Competitive Pricing: We win by losing price wars

Competitive pricing is great! It drives sales. Competitive pricing is stupid! It kills margins. Which side are you on? Do you know when to stop in order not to lose money on every sell you make?

Ask anyone in online merchandising - pricing is Voodoo. Yet, all the different approaches can be grouped into two: "cost plus" and "competitive pricing".

Cost Plus Pricing
  • Wholesale Price: changes every few months; calculated through multiple level discounts; subject to promotions and volume discounts.
  • Dropship/ Handling Fee: applied either on the product or the order level; can easily reach $50 per product.
  • Shipping Charge: ranges between $6 and $800 depending on product weight, dimensions, shipping method (USPS, UPS, LTL or White Glove), freight class/ density, origin/ destination; subject to numerous surcharges - oversize, residential, liftgate, fuel; shipping cost for a product set IS NOT equal to the sum of that for components.
  • Target Margin: usually set on the category level; can be managed on the product level for the top sellers.
Let`s imagine, you sell 100,000 products which are shipped from 500 manufacturers with 10 different carriers. Having accurate product costs means modeling all the relationships, precalculating average expected shipping costs. While perfectly doable - it appears to be extremely complex, so most of the retailers skip the hard part and guesstimate.

In my experience - even the most educated guesses are wildly wrong most of the times. Adding fixed 35 % margin doesn`t really help. Products with overestimated costs are offered at 50-60 % actual margin and those with grossly underestimated costs are still sold below the cost.

So, let`s take it as given - your costs are wrong. But if everyone else is wrong - wouldn`t the market balance itself and eventually every product be priced right?

Competitive Pricing

Raison d'ĂȘtre for competitive pricing is - people like it cheap. There is very little brand loyalty, customers switch for $5 difference on $500 product. So, as Chuck Prince (Citibank CEO) said about the mortgage derivatives disaster - as long as music plays you dance. Competitor offers a $5 discount - you reduce your price by $10. A vicious cycle leaving everyone not only shirtless but shortless.

In addition to large and midsize companies wanting to be a billion dollar company, there are hundreds of new entrants who`s only way to compete is price. Take wrong assumptions, add aggressive players and you get a Pareto equilibrium where everyone is selling at below the costs (and going bankcrupt in hard times like ours).

Way Out

So, is there a sustainable way out? A smart man said - we win by losing the price wars. You should compete whenever you still make reasonable margin, but should not sell at a loss. The only way to sell exactly at a right price is to know exactly the costs and constantly reprice the products.

My three steps pricing solution:
  1. A comprehensive product database with most recent product costs and business rules for dropship fees.
  2. Weekly expected ship cost calculation (through APIs with all of your shippers).
  3. A script that takes all the costs, adds target margins and generates retail price recommendations.
The very first run will tell you whether your costs should be renegotiated or you set too high of the margin target. Renegotiate the costs, fine-tune the assumptions and you have an auto-pilot pricing solution that assures you make nice margins on every sale and stay competitive with less sophisticated players.

Winning is fun!

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3 Comments:

Anonymous ShopCusCus said...

Great post Maxim! There are a lot of ways to mess up competitive pricing, but it should be noted that it is possible to do it effectively. It takes a lot of time and energy invested in calculations though. Fighting the product wars in a category other than price is definitely a good way to relieve headaches!

November 18, 2011 at 2:54 PM  
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