The beginning of the end for market pricing?
(or how to lower prices by 8% and increase profits by 8%)
Business theory favours market pricing — setting prices to the level the market will bear — because that maximises profits without risking market share. The problem is, as I pointed out in a recent blog, it’s pretty annoying to customers, who feel they’re being taken advantage of.
An emerging trend is to be more transparent: openness is a core part of the staggering success behind US eyewear firm Warby Parker for example, which is taking on market leader Luxottica with products at a fraction of the price, while improving the customer experience through try-at-home offers and a well thought through balance between online and offline.
Everlane, a US ecommerce clothing brand, takes things one step further with what it calls “Radical Transparency”, publishing a cost breakdown for each item, like this for example:
Cost-plus pricing is transparent, consumers understand it and find it fair. The problem for the company with cost-plus is that adding the same percentage margin to each product doesn’t optimise profits, because consumers’ price sensitivity varies at different price points because of their willingness to spend at a particular price point, or because they are aware of prices from competitors (both arguments for market pricing, by the way).
Here’s an example of a cost-plus pricing strategy that works well for supplier and customer, illustrated through the analogy of a restaurant’s wine list:
Let’s assume the restaurant offers just three wines, costing the restaurant €7, €14 and €21 respectively per bottle. As is common, the restaurant multiplies the cost by 2.5x to arrive at the price in the wine list.
As an alternative, a fixed mark-up of €7.50 is added to each bottle, then a multiple of 1.5x. So a €10 bottle of wine is sold at €25 (€10 * 2.5) using the first technique, and €26.25 ((€10 + €7.50) * 1.5) using the second.
Overall, average prices and average margins are lower with the second technique:
But it’s the weighted average price that matters, not the average. More Vin de table is consumed because it’s cheaper for those on a tight budget, while the premium wine appears quite expensive to consumers familiar with wine pricing. So with the sales split of 60%, 30% and 10% respectively for each wine type, the second method produces a weighted average margin of €16.50, while the first method only generates €15.75.
On top of that, consumers buy relatively more mid-range and premium wines with the revised pricing, moving the mix to 50%, 35% and 15%, taking the average margin over €17.
On an average day, 100 bottles of wine are sold and the P&L looks like this:
In summary: without changing the number of bottles sold, the average price falls by 8%, yet revenues and margins each increase by over 8%.
“Pricing Managers” are being increasingly employed to develop and manage a more active and sophisticated approach to pricing. As consumers, we should all welcome the additional transparency that comes with it.
