One of the oldest and most widely used tools in maintaining gross margins is the concept of matrix (or variable) pricing. With this concept, companies aim to be highly price competitive on their fastest-selling items, thus operating with thinner profit margins on those items. They then build more gross margin into the business on slower-selling ones, which tend to be less price-sensitive.
For many companies today, however, matrix pricing does not overcome the margin squeeze the way it should. There has been a stronger-than normal downward price pressure on the fastest selling items, and many companies have not been aggressive enough in adjusting the matrix upward on the slower-selling, less price-sensitive items.
Part of the problem has been competitive. No firm wants to be under-bid, even on the slowest selling of items. But too many companies are applying the matrix-pricing approach as a rote process, with all slow-selling items treated as equal. In fact, they are very different.
The real key to matrix pricing is to identify the items in the assortment that are "blind." By blind items, we mean products that are not at all price sensitive: Customers either don't know the price or don't really care. Blind items represent the only real opportunity for margin enhancement in the assortment.
Applying the blind-item pricing concept really requires that we answer three main questions:
• How much of a price increase do we need on blind items to offset a price reduction on the fast selling ones?
• What characteristics make some items better able to absorb price increases?
• How should we approach the issue of pricing to avoid competitive pitfalls?
Make price adjustments
No business has ever had a problem in finding products to sell at lower prices. Both competition and customers are helpful in this effort.
However, most companies tend to overestimate the extent to which their product assortment is totally price-sensitive. Pure commodity items, where there is almost no opportunity for adequate gross margins, are only a modest portion of sales for most businesses. There are also many products that are somewhat price-competitive, but not totally price-driven. For these items, which tend to make up the bulk of any company's sales, we can still produce a reasonable degree of added value in the transaction.
Then there are, as we've said, blind items —products that are not at all price-competitive. In setting margins, we need to treat each of these types of product differently.
The extent to which a business can use matrix pricing to alleviate growing price pressures really depends upon how many of the company's products are completely price driven, how many are less price sensitive and how many are not at all price-sensitive.
Table 1 is designed to show how much of a price increase is needed on the slow-selling (or blind) items to offset tighter margins on price competitive items and keep gross margins from declining.
Across the top of the table is the percentage of total sales that are totally price-sensitive. Obviously, the more a business sells price-sensitive items, the more we have to increase the prices of non-sensitive items.
On the left side of the table is the percentage price decrease on fast selling, price-sensitive items. Again, the larger the price reduction, the more we have to offset that with price increases on the slower-selling items.
In fact, the table indicates one extremely important fact about changing the price of blind items to offset price reductions on fast-selling ones. Namely, if a business is too committed to pure price-driven items or is in a severe price battle on those items, matrix pricing can never offset the reductions.
Consequently, as a starting point in the pricing process, businesses must first examine their marketing approach. If they are in a pure commodity business, the key to improving profitability is probably not adjusting the price matrix. The key is to change the operating cost structure of the firm. Success will come to the lowest-cost operators.
However, if the firm has a more normal product assortment, which is typical in the wood flooring industry, the issue is to limit the degree to which the firm reduces prices on the fast sellers. If the size of the price battle can be contained, the firm can then adjust the price matrix on blind items to offset the decline in margin on the fast-selling items.
With that in mind, Table 1 provides some guidelines on the size of the price increases that are required. The challenge is to find the items that lend themselves to upward price adjustments, and then institute the necessary changes.
Identify blind items
Pricing is much more of an art than a science. Whether prices should be raised or lowered depends on the nature of demand for the item and the role of the item in an overall price strategy, as well as a host of other intangible issues.
While it tends to be true that slow selling items are less price-sensitive, it is not wise to simply take the slowest moving items (the D items in inventory parlance) and increase their prices. Some slow-moving items are quite price-sensitive, because of peculiarities in the market. The only way to make a pricing decision is to look item by item.
However, the reality is that most firms have a large number of SKUs to contend with. This creates the need to make something approaching a science out of the matrix pricing art. Table 2 tries to provide something of a scientific structure to the pricing issue.
The table lists the key factors that determine whether an item is a blind item — listed in order of importance. In making a decision as to whether an item is blind, firms should look for SKUs that have at least three of the characteristics listed in Table 2. The more these characteristics appear on the top of the list, the more likely the item is truly a blind item.
Based on the checklist in Table 2, the firm can develop some decision-making rules that provide a scientific overlay to the art of pricing. For example, the firm might consider the following arrangement:
• Any item with five or more positive factors — Raise prices immediately by at least the amount indicated in Table 1 to maintain gross margins. These are most likely pure blind items.
• Any item with three to five characteristics — Evaluate the item for potential price increases, possibly on an experimental basis. Possibly the firm should attempt to achieve the increase suggested in Table 1 over two stages.
• Any item with fewer than three characteristics — Maintain the existing price structure.
Implement blind-item pricing
It's one thing to talk about adjusting the price matrix, and something else entirely to actually make the adjustments. Reviewing prices is a time-consuming activity.
Business owners and managers who lack the motivation to adjust the pricing matrix should consider the alternative. By not making upward adjustments, they are facing a continually declining overall gross margin. It is a situation that doesn't just lead to lower profits — it eventually leads to the demise of the firm.
If the emotional battle of the size of the workload can be overcome, the firm is ready to rethink the price matrix. In doing so, three guidelines are in order.
First, there should be some sort of cross-functional pricing committee in place. It is not enough for the buyers to adjust prices; the sales force must be committed to the process, as must top management.
Second, the problem should be approached on a category-by-category basis. By looking at a specific group of products, the distinctions between highly price-sensitive items and blind items becomes much more distinct. When looking at a large group of slow selling or D items from across the entire firm, price sensitivities are often hidden.
Finally, pricing should become everybody's job. Whenever salespeople encounter customer comments that certain prices are high, such information should be systematically reported to the pricing committee. At the same time, reports should also be made when customers report that they have been "looking all over town for this" or "you saved my life by having this." Both the need to lower prices and the opportunities for more value-added pricing should be reported.
The squeeze on gross margins is not likely to diminish in the near future. If firms are going to fight the price battle successfully, they must do more than simply become aggressive on fast selling items. They must also institute a sophisticated program for enhancing margins on blind items. If they do, they can maintain margins. With concerted efforts, some slight overall margin increases might even be possible.
Blind-Item Pricing Highlights
• Blind items are products that are not at all price-sensitive, and represent the only real opportunity for margin enhancement in the assortment.• Too many companies are applying the matrix-pricing approach as a rote process, with all slow-selling items treated as equal. In fact, they are very different.• Most businesses tend to overestimate the extent to which their product assortment is totally price-sensitive. Pure commodity items, which have almost no opportunity for adequate gross margins, are only a modest portion of sales for most businesses.• The extent to which a business can use matrix pricing to alleviate growing price pressures really depends upon how many of the company’s products are completely price-driven, how many are less price-sensitive and how many are not at all price-sensitive.• If a business is too committed to pure price-driven items or is engaged in a severe price battle on those items, matrix pricing can never offset the reductions.• Look for items that exhibit three or more of these characteristics: Slow-selling items, unusual or exclusive items, items that are bought only when needed, lowprice items that are not promoted actively, non-seasonal items, unbranded items and repair parts.