Last week, we discussed grey market risk, which is defined as the amount of potential lost profit due to value and cost differences that are impossible to account for on a part-by-part basis with currency exchange rates. I explained why grey markets exist and discussed how to calculate the total risk associated with your global profits. This week, I will discuss ways to mitigate that risk as part of world-class global pricing processes.
The first step in the process is to setup notifications when grey markets exist that should be managed. This should be done with at least two different types of alerts:
- When the grey market risk breaches a specified level
- When an individual part has violated a pre-determined price-collar, based on the probability of arbitrage.
Being alerted on grey market risk can occur on a relative or absolute basis. On a relative basis, an alert should be triggered when the grey market risk for any given country or region is above the moving average for all regions as a whole. Thus, you will constantly address your high-risk areas of business. On an absolute basis, apply the Pareto Rule to address the countries and regions that comprise the greatest chunk of globally aggregated grey market risk — 80% according to Pareto.
Alerts on individual parts will enable pricers in each region to proactively manage the creation of grey market risk as it happens. These alerts are based on the simple concept that the more one of your customers can save by purchasing abroad rather than in the primary country, the more likely they will do so. These alerts are defined by the grey market differential (GMD) – which tells us the direction the arbitrage will take place – and a metric called the International Part Arbitrage Ratio (IPAR), which indicates the likelihood of the customer executing the arbitrage for any given level of demand.
In last week’s blog, I mentioned that when the GMD was positive, your customers’ procurement departments will be incentivized to purchase from abroad and pay less for the product than if they purchased it in the primary country. If negative, they will be incentivized to purchase from the primary country and ship abroad to satisfy the demand of a different country. But how incentivized? Is the incentive the same for a single transmission as it is for a truckload of key fobs?
To answer this, we look at the International Part Arbitrage Ratio (IPAR) – a calculation that compares the cost to move the part across international borders with the price of the part in the primary country. Without creating a math class in this blog, I can explain the concept rather simply: While a transmission is a high-value item, it is also very expensive to ship; by contrast, key fobs are not. When you compare the cost of shipping a key fob to its value, you realize that pallets of key fobs worth hundreds of thousands of dollars could easily be shipped overseas, should the exchange rates move in favor of doing so. Therefore, you want tighter controls over global prices where the IPAR indicates a higher probability of arbitrage on your high-value items.*
The way to implement these controls is through the use of global price collars. We use collars to allow for price fluctuations within a range for each currency, but not outside of the range. Collars work as ceilings and floors that limit the amount of grey market differential that can exist between two countries. Collars are the best choice because, while we could completely eliminate grey market risk by changing prices daily, as exchange rates fluctuate, this not only creates the drawback of not allowing for regional differences – as stated last week – but also is entirely impractical.
With the use of technology, global price collars are implemented as either tight, moderate or loose across each pair of part-currency combinations. In general, a tighter collar is required when the IPAR calculation indicates a high likelihood of arbitrage, and the grey market risk is high for that part. Using our key fob example, if a single key fob costs $100 in the U.S., and the cost to ship a box of 20 to Germany is only $10, then the IPAR calculation (not shown here) indicates a high probability of arbitrage. Now, let’s pretend that we historically see demand for 50,000 units of this key fob through our selling channel in Germany – a potentially high grey market risk. With this in mind, we would want to implement a tight collar around the price of this key fob in Germany so that its price in German Deutsche Marks is always within a tight collar (e.g., five percent) of the U.S. price in dollars. By using the price collar to keep the U.S. and German prices close to one another, we greatly reduce the incentive of arbitrage that leads to reduced profits.
Setting and maintaining global price collars is part math and part heuristics, and is something that a leading-edge pricing organization must monitor diligently. One of the many decisions in this process is the determination of whether to implement “hard” or “soft” collars. Hard collars place the control of grey market risk as more important than regional price influence by not allowing regional prices ever to go outside the range of the collar. Soft collars act as alerts, allowing for the creation of more grey market risk, but also providing regional pricers the ability to price outside the collar. This decision is one of many your Pricing Steering Committee should contemplate and document.
As the trend for international sales continues to increase, more and more organizations are going to face sophisticated procurement departments that search the globe for the best price to fulfill the demand of multiple countries. By implementing the concepts I describe, you will not only be able to manage grey market risk and prevent lost profits, you also will be implementing world-class pricing processes that reinforce your company’s globalized approach to business.
* Special thanks to Phil Gorman for his work in grey market pricing solutions and the development of the IPAR calculation. Phil is a PROS teammate who works in our Professional Services Center of Excellence.