The growth of e-commerce and proliferation of international retailers in Australia has made consumers more price conscious than ever.Customers don’t just want a good product, they want a great deal.

Research shows that the most important consideration for consumers is price, followed by value and quality. This places pressure on gross margin and subsequently a retailer’s ability to generate profit.

Gross margin represents the proportion a product’s price is able to contribute to business expenses and subsequently profit after subtracting direct product costs. Gross margin percentage is calculated as:

It is important to note that when calculating gross margin:

• Revenue is net of any discounts being offered and any sales returns; and
• Cost of goods includes associated direct costs incurred e.g. product packaging and transport freight costs.

Why gross margin analysis is important

When determining an optimal pricing strategy, gross margin provides a quantifiable metric to help establish sales volume requirements.

That is to say, it enables retailers to calculate their breakeven point. Further, it provides an indication of whether a pricing strategy is sustainable i.e. can fixed costs be covered and an appropriate net profit be achieved?

Pricing

Retailers typically adopt one of two approaches in determining a product’s price, both of which require an understanding of gross margin.

The top down approach assesses readily available competitor prices in setting a price point and determines whether the gross margin percentage is sustainable within the businesses current cost structure.

The bottom up approach focuses on the costs incurred bringing a product to market (typically where a new product has been developed) and of these costs, determines a price point allowing for an acceptable gross margin to be achieved.

A common mistake

A common mistake among retailers is to confuse a product’s mark up with its gross margin.

A product’s mark up will always provide a greater percentage when compared with gross margin. As a result, retailers should be conscious of the profit embellishing effect mark up plays when determining a product’s price.

In other words, by confusing mark up for gross margin retailers may overestimate a products’ profit contribution and as a result may be at risk of under-pricing.

Mark up percentage is calculated as the difference between a products actual cost (cost of goods) and its selling price (revenue). Gross margin on the other hand calculates the difference between selling price (revenue) and profit (revenue – cost of goods).

How discounting strategies impact margin performance

We often see retailers using discounting as a strategy to drive foot traffic and sales at the expense of lowering gross margins and negatively impacting profitability.

For example, if we assume an initial gross margin of 55 per cent and a discount of 10 per cent is applied to the product, sales volume will need to increase by 22 per cent in order to generate the same dollar net profit (assuming other costs remain constant).

Recognising that while increased foot traffic may lead to cross sales, by understanding the consequent increase in sales volume required as a result of discounting, businesses will be better equipped to determine the amount and the frequency of any discounts offered.

Three discounting strategies are common among retailers which have a strong impact on the retailer’s business model.

• The High-Low pricing strategy prices products at initially high RRP (Recommended Retail Price) and then heavily discounts stock during frequent sales (e.g. Kathmandu) to drive sales and foot traffic.
• The Every Day Low Prices (EDLP) strategy relies on large sales volumes to compensate for constantly low gross margins in order to generate a profit (e.g. Bunnings and Kmart).
• The more common fat margin or ‘seasonal pricing’ strategy operates on larger gross margins and undertakes seasonal sale drives to move out-of-season stock. The strategy is common across the board from large retailers (Myer & David Jones) to smaller boutiques.

When undertaking product pricing decisions, understanding gross margin strategies, the differences between gross margin and mark up and the impact discounting plays on sales volume will greatly assist retailer’s to achieve sales and profit objectives in the age of the conscious consumer.

In my next article I will take a look at stock turns and inventory utilisation.

James Stewart is a partner and retail practice leader of Ferrier Hodgson and Azurium.