Product Pricing Methods

What you’ll learn to do: Use various pricing methods to determine product pricing

We’ll go into a bit more depth on the math of a cost-oriented approach to retail pricing. First, we will learn more about the three components of retail pricing math: cost, markup percentage, and retail price. Additional components will then need to be considered in order to perform a break-even analysis, and we will explore the concepts of gross margin dollars and gross margin percent. Then we will break away from cost-oriented pricing methods and examine retail pricing based on competition and demand.

Cost-Oriented Pricing Equations

We touched on this topic briefly in an earlier section when we calculated the markup of an item costing $4.00. We also discussed the concept of keystone pricing, which is simply a straight 50% markup on all items regardless of cost. We can easily calculate the different components of retail pricing using known variables.

To calculate the retail price based on cost requires knowing your markup objective. Markup, again, is the difference between what the retailer paid to a vendor for the product and the price at which they sell it to their customers. So for a target 53% markup on an item costing $9.00, we will need two steps. First, we need the “cost complement” of the markup which is calculated as:

Cost Complement = 100% − Markup

Cost Complement = 100% – 53%

Cost Complement = 47% or .47

Then we simply divide the cost of the product by the cost complement to arrive at the retail price.

Retail Price = $9.00 / .47

Retail Price = $19.15

To calculate markup percentage based on cost and retail price, we use the formula discussed earlier:

*Retail price minus cost price divided by retail price*

So if your item cost is $4.00 and you sell it for $10.00, you would calculate markup as:

($10.00  $4.00 = $6.00) /$10.00 = .6 or 60%

Finally, to calculate cost based on retail price and markup with a retail price of $25.00 and a markup of 55%, we would use this formula:

Cost = Retail price * Cost Complement

Cost = $25.00 * .45

Cost = $11.25

Break-Even Point

When we bring the topic of break-even analysis in to our discussion, we will need to add some additional components to our thinking. A retailer will need to understand that there is more than just selling an item for more than it costs (or even the added cost of acquiring the product and having it transported to the retailer and further distributed to stores or direct to customers).

The components gross margin dollars, gross margin percent, and fixed costs are needed to calculate a break-even situation.

Gross margin dollars is the raw profit of retail items after they have been sold. In most retail accounting methods, the gross margin dollar calculation is markup multiplied by units sold minus price adjustments and shrinkage. For example, a retailer buys 1,000 units of dog food at $10.00 and prices it at $20.00. After the 1,000 units have sold, $10,000 gross margin dollars have been generated ($20 – $10 = $10 * 1,000 units = $10,000). Now, some of the dog food was sold at a sale price of $15.00 during a promotional event. The difference between the regular price of $20.00 and the sale price of $15.00 is calculated based on the units sold at that event. If 200 units were sold on sale then $1,000 (200 * $5.00) would be subtracted from the gross margin dollar figure as a price adjustment. Also, retailers account for a variable called shrinkage which consists of damaged, lost or stolen merchandise. It is usually a small fixed percentage that is applied to all sales items across the board, say 2.5% for the sake of our discussion. Therefore, the gross margin dollars generated by the dog food product would be:

Sales dollars generated =  $20,000

Minus price adjustments  − $1,000

Minus shrinkage (2.5%)   −$     250

Gross margin dollars =         $18,750

Next we need gross margin percent. It is calculated much in the same way as markup percentage:

Gross margin percent = Gross margin dollars – cost / sales dollars generated

In this example, we take ($18,750 − $10,000 = $8,750) / $20,000 = .4375 or 43.8%.

To calculate break-even point sales, we use:

Break-even point sales  = Fixed Costs / Gross Margin Percentage

If our monthly expenses are $25,000 per year, then:

Break-even point = $25,000 / .4375

= $57,143

In our example, a retailer would have to generate $57,143 in product sales to break-even.

Competition-Oriented Pricing

Let us examine another method to develop retail pricing strategy based not on cost but instead based on competition. Competitor-based pricing, or market pricing, uses competitor’s pricing, promotions and inventory position to set a retailer’s pricing strategy. Depending on the retailer’s overall pricing strategy and business objectives, pricing may be higher, lower, or matching that of competitors.

Today prices are very transparent to most consumers. Anyone with a smart phone can be online or in a store and instantly compare prices on a similar product. That is why competitor-based pricing is so prevalent where products are easily identifiable, such as with electronics, appliances, and media. Price transparency also creates a counter-strategy where retailers avoid direct comparison through “privatizing” their branded assortments. Have you ever found the same model of mattress from Sealy or Serta at different mattress retailers so that you could compare the price?

Competition-based pricing sounds like a simple strategy to implement once a retailer has decided how pricing fits in to an overall business strategy. But with all of the channels and geographies today, there could be thousands of data points to track who is selling what for how much, especially for larger retailers. Software products have even been developed to assist retailers with this issue. Companies like Competera, Wiser, Minderest, Omnia and others offer software products to track competitive pricing and in some cases, automatically perform price adjustments at store level.

The final point on competition-based pricing relates to inventory position. Retailers take their direct competition very seriously and do not like to find out that they are being undersold by a legitimate competitor. But as we saw in the earlier case study about denim jean pricing, a lower price from a competitor is only a threat when consumers can actually buy the product at the lower price. In fact, when a retailer “low-balls” pricing on a recognizable commodity, they had better have the inventory position to support the rate of sale, otherwise they will incur the wrath of the consumer and the low-pricing attempt will actually backfire.

Demand-Oriented Pricing

In addition to cost-oriented or competition-oriented pricing, demand-oriented pricing is also seen in the retail industry. It is a strategy based on known periods or high or low demand and the elasticity of price during those periods. We will explain this strategy using a few examples.

One of the simplest examples would be the pricing and selling dynamics at your local farmer’s market. Early in the morning when the market is first open, there is the best selection but at the highest prices of the day. As the day goes on and the market nears closing, the produce will normally see a reduction in price by the sellers who are trying to avoid having any product left unsold.

Another example of demand-oriented pricing comes from the airline industry. Flights from Minnesota to sunny Arizona in February will not be at the same price as the same flight in August . The aircraft would use the same amount of fuel, have the same number of employees on board, and pay the same airport costs, etc. The flight in August would only be partially full compared to the number of travelers in February. If there are more passengers in February sharing the costs of the airline operation, the ticket price should be less in a cost-based world. But it is the opposite. This is due to demand. Arizona is a much more desirable destination for snow birds in winter thus the price goes up.

The same demand-oriented pricing exists in the retail industry. When down parkas are offered by department stores at the beginning of the fall season, they will be at their highest-ticketed price. There may be off-price promotions during “pre-season” and heading into the holidays, but most retailers will continue to “own” the down parka at the original price throughout the prime selling season. Then, when it is time for swimwear and shorts to arrive for sale, the price of those down parkas will undoubtedly be greatly reduced. With falling demand for down parkas, the retailer lowers the price in efforts to reduce inventory.

These are simple examples to illustrate the concept. Imagine the complexity of a demand-oriented pricing strategy for a large supermarket retailer where there are tens of thousands of individual products to track. The same ebb and flow of demand certainly exists in grocery products, but adjusting pricing across all of the product categories to take advantage of the dynamics would be a huge challenge. Once again, software applications have been created to help retailers handle the analytics and automation of demand-based pricing.