# 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.

# Orbitz, Pricing, & Average Initial Margin (Part I)

Several articles were written last month concerning Orbitz’s methods of targeting Mac users.  A post on the HBR Blog Network by Rafi Muhammed (Should Internet Retailers Discriminate Between Customers?, July 10, 2012) stated:

“So if online retailers can identify customers with different price sensitivities, why not charge different prices by customer type? After all, this is commonly done in the brick and mortar world. Retailers often set different prices in different locations. Target has acknowledged using this practice based on the level of competition at each location: If many rivals are close by, prices are lower, but if it’s the only game in town, prices are higher. Gas stations routinely charge different prices at different locations. Similarly, it’s customary to negotiate for certain types of products and services, so the price that anyone pays for, say, a car will vary based on product knowledge and negotiating skill.”

Muhammed goes on to debate the wisdom and ethics of such behavior, and I highly recommend reading his entire post.  (As Muhammed points out, brick and mortar retailers have long done this in the form of zone pricing.)

From a financial standpoint, what we’re really looking at is the impact on average initial margin (average initial markup) of having 1 cost and 2 (or more) retails.  Thinking through this potential pricing scheme, I decided to run a few numbers, and I’ll be posting those numbers in a couple of days.  If you have suggestions for other numbers or ratios to look at – I’d love to hear them.