It's people who set prices; let's ask them how and why they do it
Consider Walmart’s roll-back commercials from the late 1990s, in which a smiling yellow ball in a cowboy hat snapped a whip at a price tag, lowering the number by weirdly precise increments, like $9.97 to $7.83. In retrospect, this marketing was odd. Who was this ball creature? While this abstract corporate mascot has not survived successive waves of Walmart branding, it retains a curious kernel of significance. It is possible to interpret the price-whipping ball as the firm incarnate, briefly revealing itself to execute one of its most essential functions: setting prices.
“Indeed, firms set their own prices, but they do not set them just as they please.”
Yes, firms set prices. Though it’s often taken for granted or obfuscated, it’s a basic reality of business, and Walmart’s willingness to admit this in a television commercial is likely related to the fact that its prices were moving in the right direction for consumers. But what about when they move up? While price is a decidedly technical category, which is everywhere being touched and manipulated, inflation is treated as an almost elemental force, emerging spontaneously out of macroeconomic forces such as demand and expectation.
This kind of macro-mystification has left us ill-equipped to address why prices increase, and what exactly can be done about it. While heterodox economists are beginning the work of piercing this veil, there are relatively few investigations into pricing itself. This is arguably a major oversight within their research project. As Steve Mann wrote in a previous essay for Strange Matters, formulating a new, more explanatory theory of inflation might first require a robust theory of price. What complicates this endeavor is that prices are not set in a vacuum, even for those companies at the commanding heights of the economy. Indeed, firms set their own prices, but they do not set them just as they please.
Starting from this premise, the next question becomes clearer: Why do firms set prices the way that they do? This is exactly what I asked several former pricing managers, pricing experts, consultants, executives, and small business owners. Their answers are naturally biased and partial, but they present a picture of the practicalities of pricing during a period of high inflation, and hopefully complicate the overly simplified narratives that are often given about why prices change.
In line with the scope of the research and reporting, these insights are presented as a series of vignettes, a good number of which will include direct descriptions from the sources themselves, many of whom were eager to share about this topic. Keep in mind that there is a persistent tension between theory and practice, as the sources were all too aware that the best laid plans are torn to shreds by the vicissitudes of the market.
Cost + Markup = Price
The best place to start is arguably the most intuitive and common pricing methodology: the succinctly labeled, cost-plus approach. In short, you take the cost of producing a product, including all the materials and labor that went into it, and then you tack on a profit margin — a simple additive function.
“Labor costs for example, which one might assume is a major consideration in cost, are often institutionally separated from pricing.”
Stephen M. Lizou, pricing expert and former chief value officer at The Thales Group, a French aerospace company, said about 30-40% of companies continue to predominantly use a cost-plus approach. In his view, this is because most firms aren’t sophisticated enough to do anything more complicated:
“Typically, a company in cost-plus will change their price base once or twice a year maximum, and now they need to do it weekly frankly,” Lizou said. “Looking at inflation, you can assume that you’re leaving a lot of money on the table if you don’t calculate your cost and increase your price at least once a month if not every two weeks. That’s the problem with cost-plus pricing.”
This is one way of saying that the cost-plus method isn’t some automated procedure. Firms have to constantly review and update their understanding of their cost basis, which involves continually collecting information.1Interestingly, one possible consequence of the fact that the vast majority of prices are a mark-up over costs is that raising interest rates (the cost of borrowing from a bank) – generally seen as something central banks can do to combat inflation – may actually exacerbate it, to the extent this increases business costs. For an argument using historical data for this perspective, see Tim Di Muzio, “Do Interest Rate Hikes Worsen Inflation,” published by the magazine on 15 August 2022. –Eds It’s worth remembering that despite their legal status as individuals, corporations are in fact vast organizations with many procedures siloed within different departments. Labor costs for example, which one might assume is a major consideration in cost, are often institutionally separated from pricing.
“If they don’t pay attention to history, they put themselves at tremendous risk, because they don’t have any reference points as to what demand might look like.”
“They probably should bake that in more than they probably do, to be honest,” said David Ritter, a pricing consultant for mid-sized grocery stores for the professional services firm Alvarez and Marsal. “The way it usually works is that pricing teams exist within the merchandising organizations of a retailer, and often the labor sits within the store operation team. So the people making those decisions are often different, so I don’t think it’s as integrated as we like to think it is.” In most cases, he added, executives tell the labor team to use fewer hours, as opposed to adjusting prices in real-time based on fluctuating labor costs.
At the level of the whole firm, however, there is a constant feedback loop. Products can have a price history that goes back decades. If X product (or a similar product) sold for Y dollars for the last 10 years, why touch the formula?
“Legacy businesses, whether they’re brick-and-mortar or online or some combination of the two, price their assortments based upon historical listings,” said Mark Cohen, former CEO of Sears Canada and director of retail studies at Columbia University. “In other words, they carried a men’s sweater, crew-neck, shetland wool, last year for $120. They’re going to carry it again because they believe it will be in demand again, and they are motivated to keep the price the same, because they know what the interplay was between price and demand.”
If costs rise for any reason, he added, most retailers will either absorb the added costs or limit their increases as much as possible, because once they break away from that historical reference point, they’re in uncharted waters. “They are tethered to history,” he said. “If they don’t pay attention to history, they put themselves at tremendous risk, because they don’t have any reference points as to what demand might look like.”
According to this explanation, companies are not coming up with prices based on some future projected demand but rather on their sales history. This is a fundamentally different way of thinking about demand than the way economists often explain it in relation to inflation. Rather than raising prices speculatively, based on anticipated demand, many companies are actually looking squarely in the rear-view mirror.
Mysteries of the Markup
Of course, you can’t have cost-plus without a mark-up. However, the process for determining a mark-up is less clear-cut than adding up costs. There are few hard-and-fast rules for how much a firm will try to wring out of a sale, but from a pricing perspective, it’s usually something that comes down from on high.
Kevin Lemke, former pricing manager for Stanley Black & Decker, the hardware and appliance firm, said that it usually begins with a conversation with the finance team. “So let’s say we’ve historically been at a 25 point margin,” he said. “You’ll probably have a finance guy beating you up, saying ‘you got to get this up to 30 points.’ You’re probably going to have finance constraints driving that plus.”
He explained that this conversation usually begins during product development and haunts the entire process. The finance team is looking for a certain amount of margin on a particular product so that, when combined with sales across other products, the firm achieves a target firm-wide profit rate. The problem is, there are often a lot of assumptions built into these calculations. “Why that doesn’t work is, I can’t guarantee you that we’re going to get all that volume,” Lemke said. “So there’s plausible deniability, and the finance guys can sleep better at night knowing that they at least approved this thing at 30 points of margin.”
Stanley Black & Decker makes things like power drills and circular saws, where product innovations and even minor upgrades can more easily translate into cost increases. For more common goods and especially consumables, mark-ups are more often shaped by industry-wide standards, which brings us to the second most common methodology: competitive pricing.
In food retail, for instance, it is especially difficult to price goods in a vacuum because one particular company, Walmart, is so dominant. The challenge for competitors is also not just a matter of losing customers. Walmart’s pricing power (and by extension its own profit needs) ripple across the sector in myriad ways.
“Often, Clear said, brands would come to him and say they were raising prices everywhere, when it was clear that everywhere meant everywhere except Walmart.”
“Walmart controls the pricing on brands,” said John Clear, a former purchasing manager for Lidl, the German discount grocery that has recently made inroads into the United States. “It sounds very aggressive to say it that way, but what I mean is: if you take Frito Lay, they will build their business off two huge accounts, which is Kroger and Walmart, and they will make more investments in them because they need the volume to underpin what they do everywhere else.”
This effectively gives Walmart leverage. If Walmart wants to lower its prices, brands will often take the hit rather than lose their biggest account. This becomes a problem for smaller retailers when the brand comes to them to make up the difference. “Frito Lay will say ‘cool, I’ll take the 5 percent hit from Walmart, but I can regain that 5 percent by going after 10 regional grocers and increasing their prices by 5 percent.’ That’s what tiered pricing means. You start with big-box pricing, which is the cheapest, and then you work your way up from there.”
More broadly, small to mid-sized groceries generally index their prices against Walmart, and see how close they can get. So, Walmart plus 5 or Walmart plus 10 becomes a common way of thinking about their pricing strategy.
The regional player is thus hit on both sides. They are competing for customers who know full well that Walmart has the lowest prices, and they’re contending with brands that are dead-set on appeasing Walmart. Often, Clear said, brands would come to him and say they were raising prices everywhere, when it was clear that everywhere meant everywhere except Walmart. This is also an example of how the financial imperatives of a public company, which is pressured to show quarterly gains, can spill over onto the balance sheets of private companies.
Yet companies don’t sell just one product, and across a company there are opportunities for getting a little creative with margins. One approach, called blended margins, is crucial to understanding how this works.
Grocery stores tend to divide their products into two categories: key value indicators (KVI) and everything else. The former are basically products that consumers are really sensitive to cost-wise, and may actually change their shopping habits if they change. Think about how so many articles about inflation in major newspapers focus on the price of eggs, milk, and bread.
Ritter, the consultant, explained that stores will lower the price of KVIs, while marginally raising the price on everything else. “So on KVIs they might actually try to match Walmart often, but then on non-KVIs they’ll do Walmart plus 10 percent, so that your blended strategy becomes Walmart plus 5 percent.”
Outside of the highly competitive, and generally low-margin grocery business, blended margins are sometimes used because demand is only so flexible and adjusting margins can be easier than adjusting price. Dan Bronson, general manager of SingleCut, a New York-based brewery and distributor, said it will accept a lower margin on, say, a brand new IPA that really reflects the company’s approach to brewing, while looking for a higher margin on a more popular and scalable lager or pilsner. After all, your customers can only drink so much booze. “We always want to put ourselves in a position where we are not so reliant on volume,” he said. “We do sell a vice. It has a ceiling on it. We can’t expect one person to quadruple their purchasing from us — or we certainly hope not.”
The above examples all suggest a highly constrained environment for pricing. Unlike Walmart’s exuberant yellow ball, firms are hardly roving the aisles with a price gun just stamping different prices on products just as they please. Even Walmart recently had to mark down products to clear out excess inventory built up over the pandemic, and its stock price fell accordingly, as investors braced for lower profits. That being said, in the world of pricing — which you can bet has its own inscrutable discourses and debates playing out within trade publications and at conferences — there is a strong belief that pricing can be innovated.
Two approaches that are considered more innovative are dynamic pricing and value-based pricing. You likely engage regularly with the first. It’s the specialty of airlines, ride-sharing apps, and e-commerce companies: real-time fluctuations in price based on real-time changes in demand. While this approach arguably works in those handful of contexts, it’s struggled to gain purchase beyond them.
“I define dynamic pricing as the automation of pricing intelligence, allowing companies to rapidly make nuanced decisions in a scalable way,” said Seth Moore, former chief strategy and analytics officer of online retailer Overstock.com, in an interview with McKinsey. “You automate pricing intelligence by factoring in a number of components—which typically include competitive data, inventory, and demand changes—and building those components into an algorithm.” Moore goes on to explain that companies shouldn’t be overly reliant on algorithms, or make automated pricing an objective in and of itself, as they could end up destroying value rather than creating it.
As for value-based pricing, Lizou said it’s “a methodology that’s been around for 40-50 years, and it’s pretty much the notion of price based on the customer’s perceived value of what you’re delivering.” In other words, companies dig up a bunch of additional customer and product data and use this to justify pricing their items at a higher price. At one level, many luxury brands do this all the time, but Lizou said most major companies could benefit from adopting some kind of value-based approach, even as he admits that most companies don’t have the resources or the willingness to make the shift. “For them, legacy pricing is done in cost or competition, and they don’t know much about it,” he said.
Cohen, formerly of Sears Canada, is more skeptical. “I think it’s a sexy idea, and probably has a lot of intellectually valuable pathways, except when it crashes into the sensibility of the customer,” he said. “It could create a universe of very inconsistent prices across categories and time, which I don’t think human beings are going to align to. These dynamic models need common sense judgment attached to them, which is not always necessarily available.”
The ‘Implicitness’ of Demand
Many mainstream economists explain prices, and therefore inflation, by saying prices respond in a regular and nearly automatic manner to demand. Perhaps dynamic pricing models are an attempt to make that theory reality. Some of these more dynamic models try to quantify demand by looking at what’s called elasticity, which is how demand responds to changes in price. Ritter pointed out that “demand is implicit in many of the pricing tools out there, but that’s a pretty PhD-level view though – and if we’re being honest about how some of these more regional players operate, they might have a pricing team that is somewhat sophisticated, but I don’t think you’d find it’s econometrics-level sophisticated.”
“In my pricing work for the tools business, we weren’t doing intensive elasticity studies,” said Lemke. “It was more about rules of thumb and estimates.”
This implies that the lack of pricing based on projected demand is largely a technological or a resource problem. But based on multiple responses I received when asking about the role of demand, there seems to be a fundamental difficulty in isolating it as a variable when it comes to pricing decisions. In many cases, pricing managers retreat into broad macroeconomic explanations.
“It’s all about economics, and it’s all about demand and supply,” said Lizou. It’s been around for 100s of years. You can’t decorrelate supply and demand. There is demand, and there is supply. Sometimes supply is higher than demand, and the price goes down, and sometimes demand is super high, and supply is disrupted.”
In the trenches of pricing decisions, however, demand can be so difficult to predict that companies often revert to sales history and general industry standards. “In my pricing work for the tools business, we weren’t doing intensive elasticity studies,” said Lemke. “It was more about rules of thumbs and estimates.” In many cases, he added, projected demand puts downward pressure on prices. “In most situations, it’s about where the limits are. It’s not about optimization. It’s a matter of deciding we’re not going to be able to sell anything at this price.”
This echoes comments from Cohen, who stressed that firms will often do everything in their power to avoid a price increase that could potentially scare away customers and break away from precedents that help orient the company.
“Historically, inflation is related to cost, because that’s the only objective basis for price,” he said. “Increases in demand typically don’t influence price inflation, in my opinion, except when supply doesn’t keep up with demand.”~