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.