What is "Gross to Net" and why is it so relevant?
Many companies rely on third parties to commercialize their products. They typically work with a range of distribution companies, trying to achieve a healthy mix of efficiency and reach. In return for their services, these distribution companies are granted two types of fees: 1) discounts, which are on-invoice reductions of the list price, and 2) rebates, which are usually granted at the end of the year (for this reason also called off-invoice) upon achievement of specific targets. The sum of these two components is often called "Gross to Net" (GTN) as it is the difference between the Gross and Net sales. It represents a major part of the value chain and typically lies between 15% and 20% of the gross sales. For the top ten pharmaceutical companies the GTN amounts to over 50bn $.
For a manufacturer, the GTN provides the essential incentives for the market to deliver the finished good to the retailer, and hence to the final customer, and secondly it also motivates the distributor to promote the product to its clients (sub-distributors, retailers or even final customers in case of a vertically integrated player). Distributors at their end will use the incentives either to finance their operations (channel margin) or to promote products via promotional activities. The nature and proportion of the two components discount and rebates is often ignored by companies although it is a key piece of information. E.g. a company can have a high GTN but if it is all passed on to the end customer then it is just another pricing strategy (useful in the pharmaceutical industry for referencing price purposes, or for tender management, in more sophisticated approaches it can be used to create an opaque environment to the competition).
Recent consolidations in various industries and at global level are showing a clear trend. Distributors are becoming more and more concentrated, increasing the negotiation power with manufacturers. However, it is a topic rarely discussed at budget sessions which typically analyze the business starting from the Net Sales, hence after the GTN deduction. This is a major flaw, firstly because it does not provide guidance to the business leaders on the expected actions to be taken and secondly because it deprioritize the topic as it becomes a simple "ticket to play" instead of a strategic lever.
Taking decisions is hard but rewarding
A good commercial policy and GTN structure is about making choices. There are several trade-offs to consider: shall we incentivize single products or overall distributor performance? Shall we grant more discounts or give more rebates (rewards upon targets)? What is the optimal difference in incentives between the top and last tier distributors so that they are all committed? What is the right balance between financial incentives versus free cash flow imperatives? What is the credit risk worth in terms of increased GTN expenditure? Taking such decisions seems harder than it is as companies are afraid of upsetting their partners and losing business. In reality a good process and data analytics can support the trade-offs and lead to rebalancing the spend and generate high returns quickly. A typical GTN optimization project should result in double digit EBIT increases over a 3 year period.
There are four steps that we have used in our approach with previous clients:
1. Prepare the Burning platform. You need consistent communication and focus from top management on the topic. It would seem enough that the Board visualizes that a 0-5% reduction in GTN translates into a 0.5-1% dividend increase to make it a serious topic. A company could finance a mid-term dividend policy by working on optimizing the GTN! But the effects are well beyond the liberation of financial resources. The real benefits are coming from a better usage of the money spent. Let's assume that a well-organized distributor can cover its logistic costs with 3-5% margin, this means that the rest is either profit or invested in the business. And here lies the real issue - the distributor is investing in developing its business but it could also cross-finance a competitor's promotion. So the key in most cases is not really to decrease the GTN but rather to use it in an efficient and effective way to maximize return on investment.
2. Empower the organization. Companies should have a senior cross-divisional leader overlooking the company's commercial strategy and policy with resources embedded in each local organization. Such a role could be defined as global trade manager and the resources in the local organizations could be existing pricing managers with an enlarged scope. A global trade manager should be a veteran in the business, ideally coming with experience from a large distributor.
3. Develop the methodology. Having a robust methodology is key in countering the inevitable resistance in the organization. Key steps in a GTN optimization project are:
- High-level data analysis and qualitative questionnaire in preparation for the actual project kick-off with all key stakeholders.
- Kick-off meeting to share with the local team the project approach, expected outcomes and first identified features of the local market. In addition, it allows receiving feedback on the key imperatives of the local organization which should be embedded into the project objectives.
- Data gathering and analysis. The team has to assemble (often from several systems) the transactional data. This will show the shortfalls of the current practice. It will bring to light the priorities, e.g. the commercial strategy may not be aligned with the long-term plan, the commercial policy is not clear or not consistent across distributors or there is an imbalance between discounts and rebates. Often there will also be shortfalls in the execution of the pricing policy, e.g. small customers might receive higher discounts than large ones or low margin and not strategic products carrying high incentives.
- Bringing the team together. The head(s) of sales and marketing are to be involved closely; the CFO should be involved to ensure alignment with the budgeting and planning processes. Such a project is foremost an analytical effort because it's the data that will bring to light areas of improvement, but project success can only happen if the insights are translated into practical recommendations and decisions which are implemented in the following budgeting process.
4. Roll it out locally in the countries. The last step is to roll out the project on a country level. In a recent benchmark for a large multinational company a-connect could observe that the GTN could range from as low as 4% of Gross Sales up to 35%. Markets have different structures in terms of distribution layers, consolidation, competition, relationships, strategy, product portfolio, logistics capabilities, implementation skills, levels of maturity of the channel, legislation and so on. What works in a market might be destroying value in another, so it is important to address each country separately.
A typical project would take around 2-4 months depending on the organization maturity and market complexity. It might take weeks just to get hold of insightful data. The project team should include the local trade/pricing manager as key owner and 1-2 GTN specialists, e.g. from headquarter or externally. The Steering Committee should include the global trade manager, the project manager and the local management team (country manager, CFO, head(s) of sales and marketing, and sometimes head of channel).
Key levers for success
Based on our experience, the following elements are key for success of any GTN project and have the highest impact:
- Define a clear commercial strategy based on the channel trends, risks and opportunities. Include competition dynamics and strengths and weaknesses of your organization (pricing, portfolio match, brand recognition, relation with stakeholders, gross margins etc.). Identify the right balance between pull and push for the products and between discounts and rebates.
- Develop the ideal channel structure for the future and segment today's channel accordingly. Many companies fail in addressing this point and fall victim to the non-choice. In less than 15 years one of our clients went from having 25 to only 2 distributors and the gross margins consequently deteriorated. So ask yourself how many distributors you want to have? What is the share of consumption of the top 3? How many distributors do we need to have to avoid that our tier 1 distributors increase their negotiation power?
- Segment the channel. Segmentation is a must. Ask how many segments you want to have and how many players there are in each? Who can support you better in reaching remote customers? Who can partner with you to launch new products? Who has a better positioning for sales promotions? Who should simply be a logistics partner? To conduct the actual segmentation, we focus on the two criteria capabilities and willingness. You will want to reward those the most who are capable (experience, investments, software, warehouses, logistics, quality of management and sales reps, etc.) and willing (basically how is your share of wallet evolving in the distributor's portfolio and how ready is he to follow you on new products launches, promotions, etc.).
- Define specific commercial policies for each segment. The policy should reflect the strategic relevance. So more incentives to the partners that will support our growth in the long term and who are able to deliver more sales in the short term. More support in capabilities development to the segment that is still not very mature but essential to be a competitor to our first segment (which might one day raise the expectations) and finally a segment of tactical players that we should remunerate only with the minimum to provide a logistics service for the "pull" only market.
- Review the product segmentation. Are we pushing high margin and strategic products? What products need more pull in the market and for which should we e.g. shift spend from incentives to demand generation with more calls?
- Test the concept with a sample of the channel and internally, run simulations and roll out a proper training to the salesforce for them to fully understand the changes and how to implement them. Also run proper financial simulations to ensure the budget is aligned with targets.
GTN optimization requires cross-functional collaboration and should be part of every company strategy. As we saw, to successfully optimize your GTN and develop a solid commercial strategy, you need to have clarity about your overall strategy, you need to engage senior members of your firm and in the end be able to take sometimes bold decisions. Then, the results will not only be bottom-line double digit growth but also an enhanced competitive position and a stronger and more effective channel.