Cost-to-Serve Beats Cost-Plus Pricing in HVAC Distribution

Traditionally, the cost-plus pricing method has been a standard option for HVAC distributors. But the industry doesn’t operate as it used to. If you continue with a cost-plus approach, you'll likely struggle with growth and profits. A better alternative is calculating your cost-to-serve (CTS) for different customers and using that calculation to determine the price. This way, your price covers the actual value you provide and the cost of providing it.

Cost-plus pricing doesn't consider the fact that customers want more service from distributors while gross margins have been pushed lower due to competition. It also doesn't reflect varied customer demands and behaviors.

Using CTS in your pricing decisions is the answer if you want to give customers the value and service they demand without sinking your margins. It keeps you in better control of your margins to be profitable.

How to Calculate Cost-to-Serve in HVAC Distribution

CTS doesn't have to be so complex that it's prohibitive for your sales force. If it is too complicated, your sales force will likely push back. It will be too intensive to bring value to their roles and interrupt their daily flow. You must set it up to be actionable for easy use in actual sales calls. The upfront work can be complex, but the distribution to your teams doesn’t have to be.

Still, many HVAC distributors believe using cost-to-serve is challenging from start to finish and avoid it. Instead, those pursuing CTS might try to keep it simple with a one-factor method, where they only use one measurement to base CTS. They might select transportation or sales cost, for instance. While this is an excellent step toward a more effective pricing method, it isn't the best practice.

So how do you calculate CTS? And which are the best practices? In our experience, there are two best practices for making this calculation in HVAC.

Activity-Based Costing (ABC): For this method, distributors use formulas to apply expenses to orders individually. It's a commonly used method, but it takes a lot of time and isn't easy for sales teams to adopt or trust.

The Surrogate Method: This method is less complex, easier for sales teams to adopt and as effective as the ABC method. It involves applying activity-based techniques and critical factors such as returns and average order size. In addition, you're categorizing customers according to their performance compared to each other, instead of just their CTS.

Top Criteria for Calculating CTS in HVAC Distribution

Which critical factors should you use to calculate CTS using the surrogate method? The most vital metrics are in finance, operations and sales. The best metrics to use are those with measurable data, quantifiable at the customer level, relevant to every customer, and easily understood for applying in sales.

In our research, we’ve found the top seven factors for most HVAC distributors are:

1. Average Order Size: Smaller orders can mean higher handling costs.

2. Average Number of Line Items: Fewer line items can mean a higher CTS.

3. Days to Pay: More days to pay can mean a more significant opportunity cost.

4. Will-Call Orders: Will-call orders mean fewer expenses dedicated to fulfilling an order and a lower CTS.

5. Same-Day Deliveries: Such deliveries typically demand more significant expense and a higher CTS.

6. C and D Items Accessed: C and D items are slower-moving, and customers who order these tend to have a higher CTS.

7. Number of Returns: More returns often lead to greater expenses and a higher CTS.

CTS in the Field

One distributor was experiencing growth through acquisition and wanted to solve for a high CTS and inconsistent pricing. They wanted a better pricing method their sales force could easily use and adapt confidently. This meant developing a thorough understanding of CTS at their company, learning which factors were most vital for them, and training the sales force on CTS. They chose average order size, number of line items and days late as top metrics.

Once these metrics were chosen, it was easier to onboard salespeople and other customer-facing employees.

As you can see in the table below, the two comparable customers have similar sales and gross margins. However, when you calculate using CTS, it's evident there are differences to account for in pricing. For example, Customer 1 orders twice as many orders as Customer 2, ordering one item per order. They also average 12 days late. As a result, they're the more costly customer to serve, and the sales force can make pricing determinations around this fact.