We are pleased to present this guest post from Erik Grueter, a marketing associate at Price Intelligently, a Boston Price Optimization company. A link to the firm’s blog is provided at the bottom of this report.

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Driving profit in retail is hard.  Competition is often fierce. It seems that some retailers can only distinguish themselves by the amount they are willing to reduce their prices. Yet, it is possible to earn profits in retail with the proper pricing strategy. Retailers can drive profit by managing product demand and focusing on price optimization. Let’s dive into this problem and discuss some of the solutions in greater detail.

Cost-plus pricing: Many retailers are living in the dark ages of price optimization

Sometimes, it seems like a retailer’s pricing strategy consists of a painfully simple formula: Cost + Labor + Overhead = Price. This pricing strategy is called cost-plus pricing. In cost-plus pricing, you simply take the cost of doing business and add a margin on top of it. Cost-plus pricing is simple to implement but has some serious drawbacks. For a number of reasons, cost- plus pricing leaves serious money on the table. You can never fully calculate the costs of doing business, only estimate them. This means that the profit margin you thought would be enough probably will not be. Cost-plus pricing also increases the risk that you will fall into a price war with your competitors, where your only differentiator becomes price.

Most importantly, cost-plus pricing does not take into account your customers’ willingness to pay for your good or service. Your customer probably does not care how much it actually costs to produce the product you sell. They understand there are costs associated with doing business, but consumers care more about whether product fulfills their needs.

Modern, effective price strategies rely on customer value

You can develop a strategy that manages these pricing pitfalls by focusing on price optimization and driving demand based on value. Focusing on optimization demand management can put a retail operation above its competition. Consider this quote from Vincent Nijs of Northwestern’s Kellogg School of Management: “If there’s one thing you would assume from basic marketing principles, it’s that prices should be adapted to changing demand conditions.”

You need to adjust to the fluctuating demand for your products. By managing demand, you will reduce the need to lower prices and  profit margins as demand wanes.  There are many ways to manage demand. You can limit pieces to increase per unit profit. Or use bulk purchase incentives to drive shoppers toward a higher number of purchases at a lower price.

Successful operations should be testing the effects of all pricing changes and use as much data as possible. You can test the willingness to pay by employing price laddering. Or test higher prices in conjunction with holiday seasons and gauge the conversion rate. The important thing here for retailers is that they begin to build a body of data that correlates with changes in price. This way you will be able to find the highest possible price point for your product or service depending on demand conditions.

Good pricing separates the best from the rest

A standard retail pricing strategy can leave serious money on the table. But retailers can solve this problem by engaging in price optimization and thinking about how best to manage demand. Price optimization is well worth the effort. As we have noted many times before, a 1% improvement in price can result in a an 11% improvement in profit. Pricing is that impactful.

To learn more about price optimization, visit the firm’s blog. Just click on the image.