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Isn’t Cost-Driven Pricing the Fairest Approach for Shoppers?

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In the first article in the series we discussed why pricing is a hot topic these days and provided a framework for thinking about pricing. We also discussed three over-arching approaches to pricing: cost-driven pricing, market-driven pricing and customer-driven pricing. In this second article we’ll discuss cost-driven pricing in some more detail.

Isn’t cost-driven pricing the fairest approach for shoppers? In some regards a cost-driven approach to pricing may be considered to be the fairest: the retailer only makes a specified margin over and above the cost they pay for each item. From a consumer perspective the psychology behind this approach sounds reasonable – if a retailer makes a much higher margin on a specific item, isn’t that taking advantage of the shopper, whereas if the retailer makes the same margin on all items then doesn’t that seem reasonably fair?

No consumer wants to feel like they’ve paid over-the-odds for an item but most consumers, when asked what they believe to be the cost of an item, will have little idea of the exact cost and will usually assume it is a little lower than the price. In some circumstances this may be close to reality but this is not always the case, with some items being priced as loss leaders and others being priced to reflect the fact that price is not the key purchase decision criteria. At some level most consumers are aware of this phenomenon and in some situations are actively attracted by the concept of being able to buy items that are priced as loss leaders.Do shoppers link cost and value?

Are cost and value intimately linked? This knowledge of the concept of loss leaders indicates that consumers have an acceptance of a disconnect between the cost of an item and its price. This can manifest itself when you ask consumers if they should pay a higher price for a higher cost item if the shopper perceives the item to have low value. I’m sure most of us have heard shoppers say (or possibly even said ourselves) “I don’t care how much it costs, I’m not paying that price for it!” This brings us to the crux of the issue with cost-driven pricing: are value and cost intimately linked?

In all the shopper research I’ve ever seen I have not yet seen any results that indicate that shoppers either know about (or care about) the cost of a product when considering its price or value. By taking a cost-driven approach a retailer is essentially saying that they believe value is intrinsically linked to costs or they’re saying that value has a limited role in the decision about an item’s price because they’re pricing based upon a margin target they’re trying to achieve.

To provide an example of how cost and value can be disconnected we need look no further than the Apple iPhone; the iPhone is built using a lot of off-the-shelf parts that cost a lot less than the actual price of the phone itself but consumers are happy to pay the high price because of the value they associate with owning an iPhone (when the iPhone was originally introduced it quickly captured 4% of global market share from a units sold perspective but it garnered over 40% of total mobile phone gross profits globally).

Isn’t a cost-driven approach just a return to the old MSRP? Other factors to take into account when considering a cost-driven approach to pricing are: who is really driving the pricing decision and are the true price-setters looking to achieve the same objectives as the retailer? By taking a cost-driven approach the retailer is, in effect, outsourcing at least a portion of the pricing decision to manufacturers who may not have exactly the same objectives as the retailer.

With the old Manufacturer Suggested Retail Price (MSRP) approach the manufacturer used to undertake some market research to determine what consumers’ value and they would use their consumer research and the manufacturer’s own costs to determine the MSRP. This approach would focus on maximizing the overall value across all consumers and would (hopefully) lead to the manufacturer maximizing the number of units they would sell in totality. But this approach did not explicitly take into account the fact that the actual customers who shop at one retailer may be very different to those customers that shop at a different retailer. Tropicana pure premium Orange Juice is sold at both Whole Foods and Walmart but do those retailers have exactly the same customers?

So MSRP is not ideal from an individual retailer perspective, which is probably why it has diminished as a pricing practice. But retailers need to be careful of not mimicking some of those old pricing practices by leveraging a cost-driven approach that relies on the manufacturer’s cost to set the price by default. That being said, a cost-driven approach is not the same as MSRP for a couple of different reasons: retailers can use different costs when setting the price and they can vary the markup in some way.Precima at FMI Connect 2015

What cost should a retailer use in a cost-driven pricing approach? On the surface this appears to be a very simple question: you take the cost that the manufacturer charges and apply a simple markup that will cover operating and overhead costs (plus make a profit) to generate the price. But as with a lot of aspects of retailing things are never quite this simple. When I initially began working with retailers I was somewhat surprised to learn that retailers had several fields in their internal IT systems set aside for various types of costs that they used. These different costs would have various names: list cost, everyday cost, net cost, net net cost, net net net cost, dead-net cost, inventory carrying cost, buying cost, store cost, etc. – and then there is the topic of promotional allowances and their associated costs!

Retailers receive promotional funds from manufacturers, generally in return for performing some kind of promotional activity. The size of these funds can vary depending on specific circumstances and the various funding mechanisms can rapidly complicate an already complicated cost situation. Some retailers bake these funds directly into the cost during the period of the promotional activity. Others apply them holistically across all time-periods so they can understand their net costs taking into account periods of promotional activity and periods of non-promotional activity. With the arrival of EDLP retailers you then had a situation where some retailers take all of their allotted promotional funds and apply them to the costs to derive something called everyday low costs (EDLC).

The different ways that retailers handle costs and use them as the basis upon which costs are marked up to generate prices allows retailers some ability to tailor their cost-driven pricing approach. But even with these differences of approach it just tends to obfuscate the whole approach to determining prices and further removes the conversation from truly delivering prices that consumers will like.

Should a retailer vary the markup when using cost-driven pricing? Some retailers who have traditionally favored a cost-driven pricing approach have evolved their thought processes in order to tailor prices to shopper needs or to compete more effectively. One common mechanism in this regard is to vary the markup in some way, either by department, by category, by brand or sometimes by item (or groups of items). When a retailer takes this type of approach they are, in essence, stating a belief that shoppers should pay a higher markup (price) or a lower markup (price) for some items – this is an acknowledgement that competition or the shopper are being taken into account in some way, either implicitly or explicitly.

This then begs the question: how exactly should a retailer vary the markup? Should it vary at some level of the product hierarchy (product, brand, category, department)? Should it vary at some level of the store hierarchy (store, district, region)? Should it vary by geographic designation (urban, suburban, rural)? Should it vary by competitive intensity? Should it vary for key value items or by the role that the product plays? Should it vary by time-period? Or should it vary by some intersection of two or more of the above?

The retailer also has to determine if the markup should be a fixed number (e.g. 30% over costs) or if they should seek to obtain an average gross margin within a range of markup values (e.g. must achieve a gross margin of 25% with markups ranging between 15% and 35%).

The complexity of which cost to use and how to vary the markup can quickly introduce so much complexity that the pricing decision-maker resorts to a few simplistic rules to make pricing decisions. This complexity coupled with the selection of a few simple rules often leads a retailer to further disassociate the price from the value and can lead to lower customer satisfaction. But putting all of that to one side for a minute, cost-driven pricing has the added allure that it could guarantee that the retailer will generate a profit...

Doesn’t a cost-driven approach guarantee the retailer’s margin? Another aspect of cost-driven pricing that is attractive to retailers is the belief that by simply applying a markup over costs then a retailer will guarantee that they will make a profit and stay in business. There is definitely an attraction to this line of thinking. If you buy an item for $1 and sell it for $2 then you should be able to generate sufficient gross profits to cover operating costs, overheads, etc. and still have enough left over to post an attractive net profit that will please shareholders. It is certainly true that pricing every item below cost is a sure-fire way to lose money, which reminds me of that famous retailer saying: if you promote an item at less than cost, what you lose on margin per item you will make up for in volume!Cost-driven pricing approaches have evolved their thought processes in order to tailor prices to shopper needs or to compete more effectively.

The challenge with this line of thinking is that if you don’t sell an item then it will generate exactly zero dollars of profit. And while the absolute profit on an individual item is an important consideration isn’t it the profitability of the overall basket, or customer, or store that is more important? What if you sell one item at a loss or at breakeven but as a result of the low price on that item it attracts customers to your stores and encourages them to buy a whole group of associated items that all generate more gross profits?

Aren’t loss leaders a no-brainer? That said, the reverse consideration is also important. I’ve heard many retailers state that putting laundry detergent on the front of their weekly circular at a loss will drive customers to stores and lead to bigger baskets. Unfortunately this position is mostly based on anecdotal evidence and not on hard numbers. While the item being promoted at a loss is guaranteed to experience a dramatic lift in volume (accompanied by a dramatic loss of profits) there is usually little proof that the loss of profits on the promoted laundry detergent will be overcome by an increase in gross profits from new customers or bigger baskets. In other words, the retailer is guaranteed a loss of profits on the promoted item and is justifying this guaranteed loss on the basis of a hope that more customers and bigger baskets will generate a greater quantity of gross profits – a leap of faith if ever there was one.

As a result of all of the above, cost-driven pricing is not a pricing panacea for retailers:

  • From a consumer perspective, it is not always the most fair way to price because there is not always an intimate link between cost and value
  • From a competitive perspective, it doesn’t allow the retailer full freedom to use price as a competitive advantage
  • From an operational perspective, it is not always the easiest way to price due to the complexity of which cost to use and which markup to apply
  • From a financial perspective, it is not a guarantee of gross profits for the retailer

So does cost-driven pricing have any role to play in the process?

How should costs and margins factor into pricing decisions? From one perspective, it’s tempting to say that costs and margins should drive all pricing decisions; this could ensure that the retailer generates sufficient gross profits to cover operating expenses and deliver a reasonable return to shareholders. From another perspective, costs could be used as part of an output calculation that occurs after a retailer has determined what price to charge based upon the value consumers attach to an item. There are risks with both extremes. With the former approach there’s a possibility that prices will not reflect what shoppers want to pay but instead reflect what it costs manufacturers’ to produce the product and retailers to make it available for sale. With the latter there’s a financial risk that the retailer may not generate sufficient gross profits to cover all of their costs. So what is the right approach?

Costs and margins have to be used as both guard rails on the input side when prices are being set and as a check point on the output side to ensure sufficient gross profits are being generated overall. At the risk of sounding like the situation is being over-complicated, there are some items that consumers purchase mainly based on price/value where lower gross margins may have to be accepted in order to drive traffic or volume; there are some items that are bought mainly for non-price/value reasons; and then there are those items in the middle of the pack. The question for a retailer is how to incorporate these elements of cost-driven pricing into a broader approach to pricing while making the process manageable from an operational perspective.

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