IDC reports that the average selling price of a smartphone decreased to $337 in 2013, down from $387 in 2012, and it is expected to drop to about $265 by 2017. While they won’t pay for it, consumers expect more powerful devices every year.
As a result, OEMs demand even lower prices for better performing chips. Down the supply chain, this creates untenable tension between providing faster chips and not seeing margins or revenues reflect that investment. The problem for semiconductor manufacturers is that the performance gains of Moore’s Law are not keeping up with the economics. The cost of materials and R&D continue to rise.
Yet the industry favors OEMs making more money at the expense of the semiconductor manufacturers. OEMs insist chip makers eat the cost of R&D and most chip makers follow suit.
Why? Chip makers are paralysed by fear. They yield to customers’ expectations and accept shrinking margins just to keep the business. They would rather have the revenue with poor margin than zero revenue from the customer. Most semiconductor manufacturers find that for every $1 billion in sales, they’re leaving $50 million on the table.
Chip makers are artificially accelerating revenue erosion for pie-in-the-sky volume agreements. A common scenario is a customer says that they will buy 1 million chips at 70 cents per chip, and the chip maker agrees to this discount up front. At the end of the year, the customer only purchased 100,000 chips yet still received the volume discount. Had the deal been negotiated for the actual volume, the cost per chip would have been $1.50.
The key is not to let price be lower than it needs to be. By connecting price concessions to what OEMs are actually consuming rather than unmet volume, chip makers can better control revenue erosion. There are two approaches to better align concessions with consumption: (1) rebates or (2) step pricing. Chip makers should consider the following best practices when making this strategic shift.
Start with the CEO
There needs to be a mindset shift at the executive level. Company execs need to decide that they can decelerate revenue erosion and deliberately connect price to real volume consumption and not mythical price pressures. The CEO must be on board and back their team 100%. The worst case scenario is an irritated customer calling the CEO who caves to giving the customer the upfront discount he wants.
Implement Tools and Processes
The biggest objection is that companies don’t have the tools and processes in place to manage rebates and step pricing. The chip maker needs real-time insight into data sets across channels that allows for clear understanding of what their partners and customers are doing for the top line. It also opens the door for meaningful conversations about the gaps between what the customer said they would do and what they are actually doing.
This transition impacts sales, sales operations, order management and finance, which need to negotiate and structure deals in this new manner. Sales needs training and support in communicating the change. They need to effectively tell customers that they’re giving the customer the discount, but they’re giving it when the customer buys what they’ve said they will buy. Order management needs tools to process orders and to adjust accordingly if volume benchmarks are missed. Finance needs processes to support audit trail, SOX compliance and accrual of liabilities.
Manage Change
The chip maker also needs to manage change across the company, particularly with the sales team. They may need to realign sales compensation to stop sales people from being indifferent to how the deal is done. This may include accelerators for giving fewer discounts up front and paying higher commission. For instance, those sales people that move customers to a rebate or step pricing deal may receive their standard commission plus 2%.
Be Selective Where You Start
It’s wise to avoid starting with the really big parts of the business. Instead start with new business. Any new deal valued at less than $500,000 per year could automatically be put on step pricing.
On recurring business, chip makers can start where they have already won the design and the rip-and-replace risk low. The chip maker can introduce step pricing the next year or the next time the customer asks for better pricing, which is increasingly every quarter.
Agreements with contract manufacturers are also primed for transformation. Pricing abuse can run rampant among contract manufacturers who may tell the chip maker they are building for one end customer that gets better pricing, when they are actually building for another. Rebates enable chip makers to mask the end customer pricing away from the middlemen so that they cannot play the system.
Chip makers that have tested rebates and step pricing strategies to stem revenue erosion have seen an average 5% yield improvement on deals. It’s hard to argue against the math because, at the end of the day, semiconductor manufacturers cannot continue taking the brunt of dropping prices. Eventually the economics will not make sense and shareholders will be up in arms. Moore’s Law will break and it will become cost-prohibitive for chip makers to make faster chips. At that point, consumers will only get better performing devices if they and OEMs pay for it.
Content by Chanan Greenberg, senior director, Model N
