In the Gulf Cooperation Council (GCC), declining oil prices have forced states to look at other revenue sources, and have thus put pressure on businesses and their margins. The UAE, until now a tax-free country, announced that Value-added tax (VAT) is to be introduced in 2018, which as a whole, will intensify price pressure and deteriorate margins, making price management more important than ever.
The findings of Simon-Kucher’s Global Pricing Study highlight the risks of sloppy pricing and show that companies are still investing too little in price management and pricing tools. However, those that invest in price management have more pricing power to counter price pressure and attain 25% higher EBITDA margins. An alarming 49% of the companies stated that they are actively engaged in price wars, and facing price pressure. Furthermore, only six out of 10 companies managed to increase their margins compared to previous year. This general business climate shows decision-makers in the region how the introduction of VAT and a lack of effective price management pose a risk to profits. So, what effects can businesses expect from the new tax, and how can they tackle it sustainably?
Impact of VAT on consumers and businesses
As VAT is a tax on consumption, excluding essential items, it should not impact the cost of living to a noticeable extent. So whilst the overall impact on consumer demand will be minimal, for a while large-scale re-pricing will make buyers more “price aware,” i.e. more conscious of prices in general. Unaccustomed to paying any taxes on their purchases, seeing the VAT listed will have a psychological impact on consumers. The good news is that consumers cannot do much about VAT enforcement and therefore will continue to buy the everyday goods that they need. However, there may be some short-term changes in buying behavior for big-ticket items (price-elastic goods such as cars, fine dining, watches etc.), with demand brought forward as these are occasional items and are more expensive.
Since VAT is borne by the end consumer, most businesses will be able to maintain tax neutrality. However, VAT will come with certain legal requirements and reporting compliance. This will impact businesses’ overhead costs, as they will require more staff (i.e. compliance, legal, accountants, and IT professionals), and new IT systems to incorporate the taxes.
Risks for retailers’ margins
It’s up to retailers to manage the upcoming VAT to their advantage. That’s why the impact on businesses is likely to be twofold: first, since VAT is set low at 5%, the change in demand for goods is likely to be minimal. Second, retailers may be able to use VAT as an opportunity to improve their margins, but if mismanaged, profitability could suffer, resulting in price wars. Some retailers may be tempted to absorb the VAT in order to maintain or reduce prices. The danger in this strategy lies in the increased volume required to preserve margins.
In addition to reduced margins, trying to maintain or lower prices could create a price war scenario, with few winners. At the same time, increasing prices to counter this would lead to losing out on customers and in effect give rise to inflationary pressure. Retailers therefore need to employ smart pricing strategies such as bundling goods, reviewing pack sizes, and taking a granular approach to managing price points. They also must ensure that communication and promotion are sharpened during this period of change, and actively sell the value of their goods. Most importantly, they should not react with knee-jerk price cuts when faced with erratic volume changes.
Seven tips to successfully manage VAT
Companies should use the time before VAT implementation to analyze their price positioning more accurately. This requires managers to take the following steps:
1. Avoiding general X% price increases when VAT comes into place, and instead smartly reworking the entire price strategy.
2. Starting a systematic price optimization process, classifying products by their degree of competition, price elasticity, marginal return, growth potential etc. and reviewing price optimization factors for each category. Impact simulations, price fine-tuning (such as new price barriers), price communication etc. need to be considered.
3. Thinking innovatively and implementing intelligent options such as bundling and modified stock keeping units (SKUs).
4. Informing and legally “signaling” general objectives via marketing activities, and making sure the industry is consistently heading in the right direction.
5. Preventing price decreases, as many contracts refer to net prices and these will not change. Suppliers and contractors should be prepared, think ahead, and develop price adjustment strategies for their trade partners to reduce negotiation pressure.
6. Preparing the sales team with training sessions, explaining statements, Q&A sessions etc.
7. Acting rather than waiting, implementing a new price strategy that incorporates VAT as soon as possible– ideally starting now and gradually implementing changes so that by the time VAT is in place they can demonstrate price consistency and create a positive image.
If managers quickly take these tips on board, they will be thoroughly prepared to face the market changes that the VAT introduction will entail.