The Perfect Price by Koci-Robert
Hardware Merchandising, v.113(1) Ja/F'01 pg 52-54+.
Okay, forget the cliches about price. Forget about whether Wal-Mart is 10 per cent cheaper than you or why customers perceive Home Depot is the low price leader when many of your SKUs are priced less than the big box. This
is not a story about how to be cheaper. It's about developing a pricing strategy that will let you do two things: 1. stay in business. 2. make a profit.
First, why do you need a pricing strategy? Here's why.
- There is a downturn coming. The boom of the '90s is going to falter, and there will follow a time during which the current pressures you are feeling on your margins will be remembered wistfully. You will swap stories about how great things were when you only had to pay five bucks wholesale for product that the big box text door was selling for four.
- Before tough times arrive, you need one thing to weather the storm: equity. And the time to accumulate equity is now, before the economy slows. You will need equity to cover the lower sales, to maintain service and marketing levels, to make the changes necessary to move with the economic tide, and, above all, to stay out of debt. Financing a recession with debt means you will be serving the debt instead of your customers when the good times return.
- The current cost-cutting cycle has exhausted itself. The days of growing margins by hammering costs are over for now. The big boxes started it. They did most of the work by taking back control of the supply chain, and by basically scaring the hell out of manufacturers. Now, looking to grow margins on the cost side is like panning for gold in Dawson City. It may be fun trying, but you're a little late to get anything but tailings.
- Without a pricing strategy, you are leaving money on the table with every transaction. Even without the threat of a recession, who wants that?
- An increase in margin from better pricing yields a better return than the same amount saved on the cost side. According to studies done in the U.S., a one per cent increase in price will, on average, yield eight per cent
more in operating profit than a one per cent decrease in costs.
Now are you convinced? Good. But what does a pricing strategy mean? Depending on which expert you ask, a pricing strategy can be an aggressive, proactive, top-line hunt for margins using the latest software tools, or a more organic approach that picks and chooses its way across a range of SKUs for maximum return on investment. Either way, today's pricing strategies are based on a few fundamental principles:
Cost-plus pricing is dead
The term cost-plus is used much more in construction than retail, but using it to describe retail pricing procedure makes an important point. In construction, a contract is cost-plus when you charge the cost of materials and labour plus a percentage for overhead and profit. There is no financial risk involved for the contractor because his costs are covered. But there is no reward for working efficiently either, and returns are modest. By contrast, a contract job, where you charge whatever the market will bear, carries risk, but it also rewards efficiency.
In retail, when you buy inventory and mark it up at a fixed rate, you are essentially using a cost-plus mentality. The result is also the same as in construction -- you work for minimum profit, and you don't get rewarded for being a better retailer. There is an added problem. Because of
competition, some products won't sell at the markup you designate.
For the retailer, another fact of cost-plus pricing is this: you are at the end of a long chain of purchasing decisions that you have no control over. Take a look at a utility knife, for instance. From mining the elements
from the earth to your store shelf, all of the ingredients that make up that knife will be sold and resold a number of times on the basis of what the market will bear. If, when the knife gets into your hands, you just mark the price up 35 per cent without thinking about what the market would
be willing to pay for it, the effect is that everyone gets the maximum value out of that utility knife but you.
But breaking away from the cost-plus mindset is hard. Jeff McEachern, president of retail technology provider Profit-Master in Winnipeg, tells a story that illustrates a curious but very real problem many small retailers face. He was visiting a client in Western Canada who had new competition from a big box store. ``They had blanket margin across their products,'' he explains. ``On their commodities they were getting anywhere between three and 10 points, and with normal hardware they may have been getting 30 to 40 points.''
Unfortunately, the big box was not pricing that way at all. ``So the retailer has to go out and say, `I have to sell my paint or some of my commodity products at one or two points, but I have to get my head around [that] when I sell rollers or when I sell consumables that people need to have, I must get 75 points.''' The retailer had a real moral dilemma with that kind of pricing, says McEachern. ``It is different than how they historically did business. They are selling to people they know. It's an emotional issue. They felt they were always being fair to their patrons, and now they [had to] ask themselves, `Are we still being fair?''' The fact is, concludes McEachern, when they stopped cost-plus pricing, they were still being fair across the range of products, and most importantly, they were still in business because of it.
Price is about value
Once you have gotten past cost-plus pricing, you need to dig into pricing on value. That means taking a look at each SKU in your store and asking not, ``What must I charge for this in order to make a profit?'', but ``What will the market pay?'' Perhaps more importantly, it means asking
this question: ``Beyond the value of the product itself, what value can I add to give me maximum price?'' Maximum price is not always about the biggest margin. The maximum value of a product may mean to price it at a level so that it establishes your brand image and builds traffic. Here,
price is no longer about cost.
In his new book, Full Price: Competing on Value in the New Economy, business guru Thomas J. Winninger says that in the coming economy, success will be achieved by ``creating a value for your service that demands full price.'' He recommends businesses rethink and retool to focus on a
customer's ``maximum value perception'', which he defines as ``seeking and fulfilling the highest need of your premium customer.'' When companies do that, he argues, they begin to price properly according to the perceived value they provide; not according to cost.
The overall margin matters most
When you price on value -- when you ask ``What will the market pay?'' -- you soon discover there are some SKUs that don't allow healthy, high margins, no matter how much value you add (commodities are the obvious example). That doesn't mean you have to lose money. That's because when you identify low-margin SKUs, you are also able to identify high-margin items, as well. When the time comes to look at your margins, you must look at the overall margin of a basket of goods, not individual SKUs, in order to get the correct blended margin required to pay your overhead and make a decent profit.
To get the right price, constant price testing, experimentation and adjustments are a must. Sure, maybe you experiment a little now, but with today's pricing strategy, that won't be enough. You will need a regular, systematic, predetermined methodology of shopping the competition, exit
polling and planning future tests. The experts say you should have at least one price test going all the time, and rotate the testing throughout the store.
Six ways to build a price strategy
1. Identify your ``one thing''
Winninger suggests you ask two questions. The first is, ``Who are we?'' Volvo, he writes, is safety. McDonald's is fast food. So who are you? If you are a garden centre, you may be beautiful gardens. If you are a contractor yard, you might be the time-pressed contractor's solution. If you want to concentrate on retail, you may see yourself as entertainment shopping or DIY school.
Defining who you are gives you the point of view to ask the next question: ``What do we do?'' It is here that you discover your ``one thing.''
Winninger calls what you do ``one thing'' in reference to a line from the movie City Slickers. Curley, the old cowboy played by Jack Palance, tells city slicker Billy Crystal that, ``the key to life is one thing.'' Winninger says knowing the ``one thing'' that sets you apart from the
competition will give you a foundation for getting full price for your products.
Judy Palmer of London, Ont.-based retail tech provider Dimensions Retail Systems, says the same thing a little differently. ``Every store has a different avenue they want to go down. First, decide on your image, and then determine what you want the image for, and then ask what product line
that will affect.''
Why is this important? In today's competitive environment, customers want a clear, undifferentiated image of the stores they frequent before they leave the house. If they don't have a singular, clear image of your ``one thing'', you will get dumped from their ``where should I shop today?'' thinking process long before they have their boots on. Even though Burger King is just as fast, the harried consumer's first thought as he rushes out the door is ``Where's the closest McDonald's?'' Or, here's an example
of a consumer decision a little closer to where you do business. ``I want the best price so I better do the extra driving and go to Home Depot.'' Somewhere in that mental process, you want the consumer to have an image of you. What image is that? Maybe your image is ``a place where you will be liked.'' That same consumer may well add, ``But I really don't need the hassle of the parking and the crowds. Maybe I'll just walk down to Sam's.'' (Thinking while he says it, ``They like me there.'')
It is also important to define the customer you are doing ``one thing'' for. Winninger recommends you focus only on your ``premium customer'', which he says represents about 17 per cent of a customer base. They might not be your biggest clients, he says, but they are your best. ``In
addition to buying the product, premium customers purchase all of the elements related to it, such as service and installation. They are usually willing to pay full price.'' Once you have established who they are, you have two goals: shift as many customers as possible from the other 83 per cent, and constantly purify your focus, all the while keeping your premium customers satisfied.
Also, don't decide that your one thing is service. There was a time when the word ``service'' meant something. Unfortunately, the word is so overused today that it no longer means anything. Everybody has service,'' says Bob Nelson, of Phoenix-based Power Retailing, a consulting company that specializes in helping stores do special promotions. ``If a retailer is going to say he offers service, he'd better give me five different ways he offers it.'' Skeptical small retailers may be sobered by the fact that many surveys indicate shoppers feel they get good service at Home Depot. One of the biggest errors retailers make is assuming that by their very existence they have a good competitive strategy, says Nelson. ``Very few can sit there and say the guy across the street carries these products and these prices. They kind of hide their heads in the sand and say, `We're different.'''
2. Identify the price sensitivity of your SKUs
Some SKUs react quickly to price fluctuations. Some don't. An Arthur Andersen study on pricing strategies called ``At What Price?'' suggests you identify your SKUs along a continuum with ``price sensitive'' at one end and ``blind items'' at the other. (Blind items are SKUs not sensitive
to price. In other words, products most people don't buy often enough to know the price.) You then are able to choose which items you will ``price for image'' and which you will ``price for profit.''
Pricing for image, says the study, creates a halo effect of value around your store. ``By pricing at (or very near) the lowest commonly available price in the market on these select items, the retailer sends a message that customers can trust the overall pricing scheme and that the store
prices are indeed ``fair.'' Conversely, higher prices on these items -- think light bulbs -- will lead consumers to expect your prices to be high everywhere else. Price sensitive items should be promoted on end caps and displays at the front of the store to create the immediate perception that you have good pricing.
Blind items, on the other hand, are not part of creating trust. The consumer has no readily available information on what the price should be or no competitive pricing he can refer to -- think small plumbing and electrical repair parts, for example. The price you place on these items
can often be much higher than the old cost-plus approach without a corresponding loss of trust or reduction in sales volume.
Another part of identifying price sensitivity is shopping your competition. Remember that you can't price on the basis of cost anymore, so information on what the competition is doing is critical. Shopping your competition
does two important things: it establishes benchmarks for your ``image pricing'' and it reveals what your competition is doing with his ``blind items.'' One of the problems of past price shopping, says ProfitMaster's McEachern, was that ``everyone was concerned with what Home Depot was
doing with the 100 SKUs that were loss leaders and weren't looking at the blind items. But that is where the profit lies.''
Brent Lippman, president of Arizona-based retail software developer KhiMetrics, calls the sensitivity of price ``demand elasticity'' and says retailers should use revenue management software to develop a pricing strategy. ``Revenue management does three things,'' he explains. ``It
helps you understand your price image and how it compares in the market, forecasts unit sales based on the demand elasticity, and then optimizes pricing across the store.''
3. Maintain your testing program
Remember, testing never stops. McEachern recommends ``Velocity Testing'', where you choose a geographical area of your store and monitor the sales over a specific period of time. ``You can discover what products are moving in what locations within a store. What is the impact of a change in pricing?'' The testing area should be no larger than the space that can be counted in 15 minutes. Make a map of your store and start experimenting with prices to develop a history. ``Rather than just going on the floor
and moving prices up and down -- using the PFA model (pick from air) -- they've got some historical information in front of them to make a good management decision,'' McEachern adds.
4. Deliver on your ``one thing''
Your intention is to make bigger margins on blind items not just because they are insensitive to price changes, but because your store is also going to add value to the product by delivering that ``one thing.'' To succeed with any pricing strategy you must communicate effectively to
staff and customers what that is. You may have to retool your processes to deliver on your ``one thing.'' If you are ``DIY school'', you better have knowledgeable staff and a workbench somewhere where they can say not just, ``This is how it works'', but also, ``I'll show you how it works.''
This ``one thing'' can be something you already do, or a redirection for your store. What it cannot remain is an idea in your own head. It must be translated into tangible, visible processes.
The biggest challenge here is that, if you do it right, you will be forced to drop the ``many other things'' you thought you could do as well. The theory of ``one thing'' is that doing ``one thing'' exceptionally well and
focusing on your premium customer will draw more traffic than being mediocre at doing many things for many people
5. Establish your pricing
Consider your strategy in three phases. The first phase establishes pricing across the ``price sensitive/blind item'' continuum. It is a horizontal look at your overall pricing. Keep the sensitive items priced competitively, and start testing the limits of your blind items. ``There
is a huge potential for revenue growth in the 80 percent of your blind items,'' says Lippman.
To see what your overall margins are doing, use a basket of goods that represent a typical purchase. Winninger calls this ``creating packages.'' These packages are transaction-oriented groups of products that will integrate your inventory vertically. Build a sample DIY drywall transaction, for instance: drywall, tape, putty knife, compound, drywall knife, drop sheet. Without touching the price for the drywall (the price sensitive product), move the other prices around and see where you think your optimum pricing should be. Try it out for a period of time and evaluate the results. The object is to build trust and traffic with the sensitive items, and profit on the rest.
The second phase applies to your good-better-best selection. Always set prices so there is more distance between the lowest price option and the mid-range option than there is between the mid-range and high-end option.
That's how consumers almost always see the ``perceived'' value change in a good-better-best range.
The next valuation you must do is across customer type. Virtually all POP software today provides the option of charging individual customers a range of prices on a range of products. At Dimensions, Palmer calls it Matrix Pricing, and it allows you to fine-tune pricing depending on whether the customer is a premium customer or among the larger group of regular customers. ``It sounds complex, but it's not,'' says Palmer, ``because the software does all of the calculations. It just takes a lot of thought.'' With this part of the strategy, don't make the common mistake of rewarding a good customer by reducing prices when he has shown a willingness to pay full price all along and shows no inclination to object to it.
6. Don't forget lower prices
According to Palmer, many retailers can pick up two points almost immediately by using a proactive pricing strategy. Lippman says he has seen results within six months of as much as a 200 per cent increase in revenue. And that's not necessarily by increasing prices. ``A lot of it actually comes from decreasing prices,'' he says. ``Sometimes, the right thing to do is to decrease the price of the item a little bit so that the total unit sales increase and profit increases.'' The key here also is to use regular pricing checkups to see whether lower prices drove sales up enough to increase the overall margin.
In the follow-up, you want to learn all you can about how to make all your customers repeat customers. Winninger calls it ``owning the customer's buying cycle.'' What it means is building loyalty. Find out what a customer's frequency of purchase is. Develop incentive programs, such as custom ordering. Be proactive and anticipate their future purchases. The follow-up, has to include a willingness not only to look at the prices charged, but also to determine if you are delivering on your value, and if you should be changing store focus to another ``one thing.''
Winninger wants you to remain flexible and creative. ``It will be the ability of your company to look at the big picture and adapt your mindset to a new world where achievement will be measured not by usage of the firm's assets, but rather by mind and creativity control.'' Companies that are willing to remain creative and flexible, he writes, are the ones that will be able to continually determine where their most lucrative market lies.
You may be wondering what will happen to the regular processes of the store once you establish a routine of revenue management. Well, they won't change that much, but they will become more intelligent. ``Say it is the beginning of winter and you want to buy antifreeze,'' explains Lippman. ``You will look at your sales history and maybe some demographic information, and base your judgement on that. Well, revenue management adds another level of sophistication, where you will now be able to know
also that if you sell antifreeze at $2.99 a quart instead of $3.99 a quart, you'll sell x many more units, and you can extrapolate what that will do to profitability.''
Sam I am
What you can learn from Wal-Mart
The words Wal-Mart and cheap are almost interchangeable. The company founded in Arkansas by mainstreet merchant Sam Walton in 1962 is the master at giving customers not only good prices, but something more important: perceived value.
What can you learn from Wal-Mart? Clearly lots if you want to compete against it and other everyday low price retailers. Thus, we asked one of the foremost experts on Wal-Mart to help. Dr. Kenneth Stone is a professor
of economics at Iowa State University and has been studying Wal-Mart since 1988. His first observation is small retailers don't spend enough time inside a Wal-Mart studying pricing strategies and price points. ``I've had
comments from some small retailers like, `What if my customers saw me in there?' That's pretty ridiculous,'' says Stone.
Though Wal-Mart is truly good at offering low prices (it operates on relatively low gross margins, Stone says), what it excels at is variable pricing on a small minority of items deemed price sensitive. A typical Wal-Mart store, Stone says, carries between 80,000 and 120,000 items, but
only about one per cent of these -- anywhere between 600 to 1,200 items -- are considered price sensitive by Wal-Mart officials. ``Those are the items they shop the competition on. They tend to be things people know the price of,'' he says. ``If they find any competitor cheaper, the store
manager has the authority to immediately go below the competition. These are items they tend to display a lot on end caps and in power aisles.''
The reason Wal-Mart is fanatical about price sensitive items is all about perceived value. ``When people see things they tend to know the prices of [that are] lower in a Wal-Mart,'' says Stone, ``they start assuming everything else is lower. And it's not. Time after time, I've seen things priced lower in the store of a local merchant.
Take one of the most price sensitive items of all in a hardware store: light bulbs. Wal-Mart's regular price for a four-pack of GE soft white incandescent light bulbs in the U.S. is $1.44. Stone has seen the price drop as low as 75-cents if there is a price battle with Kmart, for example. ``I was shopping in Jackson, Miss., where a new Wal-Mart
Supercenter is getting ready to come in, and one hardware store I visited had light bulbs at $3.50 for a four-pack. You just can't do that!''
However, once you get deeper in the aisles, Wal-Mart sells single 150-watt bulbs for $1.98 and, according to Stone, absolutely refuses to mark those down. ``My grocery store sells them for $1.53. So Wal-Mart clearly thinks there are not enough people that use 150-watt bulbs to make it price
sensitive.'' Stone's advice for smaller retailers is to be within 10 to 15 per cent of Wal-Mart's prices. ``The biggest shortcoming local merchants have,'' he adds, ``is they simply don't understand the price sensitivity of things and don't have a list of things they need to be priced right on. They tend to go with a standard markup.''
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