When Following Pricing Rules Costs You

The NFL recently overhauled its kickoff rules in response to a glaring problem: only 21.8% of kickoffs resulted in a return. The rest were essentially dead plays—a football sailing through the end zone, followed by a commercial break. Hardly thrilling entertainment.

Rules are put in place once for a reason, yet as times evolve, you must reevaluate those rules or risk irrelevance. Even the MLB, known to be a stickler for tradition, finally made notable adjustments in 2023 by adding the pitch clock, ending position shifts, and limiting pickoff plays. All this was done to shorten the length of games and remove dead time. 

This tinkering with the rules, even reversing past changes, is a stark reminder that even the most established systems need adjustments.

Just like the NFL or MLB, retail businesses must regularly evaluate pricing rules to ensure you’re maximizing value and engagement. Does your pricing create excitement and drive results, or does your pricing lead to an uninspiring outcome?

Rules are not sanctimonious. In sports, they’re there to make the game fairer, safer, and more entertaining. It’s time for a change when they inhibit that.

Pricing rules are the same. Pricing rules are used for competitiveness, profitability, regulatory compliance, and consistency. Just as in sports, there can be many rules, but they are straightforward in their application.

The application of rules can explain how a price was generated through margin, competitive, brand premium, and price-ending rules. It is also easy to prioritize which ones to apply when a conflict occurs – such as when your competitive rule may force you below a minimum margin. Does the competitive rule have priority or the margin rule? 

But does this mean the price is right?

Follow The Rules and… Lose

As I mentioned in a prior post, the problem with only pricing by rules is that this ignores the customer.

Pricing based on cost, margins, brand premiums, or competitiveness doesn’t consider customer buying behavior.  

Pricing rules will get you a price, but it may be wrong for your business and customers.

Look at the graph below that includes:

• A margin and competitive rule define a minimum and maximum price, represented by the left and right blocks.
• The feasible range of prices is between the minimum and maximum prices.

The two curved graphs represent the revenue and profit potential depending on the item’s price. This potential is based on the item’s price elasticity or the effects of customers buying less or more depending on the price. 

In this example, the optimized price would be between the max profit and max revenue, depending on which one your business values more. However, the critical point in this example is that the optimized price falls into the feasible range of prices as defined by the rules.

But what happens if it doesn’t? What happens if it is too far left or right? How much opportunity is lost? Should the rule be relaxed, and by how much?

In the case of a government-regulated minimum, you can’t lower it. But if it is a margin rule, shouldn’t you strongly consider it?

This answer requires sophisticated math.

Some will consider optimization a priority step along with the other rules, but how do you determine priority? Should it be optimization or rules? You’re into a philosophical, arbitrary debate on this, which again is a suboptimal answer. 

Others will suggest using soft heuristics to develop an average that softens the rule, but an average is another suboptimal answer.

Imagine you did great work analyzing hundreds of variables with sophisticated algorithms, only to find an issue with some pricing rules. And then, rather than using more sophisticated math to solve the problem, you throw up your hands and average the answers together. That seems stupid. If you want a deep dive, this Fundamentals of Retail Pricing video provides a more in-depth discussion.

What to do?

Look at the graphs below.

In each case, the item’s optimized price is outside the feasible price range defined by the rules.

For simplicity, the max revenue and profit lines have been combined into one to symbolize an optimized price.  

If you look at the cost of the rule or the lost opportunity, it is the distance the optimized price is from the allowable rule price. Each graph shows how much value is being lost. The value will depend on the item’s price sensitivity and distance from the feasible price range.

For a less price sensitive item, it would make sense to violate the competitive rule. But for a more price sensitive item, such as in the first graph, the margin rule should be softened. But how much?

Rules are in place for a reason; therefore, it can be uncomfortable to eliminate a rule, especially a competitive one. Even though the item may not be price sensitive, that doesn’t mean you want to eliminate any upper boundaries and be seen as price gouging on “hidden items.” That’s not a good look. 

You will want to soften the rule and create a constrained optimization in these cases. What is that? In overly simplistic terms, the more the price violates the rule, the higher its cost. This cost is inputted into the optimization, which bends the value curve, whose high point represents the constrained optimum price.

In other words, the constrained optimum says I am willing to violate the rule, but only until the cost exceeds the benefit.

While all of this is great, in retail operations, people need to see the cost of breaking or softening any rules and the potential opportunities before they willingly violate them. 

They need an analysis that shows how much the rule costs them, what they could recoup, the number of times it has been applied, and an ability to slowly dial it back if they want to test it. 

In short, a cost of rules report does this. This analysis delivers retailers surgical precision, enabling them to soften specific rules without outright eliminating them. 

Rules serve to guide profitability, competitiveness, and compliance. Yet, rigid adherence to pricing rules without considering customer behavior will lead to missed opportunities and suboptimal outcomes. Like sports, where adjustments are made to enhance the game’s appeal, pricing rules must evolve to align with business objectives and customer needs. 

A nuanced approach, such as constrained optimization, allows for flexibility in rule application while weighing the costs and benefits of deviation.

Additionally, retailers can leverage a cost of rules analysis to make informed decisions, achieving a balance between rule compliance and strategic pricing adjustments tailored to maximize revenue and profitability.