Deal negotiation: How chip makers can stem revenue erosion

IDC reports that the average selling price of a smartphone decreased to £205 in 2013, down from £236 in 2012, and they expect prices to drop to about £157 by 2017. The increased burden on device manufacturers to innovate is accompanied by the burden to keep lower prices. This creates untenable tension between providing cutting-edge technology and not seeing margins or revenues reflect that investment. In short, consumers want better, faster devices, but they won't pay for it. The problem for semiconductor manufacturers is that the performance gains of Moore's Law are not keeping up with the economics. Even with all of the new technologies introduced in the last five years, the size of the semiconductor industry remains almost unchanged. It's still roughly a £179 billion industry. Growth areas like smartphones and tablets come at the expense of other areas like desktops and laptops. Cloud computing is a growth area but cannibalises the internal server farms. The industry is only seeing a reshuffling of where chips are used, rather than demand for more chips. All the while, the cost of manufacturing and R&D continue to rise. Chip makers can no longer be expected to pay more for production of better performing chips, while device manufacturers demand lower and lower prices for them. In an industry that only achieves single-digit growth, chip makers can't keep serving up price reductions to maintain the status quo. If they do, they'll eventually work themselves out of a business. Someone has to pay The cost of faster chips does not trickle down to consumers. Consumers pay about the same price despite their devices doing more. However, someone has to pay. Right now, the OEM companies make more money at the expense of the semiconductor manufacturers. OEMs are pressing back on the semiconductor industry demanding that chip makers eat the cost of R&D and most chip makers are following suit. Chip makers are paralyzed by the fear of losing a design. They yield to customers' expectations and accept shrinking margins because their mindset is to keep the business. They would rather have the revenue with poor margin than zero revenue from the customer. Discounting is an excusable strategy to win a new design. The problem is that the chip makers treat every deal like they're trying to win a new design. When it comes to recurring business, where the chip already has the socket on the board, chip makers need to remember that they wield some control over price because it is not trivial to rip and replace their chip and software framework. Just say no to upfront discounts Prices will continue to drop. However, chip makers can control how prices should drop. Too many chip makers are artificially accelerating revenue erosion for pie-in-the-sky volume agreements. This is so rampant that less than 50% of semiconductor and component companies bother to even analyse how well those volume commitments are met. A common scenario is a customer says that they will buy 1 million chips at 42p per chip, and the chip maker agrees to this discount up front. At the end of the year, the chip maker finds that 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 89p. Perhaps market conditions changed and the OEM can't sell their device, or perhaps they never intended to buy the higher volume in the first place. OEMs never buy more than they need, which puts chip makers at the mercy of optimistic forecasts generated by the customer and sometimes by their own sales team or distributor. 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. Rebates are straightforward – the chip maker refunds back the discount of 48p per chip when the customer hits 1 million units. Step pricing is a simple alternative providing the company has the right process and tools in sales and finance to support it. The discount is awarded as the customer consumes and meets certain volume benchmarks. For instance, the first 100,000 units are priced at 90p each, the second 100,000 units at 60p, the next 100,000 units at 50pand so on. The maximum discount is only achieved if the full volume agreement is met. If the customer stopped consuming after 200,000 units, then they only received a 15pper chip discount instead of 48pper chip discount. Yearly contract negotiations are ripe for this type of transformation because they are broken. Customers come back to chip makers 90 to 120 days after signing an "annual" contract requesting new prices. This can be due to changing conditions. The market may be softer and endcustomer prices need to drop for one reason or another. Instead of taking a hit to their own margins, OEMs want to put it back on the supply chain. It's standard procurement procedure to go back and ask for a better price even if market conditions have not changed; they're trained to do it. These price changes can be as much as 2% to 3% quarterly. Companies that have tested the rebates and step-pricing strategies have repeatedly seen an average 5% yield improvement on deals. Get others to accept the new way More prevalent, rather than selective, use of rebates and step pricing is a significant change in the way chip makers conduct business and it won't happen overnight. First 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. The biggest challenge to using rebates is that companies don't have the tools and processes in place to manage them. Transitioning to rebates and step pricing has implications for sales, sales operations, order management and finance. Everyone is impacted. It is critical to have the right tools in place to negotiate and structure deals in this manner. Sales will fear that this approach will lead to lost revenue. They will need training and support in communicating the change to customers. Sales will 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 will need tools to process orders and if volume benchmarks are missed adjust accordingly. Finance will need processes to support audit trail, SOX compliance and accrual of liabilities. For rebates and step pricing to be successful, the chip maker needs real-time insight into data sets across channels. This will allow for clear understanding of what their partners and customer are doing for the top line. It will also open the door for meaningful conversations about the gaps between what the customer said they would do and what they are actually doing. The chip maker will also need to manage change across the company, particularly with the sales team. The company may need to re-align sales compensation. Some companies opt to give accelerators for giving fewer discounts up front and pay higher commission. For instance, those sales people that move customers to a rebate or step pricing deal may receive their standard commission plus 2%. Because volume is regularly not met, the chip maker is getting more revenue up front on the deal and sales should be compensated for this value. If the chip maker fails to train sales or does not line up compensation with the new approach, then the sales person may be indifferent to how the sale is done. Be selective where you start Chip makers should be selective on where they deploy rebates and step pricing. It's wise to avoid starting with the really big parts of the business. Instead start with new customers who have little to no track record and do not merit any significant upfront discounting. Any new opportunity valued at less than £149,000 per year could automatically be put on step pricing or rebate structure. On recurring business, chip makers can start where they have already won the design and the rip-and-replace risk is low. The chip maker can introduce step pricing the next year or the next time the customer asks for better pricing, which may happen every quarter. Agreements with contract manufacturers are also primed for transformation. Contract manufacturers who purchase chips to build product for other device manufacturers are an area where pricing abuse can run rampant. Contract manufacturers 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. Prove the juice is worth the squeeze Some naysayers believe it can't be done. They think the semiconductor manufacturers should continue taking the brunt of dropping prices. However, the industry cannot continue on this path because eventually the economics will not make sense and shareholders will be up in arms. Chip makers that have tested the rebates and step-pricing strategies to stem revenue erosion have seen an average 5% yield improvement on deals. To get this type of sustainable transformation underway, chip makers can work with third-party advisors to look at their data, analyse revenues lost to unmet volume deals, substantiate the issues and determine the size of the prize. Most semiconductor manufacturers will find that for every £600 million in sales, they're leaving £30 million on the table. When a chip maker can see a nine-figure difference over two to three years from their own data, it's difficult to deny something needs to change. It's time for chip makers to say enough is enough and take back control of their margins. Chanan Greenberg is senior director, strategic markets at Model N.