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The benefits of variable pricing strategies

April 5, 2015
NATDA webinar: Pricing isn’t based on supply and demand, but on consumer behavior, emotional urgency, perceived convenience

SPECIALTY retailers, big-box stores, and the local grocery chain all adjust their prices on a constant basis.

Consumers can count on a price rollback on something they weren’t looking for and a price increase on the item they needed. So why is there so much flexibility in the pricing of these retail powerhouses?

It’s not supply and demand, according to Chad Carr, president of Rainmaker Consulting.

He said that consumer behavior, emotional urgency, perceived convenience, and effective merchandising have more to do with effective pricing than any markup formula ever will. Large retail chains threw out markup formulas long ago.

In a North American Trailer Dealers Association (NATDA) webinar, “Using Variable Pricing Strategies to Maximize Parts Profits,” Carr offered tips he has learned from trailer dealerships to squeeze every last cent out of a parts inventory.

“Experience is a wonderful teacher,” he said, “but the tuition is ridiculously high. I think it would be exciting if you tried variable pricing in several places—parts and accessories, not trailers themselves.”

A variable pricing strategy is a pricing method in which the price of a product may vary based on region, sales location, date, or other factors.

“The price could change as you move from region to region,” he said. “There’s no surprise in that. Two different sales locations could have different pricing. What are those other factors and how do they come into play with your products and customers?”

Traditional pricing strategies:

•   Basic markup.

Cost multiplied by a markup percentage equals the price. So $100 times .250 (or 25%) equals $125.

There’s another approach in which price is based on margin, not markup. Instead of taking 100 times 25%, take 100 and divide it by .75 for a total of $133.33.

“It’s the same thing, just a higher markup percentage,” Carr said. “It allows you to feel good about yourself: ‘Oh, I only do a 25% margin,’ but really, all you’re doing is taking 100 and multiplying it by 1.333.”

He said the basic markup is “simple, but it’s very difficult to have good margins across the board. You really can’t sell all of your parts at the same markup. If we take a $1 part and mark it up by 40% to make it $1.40, that’s really too low. You’re not going to be able to make money, and will probably lose money, because you have so much overhead.”

•   Cost plus.

It’s designed to solve these problems: you can’t sell all parts at the same markup; “$1 times 40% equals $1.40” is too low; and “$100 times 200% equals $200” is possibly too high.

In cost plus, the basic cost of $100 could go to $112.50 when other elements are added: freight; purchase order expenses; receiving expenses; stocking expenses (“a giant hardware store is more expensive to maintain than a tiny hardware store, and a giant parts department is more expensive to maintain than two shelves in the back of a shop”); interest/cash expenses; and other fixed overhead.

Then add a markup percentage (.250, or 25%) for a total of $140.62.

“We need to have a higher margin on the lower cost parts or else we’re not going to be able to cover those expenses,” he said.

•   Pricing matrix.

It’s designed to solve these problems: you can’t use the same markup at all price points; you can’t rationalize super-high margins; and you can’t spend all day with a calculator. (“How many parts do you have in your parts department? Hundreds? Thousands?”)

Carr said that for a parts cost of $0 to $3, multiply by 3.5 for a gross margin of 71.4%. For parts that are over $750, multiply by 1.6.

“These numbers are arbitrary,” he said. “It’s a pricing matrix. If you want to take parts that are between $0 and $5 and mark them up four times, that would also be a pricing matrix. Using this matrix, you will average about a 50% margin, and that’s about where you need to be to have a profitable parts department. If you mark up everything at a 50% margin and you don’t move anything, you won’t have a profitable parts department. But 50% is a good benchmark of where you want your margin to be.”

The benefits: it’s easy to calculate and implement; it covers the cost of handling low-cost parts; keeps you price-competitive on the high end; and maintains a 50% gross margin.

The downsides: it limits potential profit by ignoring supply and demand and by ignoring customer’s urgency; and it ties price to cost, which is normal, something most people do—but it’s not really the best idea and certainly is not necessary.

“Why do we tie price to cost? Most of you probably do. Maybe we mark up utility trailers at a different rate, but most of us are going to take our trailer and our price is going to be related back to cost.

“It’s how we were taught, even going back to elementary school math probably. Certainly if you sat down with your manufacturer or parts supplier when you got into the business, it was, ‘Oh, yeah, you mark it up.’ It gives us a sense of fairness. It feels fair to us. It’s easy to rationalize or defend price. The cost gives us a baseline comparison. And it’s easy.”

Should price be tied to cost?

Carr gave the example of three different pairs of jeans: “You have Wrangler for $21.95 and Levi’s for $47. That’s more than double the cost, and there’s not twice the material there. And at the crazy end of the spectrum, $451.24 for a pair of Dolche & Gabbana jeans. Clearly, the cost of the denim and labor to produce those jeans has absolutely nothing to do with why they’re priced 20 times what Wranglers would be.

“What is the right price? What do we want to charge? What our competitors charge? A little less than our competitors charge? A little less than MSRP? Some multiple of cost?

“The best price is what that customer is willing to pay at that given time for that particular product. This is really at the heart of what variable pricing is all about. Is it possible that the same customer would pay a different amount of money for the same product at different times? Well, absolutely. Did any of you buy roses, chocolates, and cards on Valentine’s Day? On that particular day, I was happy to spend $80, but I would never do that on any other day.”

He said basic markup, cost plus, and pricing matrix all tie the price to the company’s cost.

“That’s OK, but that’s not the best,” he said. “The more we can get away from that, the better it will be. The next method is getting away from tying price to cost. We are tying price to the demand.”

•   Calculate price/volume curve (elasticity).

It’s based on price elasticity: the measurement of how demand for a product is affected by its price.

In general: If the price goes up, demand goes down; and if the price goes down, demand goes up.

“If you have a fire sale and drop the price on all trailers on your lot, will you sell more trailers? You probably will,” he said. “If you decide you are going to double the price of all trailers, will demand go down? Probably. But there are things that are not elastic. Did anyone really change their driving habits significantly because gas got down to $2.25 a gallon? Did you really start taking the long way to work? Did you really say, ‘Instead of watching the football game this weekend, we’ll go for a drive in the country?’ Probably not.

“It blew the minds of people in the RV industry because even when gas got above $4 a gallon, people still bought
RVs. They may not have gone on as quite as long trips, but we all still drove to work and took our kids to their friends’ houses and to school. Certain products are going to have an elastic price and others are not. It’s important to know that. Don’t take an inelastic product and start raising and lowering the price.”

But consider an elastic product. If you think about the pricing based on how many you’re going to sell rather than the cost, you might look at it like this:

At $5, you sell one and get $5.

At $1, you nine and get $9.

At $4, you sell three and get $12.

At $3, you sell five and get $15.

At $2.50, you sell six and also get $15.

“So which one is better: $3 or $2.50?” he said. “That depends. What do you want the perception to be? It’s very possible that you could have multiple pricing points that could generate the same level of revenue. You want to figure out where you want to be. When Sony used to make TVs, they were always the most expensive, and they sold fewer of them. They wanted to be known as the best television. Eventually that killed them because Samsung and Dynex and everybody came along and they were making just as good a TV.”

He said the price sensitivity curve is never a straight line. How do you calculate how much you make at a different price?

“You have to actually sell things at different price points and see how many people buy them,” he said. “Your grocery store gets to do that all day long. Lowe’s and Home Depot get to do that all day long. They have enough sales volume and technology that they can be testing that and changing those things all the time.

“Let’s assume you’re doing that on some items. Well, what about your cost? We have to calculate the margin that we’re making, not the revenue, because none of those parts were free.”

The benefits: you can maximize revenue and profit by product; and it gives you the flexibility to adjust as the market adjusts.

The downsides: you’re treating all transactions and customers as equal; it takes a ton of research and math, and you probably don’t have the time to do that; and you can still leave money on the table.

•   Variable Pricing.

It’s a pricing strategy in which the price of a product may vary based on region, sales location, date, or other factors.

“It is the dominant pricing strategy of most big retailers,” Carr said. “They are not using a markup. They are not using a pricing matrix. They’re saying, ‘Let’s sell it for whatever the customer is willing to pay.’ Starbucks is a great example. There could be a totally different price based on where it’s located.”

The same wine at the same store will have a different price and positioning within the store. The price can change between a Monday afternoon or Saturday afternoon.

“I guarantee it’s changing on a regular basis,” he said. “It’s all about the perception and what they can do with the perception.”

What pricing strategy is best for your trailer dealership?

•   Basic markup.

Benefits: very easy, takes little thinking or effort. Drawbacks: not flexible enough, missing lots of profit.

•   Cost plus.

Benefits: covers costs, fairly easy. Drawbacks: takes more effort, missing lots of profit, cost-based.

•   Price matrix.

Benefits: covers costs, fairly easy, flexible. Drawbacks: cost-based, missing lots of profit.

•   Calculate price/volume sensitivity curve.

Benefits: maximize profit, not tied to cost. Drawbacks: requires lots of testing, math, and adjustments.

•   Variable Pricing.

Benefits: huge upside profits, extremely flexible. Drawbacks: it can backfire, needs regular attention.

How can you implement a variable pricing strategy?

•   Monitor for feedback, subjective and objective.

•   Keep raising your price until you get feedback.

•   Keep testing—you are mining for gold.

•   If it’s turning more than five times, raise the price.

•   If it’s turning less than three times, evaluate.

•   Offer flexibility, but define it to your staff.

•   Watch retail and merchandising experts for ideas.

“Remember: The best price is based on the customer’s perceived benefit, not your cost,” he said. ♦