Price Optimization: Margin Rate vs. Margin Dollars

With blurring lines between channels and geographies, price optimization solutions are an area of increasing interest to the retail community. Price optimization solutions can bring immense value if properly assimilated and leveraged in a company’s business environment. One area where executive involvement is critical to achieving the best outcomes from a price optimization implementation is the trade-off between margin rates and margin dollars.

You may have experienced the phenomenon of senior retail leaders, board members, and the investment community being too focused on margin rate – sometimes to the exclusion of margin dollars. This seems to make little sense since shareholder returns are based on margin dollars, not rate. Playing devil’s advocate, however, it is somewhat understandable, since a trend of erosion in margin rates can be a symptom of a sick business that is attempting to buy sales with discounts.

Yet price optimization solutions derive value from the trade-off between margin rate and dollars. Executives who do not internalize this frequently fail to move forward with price decreases due to concerns about margin erosion and end up only accepting price increases. This practice leaves profit dollars on the table since price optimization tools analyze the relationship between margin and price and suggest changes that maximize overall margin. In some cases, the retailer must lower some retail prices and reduce the margin rate to capture more potential margin dollars.

Furthermore, many budgeting and retail planning processes exacerbate this, as margin rate increases tend to be allocated to merchants and categories relatively evenly, without taking into account the different margin and elasticity characteristics of different categories.

As an example, if the company target is a 3% increase in margin rate, not every category should be challenged with a 3% increase. Some should be higher and some should be lower, based on the elasticity characteristics of the category.  Instead of this type of “peanut butter” budgeting (evenly spreading across all categories and items), margin increases should be allocated more thoughtfully, based on knowledge of the ability to manage product costs and price elasticity characteristics.

Budgeting and metrics also tie to the incentive system. Personal performance goals may need to be adjusted to de-emphasize the margin rate and incentivize collaboration to ensure that behavior is aligned with desired outcomes.  Failure to understand these dynamics and thus the power of pricing solutions at the leadership level can lead to uncompetitive pricing and can harm brand price perception.

What does this all entail? Properly deploying price optimization tools is not just a new solution set. It comes down to a mindset change and some hard conversations with the leadership team. It’s taking advantage of the deep analytics many price optimization systems offer to their fullest extent by trusting the science and baking it into redesigned business processes, roles, responsibilities, and incentive structures.

If you are considering deploying a price optimization tool and are unsure about how your organization needs to change to maximize the return on your investment, we would love to have a conversation on how Parker Avery can help.