How Should I Price Spare Parts?

About 10% of all businesses are giant and employ professional pricing experts to prepare important quotations and set most product and service list prices. The remaining 90% of U.S. businesses are SMBs — small to midsize companies. With assistance from their CFO, they task their sales, marketing, and service executives to set competitive prices for their products and spare parts. SMBs rarely have a well-thought-out spare parts pricing strategy. This article is for the 90% who set prices as one of their many responsibilities.

Accounting for Aftermarket Services Within Manufacturing Business Revenue

Service is a critical part of industrial business sales and profits, and spare parts sales are a significant component of service revenue. On average, aftermarket services account for 24% of the total income of a manufacturing business and 40% to 80% of its total profits. The total income does not account for the repeat business enabled by a company’s service business by ensuring high customer satisfaction and loyalty.

Pricing for Growth

According to McKinsey, “an analysis across 30 industries showed that average earnings-before-interest-and-taxes (EBIT) margin for aftermarket services was 25%, compared to 10% for new equipment.” They also reported aftermarket lifetime value could vary from 30% of the initial cost (for heavy trucks) to 75% for gas turbines.

They say, “At most OEMs, parts sales typically provide gross margins of over 30%, compared with an average of 10% for maintenance services —and that means they often make the most substantial contribution to average annual services revenues.”

Also, it is noteworthy that there are three ways to grow parts sales and profits:

• Increase the volume of parts sold
• Reduce the cost of parts sold
• Increase the selling price of the parts

This article focuses on the last point — increasing the parts selling price

To read a related article about spare parts, look at Managing a Spare Parts Business Is a Big Deal for an Industrial OEM

How Should I Price Spare Parts?

In the B2B OEM world, there are three product categories with a selling price:

• Physical products
• Software and firmware products
• Service products
  • Intangible services – training, preventative maintenance, and product-related consulting projects
  • Firmware and software – upgrades, bug fixes, and remote troubleshooting
  • Physical services – spare parts and break/fix repairs

The best approach is value pricing, except for spare parts and break/fix repairs, when pricing the list. Value pricing involves discovering the value the customer gains from using the product and pricing your product below the value level while covering all your costs. The process is not as easy as it may sound, but it is still straightforward.

However, value pricing is overkill in many cases, and a more straightforward method is more than sufficient.

A reminder — spare parts prices are not necessary in their own right. They also impact the invoices you send for non-contract service calls and the prices you charge for a remedial service contract that includes parts.

With this in mind, the investment of the time it takes to arrive at a fair, defensible spare parts price list is well worth the effort.

Spare Parts Categories

The industry typically segments spare parts into three categories. The segments help you identify the correct pricing method and decide how much inventory you will hold. These three categories include:

1. Proprietary, Custom, or Unique Parts: Custom motors, integrated circuits, electronic assemblies, waterjet nozzles, and operating or diagnostic software. Many of these items are considered intellectual property (IP) protected by a patent or a copywritten drawing. Users must purchase these parts from the OEM or their designated agents.
2. Proprietary Wear Parts and Other Consumables: Custom knives, x-ray tubes, and specially formulated chemicals and standards. In the medical area, ECG electrodes may be private-labeled by the instrument manufacturer, yet the instrument is designed to work with many or all brands. Buyers frequently purchase consumables from the OEM.
3. Commercial Off-the-shelf: Commodity parts that the OEM purchases from a manufacturer or distributor are readily available to anyone who needs it. Examples include switches, motors, gears, O-rings, cutting tools, and chemicals like alcohol and other cleaning agents. End users typically purchase over 75% of these parts from someone other than the OEM.

If you have a background in inventory planning, you are probably familiar with the A-B-C method of managing inventory. Here is a summary:

1. The A parts typically make up 75-80% of the annual inventory turnover and include about 15-20% of all part numbers.
2. The B parts comprise about 15% of the annual turnover and 30-40% of all parts.
3. The C parts account for about 5-10% of the annual turnover and around 40-50% of the part numbers.

Notice that the A-B-C spare parts categories align with the A-B-C groups from the inventory model, although the percent and value may differ. And just like the stocking of A-B-C parts are different for each group, the same differences apply to the pricing method.

Related article: If You’re Not Recovering Defective Parts, You’re Missing Opportunities

What Are the Ways to Price Spare Parts?

There are four primary ways to price spare parts:

• Value Pricing: This is best used for your “A” parts and should relate to the total value price of the product. For example, if the “value price” of your product is $500,000 and an “A” part contributes 10% of the total value, the selling price of that part should be $50,000. These parts are your secret sauce. They require a significant investment in R&D and may be covered by a patent. Do not feel guilty about charging a high price because someone purchased your product because of that part.
• Standard Cost + an Additional Percent: For example, whether a part costs $10 or $1,000, you automatically add 10%.
• Margin Pricing: For any segment of parts (A, B, or C), you have a margin target. To calculate the selling price:

• Market-Based Pricing: For spare parts, you can assess and analyze competitors’ prices and adjust based on your findings of competitors’ pricing available on the market. Thus, enabling manufacturers to drive sales and increase revenue. Until recently, going through all your spare parts and accurately finding the selling price from various third-party vendors was very time-consuming and tedious.

In April 2021, a new company, MARKT-PILOT, launched a new software solution that had been developed more than four years before that, providing the market intelligence needed for market-based pricing to make it an easy-to-use method.  Their software consists of three unique capabilities:

1. Identify Opportunities – See which parts you are currently charging too little or too much for and for which parts you are the exclusive supplier. Find the perfect sales price for all your parts to maximize revenue, profit, and customer loyalty.
2. Monitor Price Changes – Track how your competitors change their prices over time. Stay on top of the market and update your prices in real-time to avoid reducing margins amid cost surges and high inflation.
3. Add New Parts On-Demand – Add new parts whenever you need them to get real-time market updates and quote the part on the next day at the perfect price.

MARKT-PILOT has discovered that Manufacturers leave money on the table for 73% of their purchased parts.

Also, any of these four prices can be modified by any or all of the following four considerations:

• Alternate Source Pricing: Once you have a recommended selling price, you should check it against what your customer will pay for the same part if they do not buy it from you.

For example, if you use margin pricing, your company purchases the “C” parts at a negotiated volume price, less than the end-user low volume price. You mark it up and arrive at what you consider to be a fair selling price. If the price your customer would pay if buying the part from someone else is close to your proposed selling price, then you can keep your price or match the lower price. Or, if you do not want to match the lower selling price, then your order desk can suggest that your customers buy from the lower-priced source. Either way, you are keeping your customer’s best interests in mind.

• Competitive Pricing: It is not unusual that your customer also buys parts from your competitors since they may own equipment made by different manufacturers and use the same off-the-shelf parts. To not appear to be overcharging, you should check a few of your prices against your competitors’ price lists. Also, there is an important question that you should always be prepared to answer:

Are your competitors raising or lowering their parts prices?

• Strategic Pricing: After talking with your parts order desk, along with your sales, marketing, and financial groups, you can adjust your proposed selling price if there is a strong feeling that your customers would balk at your costs. After all, you don’t want to jeopardize a capital purchase opportunity to make your service margin look better. So, be prepared to answer this question:

Are your parts prices important to your customer’s purchase or re-purchase decisions?

• Customer Feedback: Customers will provide excellent feedback concerning spare parts pricing.

I was once told by one of my client’s field service technicians (who also does telephone support and quotes service parts) that a customer told him their parts prices were high. For example, their company offered an off-the-shelf electric motor at $700, which could be purchased from a major distributor for $179. During the same engagement, an end-user told me the client priced a wear-part for $200, so he had it made at a local machine shop for $25-$27.

If you receive this type of feedback from customers, internal sales teams, or channel partners, you should reread considerations 1-3 outlined above.

What About B2C Parts Pricing?

In the B2C world, the markup added to the cost of spare parts may be (much) higher than you would consider for B2B parts. B2B buyers are skilled in determining the price they would pay for a part if they purchased it directly from the source.

B2C buyers generally buy replacement parts from either a big box store (Home Depot, Lowes, or Walmart) if they are repairing themselves or from a service person who determines that a defective part has to be replaced.

In either case, the buyer generally follows the recommendation of the sales or service person and does not shop around before moving ahead with the repair.

The Spare Parts Business Is Important to Your Business — and Your Customer’s Business

Spare parts purchases are usually OpEx, which the financial department heavily monitors because they are considered “controllable.” When money starts becoming tight, the CFO usually says: “Cut your expenses.”

Even if spare parts are being purchased to repair a piece of CapEx, the financial people are trained to give service people a scary stare when they do not reduce their monthly OpEx costs, as the CFO asked. So, if you want your relationship with your customer to blossom, you should create a pricing scheme that balances list price and company gross margin contribution.

There are three more variables to look at before thinking about pricing individual items:

• What is the context when a purchase is made for stock or immediate use? Think about these two scenarios:
  • An automobile final assembly line in Tennessee, not Michigan, goes down. The maintenance technician quickly identifies the part causing the stoppage. He checks his stockroom and finds out that there is no replacement part in the whole facility. Forget your list price. How much more would the plant pay to have the part show up in 15 minutes? One hour? 1 shift?
  • An automobile final assembly line in Tennessee, not Michigan, goes down. The maintenance technician quickly identifies the part causing the stoppage. He checks his stockroom and finds out there is one part in the stockroom. After installing the part and returning to full production, he looked at past usage and determined that this was the part’s first failure in 18 months. He quickly calls the OEM to order a replacement part. How much extra do you think the plant would pay to have the part show up in 15 minutes? One hour? 1 shift?

• • We see that the value of a part is significantly influenced by when it is needed.

• • Most parts pricing is based on delivering within a stated time (scenario B above). If an extraordinary effort is needed to meet unusual requirements, the OEM usually adds an expediating charge large enough to cover all additional expenses (or their value).

• Will the part be new, refurbished, or remanufactured and made equivalent to new (ETN)?

• • Long before the circular economy, many companies refurbished or remanufactured parts returned by customers. This was often a functional test or a final quality control inspection. In other cases, the part had to be extensively cleaned and re-machined. But no matter what had to be done to make the returned part saleable, the pre-owned part usually sold for less than a new part, even though they both performed the same job.

• • There is one exception to what I just described. Some industries, and some businesses, define a category of spare parts as “equivalent to new” (ETN). The returned part goes through an enhanced process to ensure that not only will the ETN part perform like new, but that it will have the same remaining useful life as a new part. In those cases, a careful look at the sales and services terms and conditions will show that the seller reserves the right to use either new or ETN parts and that both carry the same warranty. And both have the same selling price.

• • If you require a defective part to be returned, who pays to ship it back, and how much credit will you give the customer?

• • When a replacement part is returned, the OEM usually includes a shipping label in the box with the replacement part. The customer is advised to use the same shipping box for the return trip and ship it within a reasonable delivery time. In most cases, there is no need to ship a defective part with overnight delivery, but within 3 to 5 days would not cause your customer any issues. And don’t forget to issue an RMA number and have the customer add it to the label.

• • The credit you issue must be determined using some sound judgment. The best way is to work backward from your new part list price. First, subtract the used part credit to arrive at a used part list price. Next, collect all the company’s costs to prepare the part for resale. Plug these two numbers into the previous selling price formula and calculate your total margin. Finally, compare the margin to your target margin and adjust the selling price as necessary. Apply your judgment by considering both the competitive and strategic pricing discussed above.

You Can Now Develop Your Spare Parts Price List

Here are the steps you will take to complete your spare parts price list:

Step 1: Decide and agree on your total spare parts sales ($) and margin (%) in the planning year.

Step 2: Divide your spare parts list into three types (A, B, and C). Model your projected year sale for each part number (quantity and standard cost) or work on an average number for each category.

Step 3: Using these three totals, decide the revenue and margin each type of part must contribute to achieving your revenue and margin target.

Step 4: Use the margin for each part number and the appropriate costing method to calculate the new list price.

Step 5: Compare the new price with the prior year’s cost to ensure customers will not suffer sticker shock when quoted the new price. Adjust if necessary.

Adjust Prices for Inflation

Inflation has been reasonably steady during our business lifetime, and materials scarcity has been insignificant. Therefore, we have increased the prices of our services by somewhere in the 1-4% range every year. Our customers understood why we were making these changes, and they did the same thing with their customers.

However, now and for the next year or two, economists are projecting an elevated level of inflation. And Material scarcity will increase the cost of some, but not all parts, by a more significant amount.

For example, oil prices recently hit a seven-year high. That means petroleum-based products like plastics and shipping costs will likely increase by more than 1-4%. Depending on your internal analyses, you have a few options:

• Do nothing and absorb the extra costs. Your customers will appreciate your decision, but you will be expecting that you may not be able to repeat the next time there are significant price increases.
• Raise prices for the affected parts and explain why, as necessary. Your customers will understand, but they will worry if you repeal the increase when the cause passes.
• Keep the current prices in place but add a temporary surcharge. Your customers will understand and see that you stop the surcharge when appropriate; if not, they will have less hassle pushing back on prices.

And what will you do if your standard cost drops? Will, you still increase the list price, keep the price unchanged, reduce the price a little, or reduce the price to what you calculate is the accurate new list price? Remember that the C parts are available from other sources so customers can see their prices. These are usually the least expensive parts, and reducing their cost will not significantly impact your margins.

The A and B parts are more expensive, and customers will notice a slight price reduction. You may place a short “note” in your order acknowledgment indicating a price drop because you are passing along part of your cost reductions. Then, when you have to increase the price, you can point out that” the pendulum swings both ways.”

Extraordinary Circumstances

All the previous ideas are based on routine business situations. But sometimes, unique situations cause us to relook at a subset of our spare parts price list.

In my experience, significant supply chain interruptions like we are being subjected to in mid-to-late 2021 cause sellers to boost prices when items are scarce and demand remains steady or even increases (hoarding).

Another situation occurs when a supplier acquires a significant quantity of the world’s supply of something and demand is steady or drops. If the vendor doesn’t want to hold the inventory and let the market work down stock levels, they may offer exclusive deals to monetize the excess inventory.

In either case, all your pricing analyses went out the window in the desire to balance sales levels and on-hand inventory. And that is what makes pricing and inventory management interesting.

About Middlesex Consulting

Middlesex Consulting helps its B2B product manufacturing clients grow their services revenue and profitability by applying the methodologies and techniques associated with Customer Value Creation and Customer Experience professions to assist its clients as they design and commercialize new services and the associated business transformations. Contact Sam here.

Image Credit: Image by Shutterbug75 from Pixabay 

Note:  This article was initially published in two parts on Thomas Insights