McKinsey: How should semiconductor companies set their prices in the face of inflation and rising raw material prices?

According to a McKinsey research report, semiconductor companies are now facing a series of complex new challenges, including fundamental changes in demand, purchasing patterns, service costs, perceived value across departments and value chains due to the global pandemic, which has led to a surge in commodity prices. The inflation of raw material costs has forced semiconductor companies to take quick action on pricing, and the price increases required to offset inflation and maintain a fixed gross profit margin may far exceed the 2% to 3% increase that many companies see at the end of each year.

inflation

For example, for a company with a gross profit margin of 30% and a sales cost of 40%, assuming that the raw material inflation rate is 20%, the company needs to increase prices by 8% to maintain the same gross profit margin. If the dependence on raw materials is greater or the inflation rate is higher, the price increase will need to be further increased.

The relationship between raw material inflation rate, enterprise dependence on raw materials and enterprise price increase

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In a highly volatile market environment where raw material prices can quickly fluctuate at double-digit rates, gaining pricing advantage is more challenging than ever, especially when pricing and procurement organizations are not working hand in hand.

In fact, almost all pricing and procurement teams operate on different schedules and operating rhythms, and there is usually no formal process for effective communication and coordinated decision-making. As a result, profit leakage is common, and the volatility of raw material prices exacerbates this problem. A few examples can reflect this problem:

Sales teams make discount decisions based on standard costs that are updated only once a year, while actual purchase costs can change daily.

While they may update standard costs more frequently, a lack of communication between the pricing and procurement organizations often means that procurement savings are ultimately passed on to customers, for example when salespeople set prices based on gross margin rather than value.

Many pricing and procurement teams hedged risks independently without coordinating with each other, for example, using spot pricing on the procurement side and fixed pricing on the commercial side, inadvertently increasing the company’s inflation risk exposure.

The challenges industrial companies face in capturing the full pricing potential from their products

(1) For devices with uniform standards and configurations, hundreds of product configurations and accessories make it very difficult to link performance and functionality to price. Limited profit and loss data and competitive insights are typical blind spots that limit value capture, and channel incentives are often out of sync with the actual value created.

(2) For custom equipment, significant differences often occur between budgeted and actual profits due to front-end gaps (e.g., insufficient cross-functional review during budget preparation, budget preparation errors, or scope changes) and execution (e.g., skill gaps or installation inefficiencies). In addition, if change orders are chargeable, the pricing of the change orders often does not reflect the complexity of post-design specification changes.

(3) For engineering components, including spare parts, poor segmentation or disaggregation data (e.g., insufficient details on IP, part lifecycle, service costs, or attributes or complexity of the basic unit) often results in inadequate pricing for thousands of SKUs (stock keeping units), and inability to discount across customer segments, regions, or product segmentation is often unexplained or inconsistent. The typical solution is a “one size fits all” annual price increase of 3%, resulting in poor price realization.

Overall, the lack of clear price performance mechanisms, such as tracking tools, process price realization, authorization, and a central quotation team, can lead to additional profit losses.

Methods for continuous improvement of pricing models: setting the right prices, optimizing discounts, and managing oversight

Ways to improve pricing models

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Setting the Right Price

Cost-plus may seem like an acceptable pricing approach because it aims to achieve similar margins across products, but experience shows that some customers are willing to pay more for specific products and services that they value most. With more refined insights, sales teams can price each product more accurately, provide customers and distributors with detailed justification for each price, and differentiate each product and its features from those of competitors.

In the attribute-based pricing model (ABP), the company sets prices based on the performance of the product.

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Different pricing levers are appropriate for each product type, depending on how customers compare competing products and services. For example, a company can use the fixed-ratio pricing lever to reset its pricing structure based on where a part is used. Start by segmenting the product portfolio based on differentiation and attributes, such as proprietary and nonproprietary technology. Then map the parts to base units and determine the appropriate benchmark for price as a share of the original unit (by segment). And adjust pricing based on competitor pricing and customer expectations—often with much higher margins.

Another lever, value-based pricing, is a powerful pricing tool, especially in highly specialized and differentiated product areas that offer unique value to customers compared to competing products.

Optimize discounts

As mentioned above, while setting list prices helps determine pricing in a way that reflects full product value and differentiation, discounts are the fundamental tool for aligning customers’ specific willingness to pay, typically on a per-transaction basis.

To maximize pricing, companies need strict discounting guidelines and implementation plans. For example, companies that do a lot of deals across customer segments and product lines can use levers to reset discount structures based on customer value and product competitiveness. Sales teams rank customers and channel partners based on their importance in sales, part attach rates, market penetration, and so on, and segment units and parts based on competitive intensity. During the quotation process, discount guidance is often provided to the sales team through a dynamic deal scoring model that compares quote characteristics with historical data and uses customer information to predict likely willingness to pay.

Using a tiered discount structure to increase company profits

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Management Omissions

For large projects, such as the design, manufacture, and installation of custom equipment, oversights can occur for different reasons: Even before the deal closes, costly mistakes can occur in budgeting, outdated pricing models, and improper translation of customer specifications. Oversights are also common during execution, for example, due to rushed procurement and operational inefficiencies caused by time pressures, engineering and manufacturing time overruns, warranty costs, and penalties for late delivery.

Change orders can eat into profits, especially when the team doesn’t carefully track the reasons for change orders and learn from their mistakes, or because the contract lacks clarity or detail about scope, responsibilities, or deliverables.

By identifying and addressing the root causes, companies can apply the levers that transform customer change orders into profit centers to minimize the cost increases incurred during implementation.

Companies can protect profits by improving management of cost-order variances

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Future Outlook

There is reason to believe that semiconductor companies can make rapid progress in today's semiconductor landscape if pricing and procurement teams learn to better collaborate using real-time data from tens of millions of transactions. With new tools and methods, these companies can gain deeper insight into margin risk, translate it into clear pricing priorities, and incorporate the details of commodity costs into conversations with customers.

As the complexity of the semiconductor market continues to grow, two certainties remain: Pricing remains the most powerful profit lever, and companies that continue to rely on outdated pricing methodologies (i.e., pricing that has no bearing on input costs or customer willingness to pay) will fall further behind as profit margins decline.