could easily overwhelm profitability when the input cost is larger than the profit margin that the firm earns. For example, if a logistic company's customers expect contracts to be firm for 6 months forward but jet fuel price jump precipitously, they could be overwhelmed with cost unless they hedged their fuel. But the cost of fuel hedging may not be something the customer is willing to pay for, since perhaps the customer is an oil company that will benefit when energy costs rise. The customer prefers to "self-hedge" and there is no reason why the seller should want to resist that.