Unless you are a purchasing professional, you do not ask this question to the vendor when they come up with an increase of their sales prices. On the other hand, if you are at the other side of the table, meaning the vendor/manufacturer, you might also take it granted that the price increase is something that happens every year, and customers accept it anyways. This has always been this way, and everyone does it, right?
Not really. Actually, the salespeople get challenged a lot at each price increase, and they might have to justify the price increases. Usually, the prices are added as an addendum to the distribution agreements, and these contracts allow the seller to update the prices with prior notice. However, customers keep the right to stop buying at the increased prices, so the business might suffer.
So, we better look into the reasons why the manufacturers apply price increases periodically (or ad-hoc), and how this can be explained to customers.
Main reason 1: Cost increase
When you read pricing books the first thing they tell you is that “price is not a function of cost, but cost is a function of price”. What they mean is that you should first define the product along with its ideal selling price and work out what cost the product should be manufactured.
In reality, I noted many companies really actually do cost-plus pricing. The coefficient used for multiplying the cost with to calculate the selling price is usually embedded in a company’s ambiguous pricing culture, and that does not get much challenged. As a product manager, once you claim that “this product will make x% margin”, which meets the financial expectations, you get a “GO” in your project review.
Therefore, once costs go up, the price must go up as well. Now, what drives the cost of a product? I will give examples from industrial companies.
Direct influencers on cost
- Raw material prices – depending on what the product is manufactured with – steel, wood, resin, other minerals, packaging etc.
- Energy prices – These directly impact the energy-hungry manufacturing processes (like steel works etc.)
- Transportation prices – The goods are rarely consumed at the point of manufacturing. They have to travel from factory to another one, and then to distribution centers, and then to the customer. Depending on the incoterms you sell at, you will be impacted by the transportation costs (i.e. DDP most, ExW least).
- Labor costs – There are almost automated factories (especially the ones in Western Europe, where labor is expensive), and there are factories that look like bees’ nest (where labor is cheaper). The labor-extensive industries like assembly, textile would be strongly impacted by changing labor costs. Also, if the company is selling services instead of products, labor cost would be the initial driver of the cost.
Indirect influencers on cost
- Inflation at the manufacturing country – If you are manufacturing in Indonesia, and if you read that the country has a CPI of 5%, expect that over time the employees will demand higher wages. This would impact your labor cost, thus pushing the product cost up.
- Foreign exchange rates – This can be very tricky. Let’s give some examples:
- You buy in USD and sell in EUR (like many electronics distributors in Europe). You’re totally exposed to currency fluctuations. If USD goes up, your product will go up immediately.
- You have price lists in GBP and in EUR – since you cannot split the market (that’s against competition law), if customers get a hold of your multi-currency price list and note that they’re not matching, be sure that they’ll order from the lower-value one. Therefore, you might need to update your multi-currency price lists regularly with the changing FX rates.
- Macroeconomic situation – a growing economy increases demand, and supply usually takes time to catch up. Meanwhile prices go up. So, if you’re in a growing economy, there are chances that the prices will go up as well. An extreme example of this has happened post-Covid with the boom of the demand.
- Regulatory changes – authorities might require additional testing, packaging, labeling for certain products, which bring unplanned costs onto the products.
Other reasons for price increases:
- Low profitability: In cost-plus pricing environment, once the company is faced with lower-than-expected profitability, the first lever the management would like to pull would be the price. Especially in large corporates, once a business is deemed “not strategic” and it turns into a cash-cow, instead of investing and improving the business, the management would tend the milk it. This is towards the end of the lifecycle of a product / business. Of course, this might backfire if the customers do not take increased prices and turn to competitors.
- Change in the competitive scene: Your competitors might go for price increases for a reason or another. This gives you room for a price increase.
Increase in demand (confidence in business, increased brand value) – Imagine the journey of Audi from 80s to 2020s. I did not calculate it, but I am sure the ratio of the price of Audi 80 vs Mercedes C series have gone up significantly in the last 40 years. It is because the company invested in its products, improved them, and brought it par with upper segment. Also, in a simple example, if you receive sales orders for 120% of your manufacturing capacity, you can balance the demand by increasing the price. It does not make sense to leave money at the table.