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.

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