Editorial
Emerging trends in retail pricing practice: implications for research

https://doi.org/10.1016/j.jretai.2004.08.003Get rights and content

Abstract

This article represents the first of several editorials to appear in the Journal of Retailing designed to examine the nexus between retail practice and research, with the goal of stimulating further research. This essay on emerging trends in pricing discusses recent advances in retail pricing optimization. We begin with a review of how retailers typically make pricing decisions using time-honored heuristics and attempt to infer the optimal decisions. However, current methods are suboptimal because they do not consider the affects of advertising, competition, substitute products, or complementary products on sales. Most fail to take into account how price elasticity changes over time, particularly for fashion merchandise, or how market segments react differentially to price changes. In addition, many retailers find it difficult to know how to price merchandise when their suppliers offer temporary “deals.” They are also generally unaware of how their pricing strategy influences their overall image. As these issues demonstrate, optimal pricing is not a static problem. Retailers must be able to react quickly to changes in the environment or sales patterns. This paper also provides examples of the more sophisticated pricing techniques that are currently being tested in practice. Finally, we conclude with a discussion of the critical components that must be incorporated into retail pricing.

Introduction

Most retailers do not use price as a basis for achieving a sustainable competitive advantage because it is too easy for competitors to copy a low-price strategy, and very few retailers can be successful with a low cost–low price strategy such as Wal-Mart's. Price can be used strategically, however, even if not always to establish the lowest price. For example, when entering a highly competitive market, a retailer could sacrifice significant profits to build market share. To pursue such a strategy may be perilous, however, unless it can be implemented properly. Retail managers must consider carefully certain key factors, such as the customers, competition, and government regulations (Grewal & Compeau 1999; Monroe 2003), and then develop, implement, and evaluate the appropriate pricing strategy and tactics.

American retailers are losing more than $200 billion a year due to markdowns, or dynamic price cuts over time (Top of the Net 2002).1 Markdowns as a percentage of U.S. retail sales represented 8 percent in 1971 and 35 percent in 1996; according to an STS Market Research study, 78 percent of all apparel sold currently by national chains such as JCPenney, Sears, and Kohl's is marked down.2 Thus, markdowns are clearly a substantial and important aspect of today's retail landscape. Retailers and their customers have come to expect prices that are below the manufacturer's suggested retail price (MSRP). For more than 20 years, manufacturers, particularly in the grocery industry, have fueled this markdown mania by tempting retailers with special temporary price reductions coupled with promotions. Retailers of all kinds use these frequent price promotions to lure customers to their stores, and in turn, customers have come to recognize the retail pattern of marking down merchandise after a prespecified period of time and therefore wait until goods are on sale. These practices have had a deleterious effect on profits and contributed to the demise of many smaller retailers.

Until recently, retailers typically based their initial pricing and subsequent markdown decisions on arbitrary rules that they believed had worked well in the past. Fortunately, a few specialized firms recently have developed software packages to assist retailers in making these important pricing decisions. These packages are just part of an assortment of programs known as merchandise optimization techniques (Friend & Walker 2001).

Merchandise optimization, which can have a direct, profound impact on the bottom line, is all the rage in retailing circles these days. It is well represented in the trade press, and most retailing conferences devote significant time to the topic. Some of the largest retailers in the country (e.g., Home Depot, JCPenney) have invested millions of dollars in sophisticated merchandise optimization software. The Canadian apparel retailer Northern Group Retail Ltd. started using ProfitLogic Price Optimization (Cambridge, MA) software and, in a test, was able to generate $60,000 of additional gross margin dollars on one stock keeping unit (SKU) by holding its outerwear at full price, though prior experience indicated that it should have reduced the cost by 30 percent (Retail Systems Alert 2003).

Similarly, price and promotion optimization software developed by KhiMetrics’ (Scottsdale, AZ) has been implemented successfully by top retailers in the grocery, drug, electronics, specialty, and mass merchandising fields. Results from controlled field experiments demonstrate that their solution consistently outperforms that of the control group by increasing profit (1–2 percent of sales) while maintaining or increasing sales, depending on the retailers’ desired goals. Moreover, sales were increased or maintained without any negative effects on total unit movement. Depending on the retailer's margins, the increased profit translates into an overall 5–15 percent increase in gross profits, and the results were consistent across retail industries.

Retailers have a plethora of decision-making tools available that can help them in the following areas: planning assortments, initial pricing, sourcing/vendor collaboration, buying, allocation of merchandise to stores, promotion, planning replenishment (rebuys), space management (planograms), and markdown pricing. Our goal is to examine emerging pricing practices by retailers and identify pricing research opportunities—across time (e.g., initial pricing and markdown pricing decisions), categories and SKUs, and customer segments—that we believe have strong implications for both research and practice.

Section snippets

Traditional retailer pricing techniques

Typically, retailers make pricing decisions on the basis of time-honored rules. Retailers using the rules-based approach often apply a fixed percentage markup onto their cost; a keystone markup, for example, results in a markup that is 50 percent of the retail price. Rules are applied to markdowns as well. For example, fashion retailers often take a fixed percentage markdown on merchandise that has been in the store for a certain number of weeks, followed by an additional markdown a few weeks

Two disparate pricing problems: fashion and staple merchandise

Although there are many types of merchandise, from an inventory management perspective, most SKUs fit into one of two categories: fashion or staples. Fashion is a category of merchandise that typically lasts 8–12 weeks, and sales vary dramatically from one season to the next. Within the fashion category, a specific style or SKU sells for one season or less. Although the life cycle of a typical fashion item is much shorter than that of a staple, its life span depends on the type of category and

Critical components to be incorporated into retail pricing

Retailers are interested in maximizing their profits. To do so, they need to understand how to price their merchandise optimally. What does optimal price really mean? It is the price at which profits are maximized by item or group of items. Of course, this process is not as easy as it sounds. For example, by maximizing the profits of one item by setting its “optimal” price, the retailer may sacrifice profits on another item whose demand correlates with the first item. To illustrate, if a

Implementing retail pricing

The basics of developing and implementing retail pricing using optimization programs look simple. However, if this were the case, retailers would have done so long ago. To develop and implement an effective pricing strategy, analysts must carefully consider several additional factors.

Discussion and directions for further research

Pricing optimization currently is one of the hottest topics in the retail industry. Much of the basic optimization methodology is well developed in academic circles, particularly in retailer decision-making frameworks (e.g., Tellis & Zufryden 1995). Yet the compilation of these techniques into a cogent system that can be used on a daily basis by retailers is fairly new. This article has assessed the current state of retail price optimization by examining what should be included and considered

Acknowledgment

The authors thank Bill Bearden and David Bell for their thoughtful comments on a previous draft of this manuscript.

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