Pricing for Results: Part 1

Pricing is a crucial but often misunderstood aspect of retailing. Questions about pricing include the relation between margin and markup, the effect of lowering prices, how to price sale items, and how to create a positive price image. Pricing creates your gross margin, which is as important as any single aspect in operating a grocery store. Despite its importance in relation to profitability, pricing is usually one of the most unorganized and unsophisticated segments of the retail puzzle.

Margin and Markup

Due to a weak understanding of margin and markup, co-ops often use single markup systems per department; this causes non-competitiveness, a negative price image, a loss of flexibility, and no margin control.

Retailers need to accustom themselves to thinking in terms of margin rather than markup. First, let's define the two:

Margin=the ratio of gross profit to selling price  gross profit
selling price .35
1.35   ===.26 or 26%      Markup=the ratio of gross profit to cost  gross profit
cost .35
1.00   ===35%     

Margin relates gross profit to selling price. Markup relates gross profit to cost. Here, the margin is 26 percent of the selling price; markup is 35 percent of cost.

Why rely on margin rather than markup? Markup doesn't sufficiently express gross profit, because the markup isn't always realized. Items may be discounted or mismarked, thus reducing the selling price; and some items may spoil or break or be stolen, eliminating the sale altogether; yet the purchase/wholesale price is still paid. For these reasons, markup will not yield an accurate measurement of gross profit.

Margin is more accurate because it measures profit against actual sales-gross (profit) margin is derived by subtracting purchases (cost of goods sold) from sales. Gross margin is the standard for determining and analyzing profit in the grocery business, and profit earned on a single product or an entire business is expressed in terms of margin.

Conversionsmargin=markup
1 + markup=.35
1 + .35=.26 markup=margin
1 - margin=.26
1 - .26=.35

A gross margin of 26 percent can be derived, arithmetically, by marking up every item 35 percent. But the various forms of "shrink" reduce the realized gross margin. Shrink must be budgeted for when setting margin goals. Secondly, if you were to mark up every item the same percent, your prices would be noncompetitive.

Taking both shrink and competitive pricing into account, your aim as a retailer is to create, through a variable margin, a competitive pricing structure. Your pricing needs both to create a positive image for your store and to deliver your budgeted gross margin.

Contribution Margin

Let's look at an example of a simplified variable pricing system. Say that your store sells only groceries and produce. The first step is to look at the total sales for each category. Assume you do $10,000 in sales per week.

salescategory% of total$7000grocery70%$3000produce30%

Next, do a quick review of the competition to determine what the limitations of our price structure can be. Such a review in this case reveals that we cannot mark up the groceries more than 25 percent. By marking up groceries 25 percent, we will realize a margin of 19 percent after shrink:

categorymarkupideal
marginless
shrinkrealized
margin% total
salesgrocery25%20%1%19%70%

The next step is to determine the contribution margin of the grocery department -- that is, determine the department's contribution to the overall margin goal. The formula for determining the contribution margin is to multiply the department's percent of sales by the realized margin for that department:

realized
margin
.19XX% of
total sales
.70==contribution
margin
.133 or 13.3%

The next question is, how much do we have to mark up produce to reach our overall store margin goal of 20 percent? Since grocery sales are contributing 13.3 percent of that 20 percent total, the needed contribution from produce is 6.7 percent.

The competition in produce, this store has determined, won't allow us a total markup of more than 40 percent in that department. Since the contribution margin needed is 6.7 percent, we can figure out the realized margin and see if it is within our competitive limits:

needed
contribution margin
.067÷÷% of
total sales
.30==realized
margin needed
22.3%

Adding in a shrink factor of 5% for produce, our needed margin becomes 27.33%. This translates to a 37.55% markup, which is within our competitive bounds.

markup=   margin   
1 - margin=    27.33    
1 - 27.33=37.55%

In the above situation, within the competitive pricing limits mentioned, we would have the options of lowering the grocery margin or increasing the produce margin, if desired.

Variable margin pricing gives you the tools to be flexible in your pricing while at the same time controlling your margins. The example we just created is simplistic. Each department should be looked at, and products within the department priced at a variable margin that gives your store a competitive price image. For example, within the dairy department, eggs, milk, and butter should all carry low margins as they do industry-wide, while other products such as yogurt could carry a higher margin.

Contribution margins for each product need to be calculated before a new pricing structure is set. It is a timeconsuming project, but the returns are well worth the effort: a positive price image and increased gross margin.

Next time, we'll talk about measuring a change in price structure, establishing a positive price image, and pricing for promotions [CG #10, April-May 1987].