Price Optimization

In this post, let me try to present some basics of pricing strategies and price optimization. One would agree that right pricing is of great significance to a retailer to succeed in today’s competitive landscape. This post would touch upon the broadly followed practices of pricing and the factors influencing pricing decisions of a retailer. I’ll try to document more about the role that analytics has to play in price optimization in another post.

Basics of Pricing

The very basic pricing method is to add a mark up to the cost involved in production, distribution & transportation of a particular SKU. For instance, the cost of raw materials, the variable cost per unit of production and SGA (Selling, General & Administrative Expenses) constitute the cost of an SKU. The retailer may wish to add a mark up of (say) 30% in addition to the cost incurred and fix the price.

The evolution of such a basic pricing mechanism led to rule based pricing techniques. For instance, a retailer may have a rule based engine that will decide upon the price of various categories of SKUs like the following example:

If the PRODUCT CATEGORY = ICE CREAMS,

1. Set MARKUP = 15%;
2. Set Last Digit of the Price = ‘9’;
3. Set Price = 95% of Competitor’s price; (5% less than competitor)
4. Set Private Label Ice Cream Brands = 80% of Popular brands; (20% less than popular ice cream brands)

In advanced systems that employ analytics to optimize the price of various SKUs, we can see even more sophistication, for example to do a “What If” Analysis, to determine the effect of a price change on the sales etc. Whatever be the tool deployed to optimize price, the retailer needs to be aware of certain key attributes that have a direct bearing on the way prices are fixed. Let us see that in the following section.

Factors influencing pricing decisions

As we know, a retailer has hundreds and thousands of SKUs in a store and there should be a way to manage the price of all these SKUs by some automated means. Though there is an MRP fixed by the manufacturer of the products, the retailer may wish to consider the following factors (not exhaustive) before fixing the price of that SKU in a particular store.

• Demand for the product
• Change in product mix and/or prices
• Regional influence on price
• Competitor’s pricing strategies
• Economic Conditions

Let us try and understand how these factors play a role in fixing the price of a particular SKU.

Demand: The demand for a product has a lot to do with the pricing of that product. If the demand is more and there are not many competitors available, then the retailer has an upper hand over fixing the price. The same is true when there are not many substitutes for that product. For such products, the demand elasticity will be very less. I.e. The demand for the product will not change significantly even if we change the price much.

Change in product mix and/or prices: The change in the offerings made by the retailer will have an impact on the price of certain SKUs. For example, there may be some complementary products (which are always bought together). If one of those products is not available on shelf or discontinued by the retailer, the sales of the other product will be affected and hence the retailer may have to reduce the price of that SKU to clear the stock. Similarly introducing a new SKU can have a cannibalizing effect on the sales of an existing SKU, which will prompt the retailer to reduce the price. Similarly, if a price of a product is reduced, that may improve sales of that product and also promote the incremental sales of another product, which has close association with that SKU. (Please refer Market Basket Analysis to know more on product association)

Regional influence: The region in which the retail store is located also influences the price of different SKUs. Local demographics may indicate that some SKUs should be competitively priced whereas other can be priced with a premium. For instance, if there is a supermarket present near by a hypermarket, the grocery products sold in the hypermarket should be competitively priced as against the supermarket. However, if there are some product categories which are not present in the supermarket, those goods can be priced at a premium in the hypermarket. Store clustering and segmentation can be of help in grouping stores for such purposes.

Competitor’s price: Competitors’ prices for various SKUs are always watched by retailers and are used to decide the price of SKUs in their stores. The key lies in the reaction time. (Speed with which the response to a competitor’s price change happens). This demands closely watching competitor’s price, implementing the price changes in the system and ensuring that the execution happens in-store. In-store execution will mean re-labeling of the impacted SKUs with new prices and implementing the changes in Store POS. Any lapse in this could cause greater confusion and loss to the retailer. One can understand that when an SKU is priced low at the POS, but not reflected properly in store shelf’s labels will lead to lost sales. Similarly, when an SKU is priced low in store shelf and higher in the POS, it can lead to customer dissatisfaction and even to litigations.

Economic Conditions: The general economic conditions like inflation will impact the demand for a particular product and in turn the pricing for that product. The sales history and trend in the sales can help to understand the demand pattern for SKUs. Hence the pricing software of a retailer has to be highly integrated with the demand forecasting system to decide upon the prices. Sometimes, the life cycle of the product may influence the price of that product. Generally, during stages of “Decline”, the price of the product is reduced so as to promote sales and clear the stock.

I hope this gives a preliminary understanding about the various factors that influence the way prices are determined and optimized for SKUs.