- Posted by Jim Sills
- On June 26, 2018
Small price changes can have large impact on bottom line.
We are often asked what is the value of price optimization. The reason price optimization is so important for retailers is two-fold:
- Retailers have small net margins
- Retailers have fixed operating costs
A small increase in the top-line largely drops to the bottom line. Let’s consider an example. Suppose I have $1B in revenue at a 25% gross margin and 2% net margin—I take $20M to the bank. This means that if a sell a product for $100, my gross profit is $25—the cost is $75. My operating cost levied on this item is $23, so I take $2 to the bank. Now suppose that I raise my price by $1. My operating cost is unchanged, so I now take $3 to the bank. This is a 50% increase in net profit.
However, sometimes a price increase will decrease units or shift demand to another product. The shopper may chose to purchase a less expensive brand, shop a competitor, or not purchase anything. It is critical that retailers only increase price on items where shoppers are not price sensitive or where shoppers are inclined to purchase an alternative product that has a higher gross margin percentage.
The value of price optimization is not restricted to price increases. Suppose I lower the price of some items and grow the basket from $100 to $101. The same increase in net profit can be realized. Some items like private label brands have a higher gross profit. Sophisticated price optimization software understand the shift in demand between national brand and private label and can set the private-label national brand gap to maximize profit and revenue.
A price decrease is a mistake if units, traffic, or basket size does not increase. Otherwise, the retailer is simply reducing their gross margin. It is critical that price decreases on made on highly price sensitive items. Some retailers are pursuing an investment in price image to drive more traffic or increase customer loyalty. Price optimization can identify where those investments yield the greatest return.
In today’s competitive retail market this type of approach is a must. This is a simple but powerful use case that you can take to your boss in order to justify an investment in price optimization.