# Average Initial Margin (Part II)

I’m often asked how to calculate initial margin for a category (i.e. average initial margin.)  The best way I’ve found to explain this is to create a “what if” scenario with numbers, and work it out.

The pricing question posed in my last post (Orbitz, Pricing, & Average Initial Margin) can be analyzed through an average initial margin calculation.  It is a question of a retailer having one cost, but wanting to charge two different retail prices.

To apply numbers to this scenario, we could assume the following:
Cost = \$10
Desired retail = \$15 and \$20
Desired average initial margin = 35%

Calculations:
1.  Determine how many products we must sell at each price to achieve a 35% IMU.  Start by finding what the retail price would be if we were to sell the product for only one price instead of two.
R = C/(1-IMU)
R = 10/.65
R = \$15.38

2.  But, we want to use two prices.  So, how many units must be priced for \$15 and how many for \$20 in order to hit a 35% IMU?  Knowing that the items I price at \$15.00 will fall \$0.38 short of the target, and those priced at \$20.00 will go \$4.62 over the target.  To balance these amounts, I must price:**

• 462 units, or 92.4% of the products (462/(462 + 38),)at \$15.00
• 38 units, or 7.6% of the units (38/(462 + 38),) at \$20.00

** 462 units * \$0.38 = 38 units * \$4.62

3.  What happens to the average initial margin if we change the unit balances up a little?  If, instead of the above percentages, we believe that we should price the products as follows:

• 80% of the units at \$15.00
• 20% of the units at \$20.00

Total Cost
Product A            80 units * \$10 cost = \$800
Product B            20 units * \$10 cost = \$200
Total cost = \$1000

Total Retail
Product A            80 units * \$15 retail = \$1200
Product B            20 units * \$20 retail = \$400
Total retail = \$1600

Average IMU = (1600-1000)/1600 = 37.5%

4.  The initial margin percentage didn’t change a great deal, but what happens to the dollar amounts?  That depends on the number of units sold.

Begin by calculating dollar initial margin at the original price of \$15.38.  If we project this based on 100 units, the dollar initial margin would be:

R – C = IMU\$
\$1538 – \$1000 = \$538

Now, what would the dollar initial margin be if we were to price 80 units for \$15 and 20 for \$20?  Using the same formula:

\$1600 – \$1000 = \$600

Under this pricing scheme, we make an extra \$62.

But, what if instead of purchasing 100 units, we purchased 10,000 units?  Working the numbers out just as we did above, you will see that using the two-tiered pricing scheme will earn the retailer an extra \$6,200.

Please comment, or send me an email, if you have any suggestions or questions.