Setting Prices for Maximum ROI
Setting Prices
by Alan Fisher
After 25 years of working with retailers, I found that most of my clients used a formula for setting prices. In the industries where I consulted, most of them used the old Keystone method (two times cost). If their products actually sold at that price, the stores would be profitable. But, as we all know, we rarely end up with the profit margin that we intended (in this case 50%).
It is important to understand, mathematically, what happens to the net profits of a business with specific levels of markdowns. The starting point is to look at a financial statement that covers 12-month and look at Operating Expenses at a Percent of Income. Many of my clients operated at 42-44% OE. If we pick the lower one as a starting point, everything that sells above 42% is profitable, below is a loss. If we Keystoned the products and sold them, we’d have an 8% net profit.
But, if we take a 20% markdown on some of those items, the gross profit drops to 37.5%. Uh-oh, we lost money on these. If we sold one at full and one on markdown, the gross profit drops to 44.4%, but at least there would be a net profit. With 2 markdowns and 1 full price, the store is at breakeven. This sounds like a big risk to take, having to sell 2 of every 3 at full price.
As I worked with retail buyers, I tried to get them to get away from pricing formulas and consider ‘What is my customer willing to pay for this?’ before they considered their cost of acquiring the product. If the buyer believes $50 is the right customer price and the product costs $30, then it has a high likelihood of ending up as markdowns if a formula is applied to its selling price. If the buyer thinks $50 is the price and $20 is the cost, then it represents a good chance to earn profits (particularly if the buyer did not apply the Keystone formula and set the price at $50, not the 'calculated' price of $40).
In many cases, we were able to increase that initial price to a point where it was closer to 60% (2.5 times cost if you want to know what that is mathematically). Now when the store took a 20% markdown on unsold products, the gross profit was at 50% and it took a second markdown effort to drop this in the loss column.
It is surprising that many times the objection to such an approach to pricing is in the owner’s mind, not in the consumer’s mind. They don’t recognize what you paid and they want to believe that there is value in the price vs. product comparison. I once had a client who dug her heels in to fight me on this, but agreed to try. Six months later, she told me that no customer seemed to flinch and that she didn’t believe she had pushed her prices to their limit. For a store that was breaking even before the pricing philosophy change, she turned to quite profitable in a short period of time.
I realize that there are many factors in pricing, not the least of which is competition. But aren’t there products where this approach could be used? What have you got to lose (except for some of your losses)?
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