Price decisions directly impact a retailer’s profitability and competitiveness. Thus, pricing is one of the most important decisions managers have to make.
After all, pricing can make or break a business: set prices too high, and you shut yourself out of competition with other retailers. But price too low, and you can’t cover your costs.
So, you’d think retailers must have adopted some pretty sophisticated pricing strategies by now, right? Unfortunately, not really. Here are some numbers that give an idea of the state of affairs:
- Companies are still radically underestimating the potential of strategic pricing for driving growth. The 2019 Global Pricing Study conducted by Simon Kucher & Partners found that only 12% of businesses identified price as the biggest driver of future profit growth.
- Perhaps that’s why only about half of businesses have a pricing strategy in place, according to a survey conducted by the Institute for International Research and Zilliant.
- And those strategies aren’t necessarily that sophisticated. A Professional Pricing Society (PPS) survey found that 30% of retailers price new products by merely matching their nearest competitors’ prices.
- Nor are businesses taking advantage of the latest technological solutions to developing retail price strategies. 45% of companies still use spreadsheets as their primary tool for pricing, according to a 2016 PPS survey.
Why is optimizing price such an under-implemented technique? Well, it turns out there are several factors that have discouraged retailers from developing and implementing effective strategic retail pricing policies:
- In the 1990s, a booming economy, robust demand, and cost-cutting programs drove up company profits without managers having to devote too much attention to their pricing mechanisms. Today’s retailers have inherited that laissez-faire attitude.
- Until recently, price optimization research was costly and time-consuming, making it out-of-reach for most businesses.
- Pricing is a relatively understudied field in marketing research.
- Of the pricing research that does exist, most managers report finding it too opaque and complex to be of any practical use.
Here’s the thing, though: retailers need to leave all that in the past. Now more than ever, intelligent pricing is a critical mechanism for success. It’s essential in today’s highly competitive, individualized, globalized retail environment.
What’s a manager to do? Well, they can start with a return to basics. There’s a whole list of tried-and-true mathematical retail price formulas that can help operations zero in on more effective prices.
All of these are far superior to relying on gut instinct or “follow-the-leader” competitive pricing alone.
However, keep in mind that stakeholders shouldn’t use these strategies in a vacuum but rather as part of a larger, multi-factor pricing strategy. Once retailers have those formulas down pat, it’s time to look at more advanced pricing considerations.
To get started on the road to optimized pricing, let’s take a look at some of those elementary retail price formulas, then evaluate some more advanced pricing strategies. Finally, we’ll review some of the recent technological developments that can help managers drive growth and increase profitability through effective pricing.
The Basic Retail Price Formula
The most common retail price formula is the single-factor cost-plus model, which involves estimating your cost of goods and adding that to your target markup.
- Definition: A “markup” is “a percentage added to the cost to get retail selling price.”
Many retailers simply calculate their markups based on what their competitors are doing.
For instance, one study on purveyors of eyeglass frames and lenses found that all surveyed businesses were blindly adding a 20%–30% markup to product cost to match their competitors. They did this instead of adjusting the markup to suit their unique needs.
Some simple formulas can give retailers a competitive edge in pricing and price according to their unique needs.
Here are the three most important basic retail price formulas:
- Retail Price = Cost of Goods + Markup
- Markup = Retail Price – Cost of Goods
- Cost of Goods = Retail Price – Markup
15 Other Basic Retail Price Formulas
Now it’s time to get into the nitty-gritty. While the above list will generate the three basic numbers that are the most important to any retailer as they set prices, several formulas can provide even more nuance when making pricing decisions.
Here’s a list of the top 15 most common retail price formulas:
- Break-Even Analysis: Fixed Costs/Gross Margin percentage
- Contribution Margin: Total Sales – Variable Costs
- Cost of Goods Sold: Beginning Inventory + Purchases – Ending Inventory
- Gross Margin: Total Sales – Cost of Goods
- Gross Margin Return on Investment: Gross Margin $ / Average Inventory Cost
- Margin %: (Retail Price – Cost) / Retail Price
- Inventory Turnover: Net Sales / Average Retail Stock
- Initial Markup: % = (Expenses + Reductions + Profit) / (Net Sales + Reductions)
- Maintained Markup:
A) MM $ = (Original Retail – Reductions) – Cost of Goods Sold
B) MM % = Maintained Markup $ / Net Sales Amount
A) $ = Retail Price – Cost
B) % = Markup Amount / Retail Price
11. Open to Buy: (Planned Sales + Planned Markdowns + Planned End of Month Inventory) – Planned Beginning of Month Inventory
12. Quick Ratio: Current Assets – Inventory / Current Liabilities
13. Reductions: Markdowns + Employee Discounts + Customer Discounts + Stock Shortages
14. Sell-Through Rate: % = Units Sold / Units Received
15. Stock-To-Sales Ratio: Beginning of Month Stock / Monthly Sales
The Drawbacks to Mathematical Retail Pricing Formulas
Cost-plus pricing and other basic mathematical retail pricing formulas (also referred to as “rational” pricing strategies) were by far and away the most common techniques used by retailers in the 1980s and 1990s.
Their popularity continues today, especially among managers of SMEs who don’t necessarily have the resources or expertise (or at least, don’t believe they do) to apply more advanced techniques to their pricing practices.
But these formulas have their limitations:
- They assume that average unit costs are linear and stable over time when, in reality, no price perfectly corresponds to volume, nor does any cost remain static.
- They make assumptions about demand, mostly that demand remains consistent over time, which does not reflect economic reality.
- These pricing formulas ignore complex consumer and competitor information.
Any strategy for arriving at an optimal price needs to acknowledge the rich, intricate network of influences that impact any given purchasing decision.
This is not a purely pragmatic, rational process, and any retail price formula needs to be adequately flexible to reflect that complexity.
The most effective retail price formula is going to take into account:
- The retail operation’s processes
- The retail operation’s resources and capabilities
- The physical needs of the market
- The psychological needs of the market
Here’s a look at some of the more advanced retail pricing considerations that should supplement any retailer’s use of the mathematical retail formulas listed above.
Advanced Retail Pricing I: Match Your Retail Pricing Situation to Your Retail Price Formula
The following is a breakdown of three common retail situations that demand different strategic retail price formulas:
1. New Product Pricing
When retailers are introducing a new product to the market, they should consider the following pricing strategies:
- Skim Pricing: Skimming is the practice of setting a high initial price that will then be strategically discounted over time.
The benefits of implementing skim pricing when introducing a new product include:
- At first, the higher price attracts higher-spending buyers who are less sensitive to price and have a unique demand for the product
- When that consumer segment gets saturated, skimming allows retailers to broaden the product’s appeal.
Skim pricing is recommended when there is a high level of product differentiation; i.e., there isn’t a multitude of imitative products in the market. The product needs to be “special” enough to merit a higher initial price in the minds of consumers.
Skim pricing is also recommended when there is evidence that price-insensitive buyers exist in that market.
- Penetration Pricing: Penetration retail pricing is basically the opposite of skimming: it refers to the practice of setting a low initial price for a new product.
The benefits of penetration pricing include:
- It can help speed up the adoption of a new product.
- It can help establish a new product as a market standard.
Penetration pricing is recommended for retailers with cost advantages due to scale.
- Experience Curve Pricing: Similar to penetration pricing, experience curve pricing refers to setting a low initial price for a new product. In this scenario, pricing depends on a so-called “experience curve” that justifies the lower cost with the assumption that unit costs are going to fall as production volume increases, due to the operation’s increased familiarity with the manufacture of the product, deals on wholesale purchases of raw materials, and so forth.
The benefits of experience curve pricing include:
- It can help speedily boost volume in order to help retailers drive down unit production costs.
Experience curve pricing is recommended when market analysis provides evidence that costs will actually fall with increased volume due to demand. Note: Researchers are divided as to whether experience curve pricing is an effective long-term strategy for setting retail prices.
2. Competitive Pricing
When retailers are operating in an economic environment in which a.) the market is mature, and b.) it’s easy to estimate demand, and demand is expected to remain consistent, they might want to consider the following pricing strategies:
- Leader Pricing: Also known as “umbrella pricing,” leader pricing involves a retailer taking the risk of being the first to initiate a price change, with the expectation that their competitors will respond by doing the same. Retailers who adopt leader pricing will often have higher prices than their competitors in general, and most often also have the highest market share for their product.
- Parity Pricing: Parity pricing involves a retailer either maintaining a constant relative price with its competitors, or simply adopting prevailing market prices. Parity pricing is recommended only for retailers operating in a mature market who have high costs.
3. Product Line Pricing
When a retailer offers several related products or services (such as complementary accessories like batteries, ancillary services like free shipping, or product substitutes), they should consider the following retail price formulas:
- Complementary Product Pricing: The complementary product retail pricing formula involves setting a low price for the main product, and a high price for its accessories or complementary products.
The most famous examples of this strategy include Gillette’s practice of selling cheap razors and expensive replacement razor blades, or HP selling cheap printers and jacking up the price on replacement ink cartridges.
This strategy operates under the principle that it will be more expensive to the consumer to switch products than to pay these higher costs for ancillary items.
- Price Bundling. Price bundling involves a retailer offering multiple related products, or a main product and its accessories, as one unit for a cheaper price than if each product was sold separately.
Price bundling has been proven to be a highly effective strategy for driving sales, as it induces buyers to believe they are “getting a good deal.”
- Hint: Price bundling is one key area where today’s sophisticated retail management platforms can add value. For instance, Kitting and Bundling is one of the main features offered by SkuVault’s Inventory Management System. It allows retailers to maximize potential sales by developing and easily fulfilling several bundle variations. (We’ll get into more detail on these kinds of tech-driven solutions in a little bit.)
- Customer Value Pricing: Customer value pricing involves a retailer offering different versions of 1 product. The most expensive product in the line has the most features, while iterations of the same product with fewer and fewer features are offered at lower and lower prices. This strategy has been proven to boost sales in a low-growth market.
Advanced Retail Pricing II: The 6 Basic Psychological Aspects of Retail Prices
The relatively pragmatic, mathematical retail price formulas outlined above have been demonstrably helpful in spurring growth, but when looking into pricing strategies, retailers shouldn’t minimize the impact of the psychological factors that can influence a potential buyer’s willingness to pay.
While the above formulas will generate a range of optimal prices, retailers may want to tweak those numbers in light of the following 6 psychological precepts:
1. Odd-Cents Pricing.
Studies have found buyers tend to be more attracted to prices that:
- End in the odd numbers 1, 3, 5, 7, or 9 (but especially 5 and 9)
- End in a number just below a zero, like .49, .99, 5.95, and so on.
One study even found that consumers are less likely to buy an item when the price is reduced to an even number—they would be more willing to pay $10.99, for instance, that $9.46. Researchers suggest the odd-number ending signals to buyers that they’re getting a discount.
2. 9 vs. 0
The above logic applies when retailers are trying to appeal to price-sensitive buyers. In higher-end markets, however, the opposite logic prevails. Researchers have found a price ending in 9 carries connotations of discounts, lower quality, and poorer service—for higher-end products, such as luxury eyewear, it may be more effective to end the price in a 0.
3. The first figure
Buyers tend to find that the first digit in a price is the most significant digit. For instance, consumers are more willing to tolerate a price hike from $20.51 cents to $20.57 cents than they are a hike of $29.99 to $30.03, even though the latter price spread is lower.
4. Length of price
Buyers tend to find the distance between a 3-figure price like $5.99 and a 4-figure price like $6.15 to be much greater than the distance between two 3-figure numbers, like $5.50 to $5.99.
5. Price rounding
Buyers tend to view a range of prices as 1 rounded price. For instance, $2.50 to $3.99 tends to be rounded to an even $3. Price increases that stay within that range will be less noticeable and more acceptable to the average consumer.
6. Price spread
If a retailer offers a product line that ranges dramatically from the very cheap low-end to the very expensive high-end, customers will almost invariable buy the cheaper products and ignore the most expensive ones. Retailers are advised to avoid large price spreads in order to encourage buyers to consider the more expensive products.
The Benefits of Customized, Variable, Data-Driven Retail Pricing
So far, we’ve reviewed the basic retail price formula and 15 other common pricing formulas, the more advanced retail pricing strategies that correspond to three common retail environments, and the basic psychological factors to keep in mind when setting prices.
Now it’s time to turn our focus to retail price strategies for the 21st century. Thanks to innovations like the recent introduction of AI-driven, data-powered retail management software, managers have access to a wealth of information that they can exploit in service of cutting-edge pricing strategies that have a significant impact on profitability.
Here are the two biggest innovations in retail pricing brought about by these new technological solutions:
1. Differentiated retail pricing
Also known as “individualized pricing,” differentiated pricing involves selling the same product at different prices to different buyers or in different situations. For instance, a return customer with demonstrated loyalty to a given retailer may be given a special discount on a product that’s not available to other customers; or a first-time buyer might be offered a special deal that, in turn, is not provided to return customers.
A Zilliant study found that implementing strategic price differentiation strategies can increase margins by 15% and more.
The advanced, granular sales and inventory analytics and reports offered by platforms like SkuVault give users unprecedented insights into how products perform.
This, in turn, plugs into sophisticated and accurate inventory forecasts, allow retailers to make these kinds of smart, laser-precise, highly effective individualized pricing decisions that help boost their bottom line.
2. Dynamic retail pricing
Dynamic retail pricing refers to frequently adjusting retail prices in response to changing competitor prices, fluctuating consumer demand, and other market variables. This strategy encompasses actions like “daily deals” and surprise “flash sales.”
Merchants who have harnessed the power of big data have developed highly sophisticated dynamic price management. McKinsey reports that Amazon, for instance, can react to a change in a competitor’s price in under an hour, and typically reprices best-selling products 3–4 times a day (and as much as 12 times a day). Other e-retailers have been found to change the price of 10–20% of their available products on a daily basis.
And these dynamic strategies are paying off. A study by Marn and Rosiello found that retailers who frequently adjusted their prices (even by as little as 2–3%) could see a jump in operating profits by as much as 35%. In fact, these small price adjustments had a far larger impact on profits than tweaks to cost structures or sales volumes.
SkuVault’s Inventory Management System provides key support for managers who are interested in implementing dynamic retail pricing because it allows them to place a temporary hold on inventory to guarantee and automatize the fulfillment of daily deals and flash sales.
Clearly, in addition to reviewing the general retail price optimization formulas outlined above, retailers seeking a competitive edge would do well to research the kind of technical solutions we’ve mentioned here, like those offered by SkuVault, to develop a pricing strategy for the 21st century.