How to reduce price protection costs

A company with a distribution network sometimes finds it necessary to engage in price protection, where it reimburses its distributors for any price reductions on products they still have in stock. By doing so, the distributor does not have to sell at a loss. This is a particular concern in the consumer electronics market, where product prices decline continually as a result of price wars.

There are several ways to minimize these price protection costs. First, deliberately ship in smaller quantities, with more frequent replenishment cycles, thereby preventing distributors from building up large inventory stockpiles on which price protection payments must be made. If distributors resist this approach, then offer them incentives to do so that cost less than the projected savings from the price protection costs.

Second, join with the distributors in using collaborative forecasting and replenishment. Ideally, this means that the company has direct access to each distributor’s inventory database, and can see sales trends and stocking levels in real-time. This allows the company to precisely tailor the size and timing of shipments to avoid price protection costs.

Third, do not allow distributors to order in excessively large volumes. This can most easily be done by not offering volume discounts. However, over-ordering can be a significant problem simply because price protection and inventory return policies are excessively liberal, since distributors know they can return whatever they do not sell. Thus, some degree of restriction in these policies will almost certainly lead to less over-ordering.