While they won't pay for advanced features, consumers expect more powerful smartphones every year. In fact, IDC reports that the average selling price of a smartphone decreased to $337 in 2013, down from $387 in 2012, and price tags are expected to drop to about $265 by 2017.
As a result, OEMs demand even lower prices for better performing chips. 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 manufacturing and research and development (R&D) continue to rise. OEMs insist chip makers eat the cost and most chip makers follow suit.
Why? Chip makers are paralyzed by the fear of losing a design. They yield to customers' expectations and accept shrinking margins just to keep the business. They would rather have revenue with poor margin than zero revenue from the customer.
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 analyze how well those volume commitments are met. Most will find that for every $1 billion in sales, they're leaving $50 million on the table.
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 of the chip manufacturer. 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 challenge is that companies don't have the tools and processes in place to manage more prevalent, rather than selective, use of 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.
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 effectively communicating the change to customers. Order management needs tools to process orders and to adjust accordingly if volume benchmarks are missed. Finance needs processes to support audit trail, compliance with the Sarbanes-Oxley Act 2002 (SOX), and accrual of liabilities.
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 on the starting point
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 $250,000 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, where pricing abuse can run rampant, are also primed for transformation. 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 have repeatedly 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. It's time for chip makers to say enough is enough and take back control of their margins.
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