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Deal Negotiation: How Chip Makers Can Regain Control of Their Margins

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.

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 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.

Let us know what you think in the comments section below.

13 comments on “Deal Negotiation: How Chip Makers Can Regain Control of Their Margins

  1. FLYINGSCOT
    May 19, 2014

    Your article really hits home as it always feels like the big OEMs have us semicons over a barrel when it gets to negotiating pricing.  What also helps is not to go after “me too” parts so that the levergae of the cusotmer is less.

  2. Hailey Lynne McKeefry
    May 19, 2014

    The idea of fear resonates for me. Businesses run by fear often make poor decisions. One saying “That which we fear we create.”

  3. kilamna
    May 20, 2014

    The age old mantra in the semiconductor industry has been 'we'll make it up in volume'. But when we are shipping a few bucks with each chip making it up in volume piles up high rather quickly. There has to be a bit of market power to pull off the suggested actions; if the price is too high in the early stages volume may never pick up to result in reduced costs, and improved margins. One approach that I have toyed with is to have OEMs place a certain amount in escrow, sort of an LoC, that is then an assurance to the seller that if the volumes are not met the higher net price is indeed met, a reverse rebate. Another idea is to have OEMs have a capital stake in the semiconductor plant, not very practical though.

  4. Chanan Greenberg
    May 20, 2014

    While I agree that it is “easier” to hold the line with proprietary products I have seen ample examples of companies with “commodity” product lines improve their results through the use of rebates and step pricing with their more established customers. At the end of the day distributors, contract manufactuers and the OEMs cannot make products without chips. “Taking away the business” only makes them hostages of a smaller number of suppliers. So, as long as they get a discount and are simply asked to earn it, it should not drive too much lost business

  5. Chanan Greenberg
    May 20, 2014

    I coult not agree more. Any experemintation with creative deal structures is better than just giving up. The ones proposed are interesting though I have not seen much of it happen. The advantage of rebates and step pricing is, we are not inventing the wheel, just expanding the use of an established mechanism.

  6. kilamna
    May 20, 2014

    My proposal is for a 'reverse' rebate. Pay the volume ordered [or cumulative volume ordered] and the excess ASP over the forecast volume price goes into a holding-escrow account.

  7. Chanan Greenberg
    May 20, 2014

    Got it.

  8. Hailey Lynne McKeefry
    May 20, 2014

    @Azmat, interesting ideas. How did your customers take to the reverse rebate? Did you find you had success with it with a certain type of customer?

  9. kilamna
    May 20, 2014

    The mid-size were easier to work with; we had to wait a couple of annual cycles to get the 'template' set up.

  10. Hailey Lynne McKeefry
    May 20, 2014

    @AzmatMalik, that's not suprising, I guess. The smaller organizations would likely be more nimble and also have less leverage with suppliers. It sounds like patience is a virtue when trying to create these new systems.

  11. Taimoor Zubar
    May 23, 2014

    “While I agree that it is “easier” to hold the line with proprietary products I have seen ample examples of companies with “commodity” product lines improve their results through the use of rebates and step pricing with their more established customers.”

    @Chanan: I think the problem with commodity products has been the volitality in their price. With proprietary products and the association of a brand, the price stability becomes better. In the long run this eventually helps in keeping the revenues stable for commodity producers.

  12. Chanan Greenberg
    May 23, 2014

    I agree, it was  what I was trying to say (not as eloquently as you put it) when I referred to “established customers” – meaning companies who recognize the brand, have a standing on going businsess and relationship with the manufacturer 

  13. Taimoor Zubar
    May 23, 2014

    “One approach that I have toyed with is to have OEMs place a certain amount in escrow, sort of an LoC, that is then an assurance to the seller that if the volumes are not met the higher net price is indeed met, a reverse rebate”


    @Azmat: That's an interesting initiative. Normally LoCs are written as simply agreements of payments without mentioning anything about the assurance of a volume. I do wonder how comfortable the OEMs are in accepting this as a clause.

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