3.9 Pricing
In this section, we discuss the role that pricing plays in the supply chain.
role in the supply chain
Pricing is the process by which a firm decides how much to charge customers for its goods and services. Pricing affects the customer segments that choose to buy the product, as well as influencing the customer’s expectations. This directly affects the supply chain in terms of the level of responsiveness required as well as the demand profile that the supply chain attempts to serve. Pricing is also a lever that can be used to match supply and demand, especially when the supply chain is not very flexible. Short-term discounts can be used to eliminate supply surpluses or decrease seasonal demand spikes by moving some of the demand forward. All pricing decisions should be made with the objective of increasing firm profits. This requires an understanding of the cost structure of performing a supply chain activity and the value this activity brings to the supply chain. Strategies such as EDLP may foster stable demand that allows for efficiency in the supply chain. For example, Costco, a membership-based wholesaler in the United States, has a policy that prices are kept steady but low. The steady prices ensure that demand stays relatively stable. The Costco supply chain exploits the relative stability of demand to be efficient. In contrast, some manufacturing and transportation firms use pricing that varies with the response time desired by the customer. Through their pricing, these firms are targeting a broader set of customers, some of whom need responsiveness while others need efficiency. In this case, it becomes important for these firms to structure a supply chain that can meet the two divergent needs. Amazon uses a menu of shipping options and prices to identify customers who value responsiveness and those who value low cost. This identification allows the company to serve both effectively, as shown in the following example.
**EXAMPLE 3-7 Amazon.com**
Amazon offers its customers a large menu of prices for products that are purchased from the company. For example, in January 2014, a person purchasing two books worth $40 could use standard shipping (3 to 5 business days) at a cost of $4.98, two-day shipping at a cost of $14.97, one-day shipping at a cost of $24.97, or free shipping (5 to 8 business days). The pricing menu allows Amazon to attract customers with varying levels of desired responsiveness. Whereas customers paying for one-day shipping impose a high degree of uncertainty on Amazon, customers opting for free shipping can be used to level out the workload at the warehouse over time. Amazon can thus use its pricing to provide responsiveness to those who value it while using customers who want a low price to help it improve its efficiency.
components of Pricing Decisions
We now describe key components of pricing decisions that affect supply chain performance.
Pricing and economies of scale Most supply chain activities display economies of scale. Changeovers make small production runs more expensive per unit than large production runs. Loading and unloading costs make it cheaper to deliver a truckload to one location than to four. In each case, the provider of the supply chain activity must decide how to price it appropriately to reflect these economies of scale. A commonly used approach is to offer quantity discounts. Care must be taken to ensure that quantity discounts offered are consistent with the economies of scale in the underlying process. Otherwise, there is a danger of customer orders being driven primarily by the quantity discounts, even though the underlying process does not have significant economies of scale.
everyday low Pricing versus high–low Pricing A firm such as Costco practices EDLP at its warehouse stores, keeping prices steady over time. Costco will go to the extent of not offering any discount on damaged books to ensure its EDLP strategy. In contrast, most supermarkets practice high–low pricing and offer steep discounts on a subset of their product every week. The Costco pricing strategy results in relatively stable demand. The high–low pricing strategy results in a peak during the discount week, often followed by a steep drop in demand during the following weeks. The two pricing strategies lead to different demand profiles that the supply chain must serve.
Fixed Price versus Menu Pricing A firm must decide whether it will charge a fixed price for its supply chain activities or have a menu with prices that vary with some other attribute, such as the response time or location of delivery. If marginal supply chain costs or the value to the customer vary significantly along some attribute, it is often effective to have a pricing menu. We have already discussed Amazon as an example of a firm offering a menu that is somewhat consistent with the cost of providing the particular supply chain service. An example of when the pricing menu is somewhat inconsistent is seen at many MRO suppliers, which often allow customers to have their order shipped to them or to be picked up in person. A customer pays an additional shipping fee for home delivery, but pays nothing for a personal pickup. The pick, pack, and deliver cost at the warehouse, however, is higher in the case of a personal pickup compared with home delivery. The pricing policy thus can lead to customer behavior that has a negative impact on profits.
Pricing-related Metrics Pricing directly affects revenues but can also affect production costs and inventories, depending on its impact on consumer demand. A manager should track the following pricing-related metrics. With menu pricing, each metric should be tracked separately for each segment in the menu:
Profit margin measures profit as a percentage of revenue. A firm needs to examine a wide variety of profit margin metrics to optimize its pricing, including dimensions such as type of margin (gross, net, and so on), scope (SKU, product line, division, firm), customer type, and others.
Days sales outstanding measures the average time between when a sale is made and when the cash is collected.
- Incremental fixed cost per order measures the incremental costs that are independent of the size of the order. These include changeover costs at a manufacturing plant or order processing or transportation costs that are incurred independent of shipment size at a mailorder firm.
- Incremental variable cost per unit measures the incremental costs that vary with the size of the order. These include picking costs at a mail-order firm or variable production costs at a manufacturing plant.
- Average sale price measures the average price at which a supply chain activity was performed in a given period. The average should be obtained by weighting the price with the quantity sold at that price.
- Average order size measures the average quantity per order. The average sale price, order size, incremental fixed cost per order, and incremental variable cost per unit help estimate the contribution from performing the supply chain activity.
Range of sale price measures the maximum and the minimum of sale price per unit over a specified time horizon.
Range of periodic sales measures the maximum and minimum of the quantity sold per period (day/week/month) during a specified time horizon. The goal is to understand any correlation between sales and price and any potential opportunity to shift sales by changing price over time.