Global Pricing: Understanding and Managing Grey Market Risk

August 31, 2012- 

A recent article in The Economist tackled the issue of international productivity and reviewed the concept of the Big Mac Index, an imaginative way of looking at exchange rates. It states “The Economist’s Big Mac index grapples with the tricky business of international price and wage comparisons. At its heart is the theory of purchasing­-power parity (PPP).

“Economists reckon the price of a good should not vary much across efficient markets. Otherwise people would buy in cheap markets and sell in dear ones un­til prices equalised. PPP generalises this ‘law of one price’. Over the long run, it suggests, exchange rates should ad­just so a basket of goods costs the same in different countries. If that basket is whimsically taken to contain only a Big Mac, then burger prices may be used for back-­of-­the-­napkin currency valuations. In January a Swiss Big Mac cost $6.81, compared with $4.20 in America and just $2.44 in China, hinting at an over­valued franc relative to the dollar and an undervalued yuan.”

How can this help us understand grey markets and parts pricing? In a nutshell, grey markets exist when a customer can buy a product from another region and ship it to the home region, cheaper than purchasing the product directly from the home region. This situation has become more prevalent because of sourcing from multiple regions and globalized purchasing that can look across regions for the best price.

Because of different brand values, dif­ferent labor rates and different produc­tion costs, the difference in list prices for a single product across the globe can be greater or less than the difference ac­counted for in the currency exchange rate. So while PPP and “the law of one price” is a nice theory, the reality is that currency exchange rates are really de­signed to only eliminate financial arbitrage in currency trading and differences in prices exist around the globe.

There are two common situations where companies will find themselves facing a grey market. In the first, the company sells parts in many countries and has manufacturing facilities in at least two of those countries, thus exposing the com­pany to more variables that will create cost differences that cannot be eliminat­ed with currency exchange rates.

In the second situation, the company sells parts in many countries, but only has manufacturing facilities in one country, which limits the number of variables that might cause the grey market to ex­ist. In this situation, one might think it would be quite easy to eliminate the grey market entirely, simply by using the exchange rates to set prices globally. While this is completely possible, many companies opt not to do this because this form of centralized pricing does not accommodate for regional competition and perception of value. Therefore, many companies will opt for a decentralized pricing approach, which gives each coun­try its own pricing authority and results in the possibility of grey markets to exist once again.

Now that we know why grey markets ex­ist, let’s take a look at how they incentiv­ize your customers’ purchasing behavior. The difference between a product’s price in the primary country, and the landed cost from another country (this is the cost to acquire the product from another country – it includes the exchange rate adjusted price, shipping, tariffs, and transfer costs) is called the grey market differential.

If the grey market differential (GMD) is positive – meaning that the landed cost from another country is less than the product’s price in the primary coun­try – then 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, which decreases your overall global profits. The grey market differential, multiplied by the volume of demand in the primary country is the amount of profit at risk – labeled grey market risk – that your company faces with that particular product between the two countries.

What can one do to manage grey mar­ket risk and battle intelligent global pro­curement departments? 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 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.

Earlier in the article, 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 article, 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 high­value 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 GMD 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 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 francs 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 described in this article, 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.