Chunky or Smooth? Value-Based Pricing at Retail & Disti

Retailers and distributors can’t do value-based pricing for one simple reason: too many products. There is just no reasonable way a brick & mortar or online retailer or distributor can do market research on thousands to hundreds of thousands, if not millions of individual items known as shop keeping units or SKUs. Market research cost too much for each product and the benefits of improving prices on products that aren’t sold that much isn’t worth it. Plus, it will make the outlet non-competitive? Right?

Well, not quite.

Altering Assumptions of Value-Based Pricing for Retailers and Distributors

Value-based pricing is an approach that aims to price offerings according to the value customers associate with the offering in comparison to its alternatives.

The central equation that defines the price customers are willing to pay according to value-based pricing states that the best price a firm can capture (PF) is the price of the nearest competing alternative from the customer’s perspective (PC) adjusted for the perceived differential benefits (BF - BC).

PF ≤ PC + (BF – BC)

For a retailer or distributor of manufactured goods, the alternative for a customer to buying from their outlet is to buy the same, or almost the same product from a competing outlet. Since the competing outlet basically carries the same items, that retailer or distributor often feels it must have basically the same prices, if not try to be cheaper and use price as a means to capture customers.

Taken from this viewpoint, the benefit differential between different outlets is assumed to be zero and value-based pricing encourages retailers to basically have the same price as their competitors, if not lower.

Hence, from this viewpoint, the only research a retailer or distributor needs to do is watch their competitor’s prices and match or beat them; a pure form of competitive pricing.

But this sophomoric line of thinking is not the end of the story.

Pure competitive based pricing assumes that customer price compare voraciously and all competing outlets basically offer the same customer experience. Both of these assumptions are wrong.

We addressed the issue of the shopping experience and occasion impacting the prices a retailer or distributor can capture in Retail, Black Friday, and Value-Based Pricing, To avoid redundancy, we herein directly address the overarching objections to value-based pricing for multi-product outlets: customer price comparisons and too many SKUs which are both related to the concept of price image.

Only a Minority of Customers Price Compare Voraciously

Research has repeatedly demonstrated that only a minority of customers price compare voraciously between multi-product outlets.

Even in this time of showrooming, only a minority of customers will actually pull out their cell phones and check prices online before buying in a store. I know it sounds crazy that people won’t take the 5 seconds required to scan an item and check prices, especially given ubiquity of smartphones the number of apps designed to do exactly that, but it is true.

Rules of thumb, which vary depending on who is reporting the statistics and the study being done, indicate that only 20-30% of customers are price sensitive enough to price compare individual items, and even then the price comparer segment rarely compares prices on everything. This is found in online environments as well as offline, and for distributors in business to business markets as well as consumer retail.   Granted, price comparers are a large segment of the market, but it is still a minority and even they don’t do it all the time.  

Most customers form a price image of an outlet and use that price image to anticipate the price competitiveness on individual items.

A price image is the general belief of the overall level of prices that consumers associate with a particular outlet [Hamilton & Chernev, 2013]. This price image does not necessarily reflect the actual price positioning of an outlet compared to its competitors. It does reflect the attitude of customers, which may or may not be accurately based in reality. And, price images can be shaped through the environment, marketing communication, and even signpost pricing itself.

The fact that the price image impacts the perception of prices more than the actual prices on items represents both a challenge and opportunity for retailers and distributors. Some low-priced outlets may have a high-price image and some high-price outlets may cultivate a low-priced image. Business people can actively cultivate the price image they desire. And, if they don’t, they may get a price image that they don’t want.

As business people, we cannot lament the issue price images as the deliberate manipulation of customers by competitors. Our job is not to change human behavior; that would be manipulative. Our job is to serve the humans in the way they behave. That meets the existential purpose of a firm: to serve customer needs profitably. If customers respond to price image more than actual prices, than business people have a responsibility to actively manage their price image.

Managing price image is more important for attracting customers and growing market share than managing every individual price to be competitive for multi-product outlets since most customers don’t price compare every product they buy.

Price Image and Value-Based Pricing

Once we accept the reality that price image determines customer purchase rates as opposed to the prices itself, we have opened the door to value-based pricing for multi-product outlets.

Price image has been found to be impacted by some items more than others in multi-product outlets. In particular, the prices of frequently purchased consumables are found to impact price image more than infrequently purchased items. Therefore, it has been proven than high-priced multi-product retailers can craft a low-priced image by maintaining competitive prices on frequently purchased items while holding relatively higher prices on infrequently purchased items.

And purchase frequency is only one of many factors that determine the impact of an individual item on a store’s price image. There is also the issue of product popularity, product price as a percentage of category spending, price and proximity of competitors, and much, much more. Even lighting has an effect.

This and other facts explains why Amazon.com, Wallmart, and others are known to have low prices on some items while maintaining higher prices on others, and still be popular retailers.

I myself have consistently noticed my best selling textbook, Pricing Strategy, is priced competitively compared to college bookstores at Amazon.com while my useful but less popular manual on Excel for Marketers being touted (temporarily) for an incredulously high price near $3000 on Amazon while closer to $50 on Barnes & Noble. I doubt anyone purchased at this price at Amazon.com. And, to be fair, it is from an “International Online Bookstore”, not Amazon.com itself. But still, it was priced far above its Barnes & Noble competitor. See the headline for proof.

Value Based Pricing in Practice at Multi-Product Outlets

When executives realize they should focus on managing price image, pricing itself must move from cost-plus pricing and move towards value-based pricing.

Most retailers and distributors price from a peanut-butter cost-plus mentality.

In the peanut-butter cost-plus approach, the cost of an item is known by the multi-product outlet by its purchases from the origination manufacturer. Given the fixed cost nature of that retailer or distributor, that outlet knows the gross margin it must achieve on average to cover its costs and possibly make a profit. With that target margin in mind, the retailer marks-up every item to achieve a uniform gross margin. Like spreading peanut-butter on bread, margins are spread uniformly across all products.

(Some call this butter-and-jam pricing. I like peanut butter more.)

Even in category management, a highly popular and growing field for consumer retailers, a slightly modified peanut-butter margin approach is highly common. The modification they make: some categories get a slightly higher margin than others, but all products in a category get the same margin.

But multi-product outlets can do, and some have done, much better.

Some retailers and distributors have been able to consistently (over the span of several years that is) raise margins and increase market share simultaneously. What is their secret? They noticed that some specific items could be priced with relatively high margins while other specific items had to be priced highly competitively with a commensurately low margin to capture customers.

That is, they choose to use chunky peanut butter rather than smooth in spreading their margins.

(Now, do you see why I like the peanut butter metaphor?)

Chunky Peanut Butter Pricing

The chunky-peanut-butter margin approach is a type of value-based pricing. One where those multi-product outlets noticed that some products will still sell even with higher margins while others would not. That is, for some of their thousands of SKUs, multi-product outlets found that customers would express a relatively higher willingness to pay than others.

Now how did they find this? How did the find which of their thousands to millions of SKUs could be sold with a higher margin and which cannot? Insight, Experimentation, Measurement, and Results Driven Decision Making.

That is, they applied the principles of continuous improvement to pricing.

The steps to a continuous improvement cycle is usually defined as Plan, Do, Study, and Act. In chunky peanut butter pricing, pricing managers formulate an insight on which products might be able to carry a higher margin. That insight may really just be a guess, but it is enough to start. With that insight, they design an experiment, a price test, to see if their insight is correct. With that experiment Plan, they run it in the Do step. Once completed, they collect, analyze, and Study the results to determine if there was a connection between the hypothesized insight and the achieve results. From that study, they make a decision: repeat, improve, or discard and try something else. That is, they Act.

Sometimes this requires a “big data” approach, but other times not. Sometimes the experiment will go spectacularly glorious, but other times not. The key to this approach isn’t to get it perfect every time, but rather to be willing to make recoverable mistakes and let the data be the guide on the path to improvement. The outcome is not only a learning organization, but insight into the multi-product outlet’s customers and what drives their behavior. Oh, and they also tend to end up with better profits and happier customers.

This approach is likely to require statistical analysis of historical pricing, sales, and competitive data. But notice it doesn’t talk about customer research in the forms of surveys or focus groups, things that have been classically taught regarding pricing and marketing. No, this is different. And this is ok.

Value-based pricing isn’t just one technique or methodology, it is a philosophical approach to price things where customers are willing purchase, profitably. Hence, it shouldn’t surprise anyone that that goal can be achieved through different methodologies, much less that the methodology needed in some businesses are different than that needed in others.

Yes, retailers and distributors can do value-based pricing and make it work. In fact, some have. The form it takes in multi-product outlet environments is generally different than that used by their suppliers, but the customer orientation and profit outcomes are shared.

Anyone care for some chunky peanut butter margins?

References

• Hamilton, Ryan; Chernev, Alexander; “Low Prices are Just the Beginning: Price Image in Retail Management”, Journal of Marketing 77 (November 2013), p 1-20.