Every few weeks I’ve been trying to take a post or a question from the Facebook world and use a little more space to give it some attention. Originally, I had planned to respond to a post from a different group but it would have focused on a particularly critical person in a particularly critical group. Further, I would have criticized the critical person’s post in the critical group and that just seemed like a lot of criticism. This would have made me grumpy and my main point was going to be “stop being so grumpy” and that’s a whole downward spiral. So, I passed on that opportunity. However, if you’re interested, I actually already described my view in a post called Be Nice: A Business Strategy.
Rather than go down that route, I decided to respond to a post from the always helpful Joshua Krilov. I’m going to disagree with him (sorry!), but he’s still a really smart guy and I often look forward to his contributions in the FBAMaster group.
So, first I want to start with what I really like about this post. When you create a product on Amazon, you get the option to choose the SKU (also called mSKU, Stock Keeping Unit, Merchant Stock Keeping Unit) when listing a product for sale. If you don’t take this option, Amazon will assign it a random alphanumeric combination. The benefit to letting Amazon do it is that it saves you about 2 seconds of typing. The benefit of doing it yourself is that you can encode any information that you want. Maybe the product has an expiration date you want to remember. Maybe you want to be able to remember what store you bought the item from. Maybe you want to mark what category the product is so it’s easier to sort your manage inventory page by category. There’s all sorts of information that might be really useful to have encoded into the SKU and thus available to you whenever you glance at the product. So, I hope you all take Joshua up on his advice to make use of the SKU field when listing products.
Now, let me shift to why I disagree and would go so far as to say it is potentially harmful.
First, what is he suggesting? He’s saying that when you list a product you have all of the information available to you (how much you paid, how much fees will be at various price points, etc.). Using this, a person could figure out at what price point they will break even (ie. they won’t profit on the item, but it won’t be a loss, either). His suggestion, then, is to include this information in your SKU so that later as you’re looking at the Manage Inventory page and consider price changes, you instantly know the point at which you shift from making money to losing money.
Hopefully I’ve accurately conveyed Joshua’s point. If I’ve misrepresented him in any way, I’ll make sure to get a retraction on here. I do think, though, that this is the essence of his point. In fact, you might be nodding your head along and thinking that this is a great idea. To be fair, I have done a version of this in the past, so I’m not faulting anyone who thinks that this is a good practice. However, allow me an opportunity to explain my contrarian view.
The first question I would ask Joshua is how he decides how much to price something. This is not a particularly easy question. Business schools might have students spend an entire semester looking at various models. One option, for example (which Chris Henway alludes to in the comments) is a Cost-Plus model. That is, we consider all of the costs that go into making/acquiring a product to sell and getting it to the customer and then add an amount to that total which functions as the profit (this is very similar to the markup pricing model where we take the costs and mark it up by a certain percentage). There are probably scenarios where it makes sense to use Cost-Plus pricing. For example, if you had no idea what consumer demand was, had no idea what competitors were charging, and you wanted to try to make profit margins as uniform as possible across various products and various time frames, this might be an option. Further, if the business has to ‘sell’ customers, it’s one of the easiest pricing structures to explain, “Look, we get this car for $18,000 from the manufacturer. Another $1500 goes to the showroom, electric company, etc., and then I’m left with $500. I would love to be able to come down further but I can’t take another penny off or my kids aren’t going to have shoes to wear to school.”
Another option is a value based pricing scheme. In this model, a product is created with perceived value enhancements and prices are chosen to reflect that as opposed to historical pricing, competition, etc. For example, when Apple comes up with the iPhone, it doesn’t matter how inexpensively they created the product (Cost-plus pricing). They sure don’t care how much phones used to cost because in their estimation, an iPhone is so much better than any previous phones that they can charge far more. Further, they don’t even really care how much Samsung and company charge for their phones. They realize that there is perceived value in the Apple logo and so they can charge more (smart phones have become almost commodities so this is changing. A different example would be Nike charging hundreds more for nearly identical shoes without a swoosh from another brand.) As you might expect, this model works best when perceived value has been created that differentiates your product from a competitor.
Lest this turn into a boring econ lecture, I’ll try to move quickly to a third key pricing model. Most economoists would acknowledge that most of the time a Market-based or Competition-based pricing structure is the most efficient. In this model we’re looking at things like supply and demand, price elasticity/sensitivity, etc. The terms aren’t particularly important for our discussion. The key point is that when we’re dealing with competition where the products are similar, we have a market that is created and our pricing is driven largely by our competition. Suppose we have no preference between Shell and Arco gasoline. Suppose that both are on the same side of the road, equally accessible, equally clean, well-lighted, etc., and both are right next to each other, then we’re very likely to just buy gasoline from the cheaper of the two. The two will, by necessity, need to consider the pricing of the other gas station in setting their own prices.
This model is all the more true when we’re selling identical products. When someone goes to buy Pie Face on Amazon, they’re not making a decision between JoeBob’s Store or JaneDoe’s store. Half of the time they don’t even know that JoeBob or JaneDoe exist. They’re just buying the cheapest option (or, more likely, the buy box, which is very sensitive to pricing when all else is equal).
In the market-based economy that Amazon has created, we don’t have the liberty of a Cost-Plus model where we can just arbitrarily choose a dollar amount or percentage markup that we want. If we decide we want Cost plus 70% but the buy box is at your cost plus 50%, you’re out of luck. Further, we generally don’t have a value-added option because we’re selling identical products. On the contrary, what we’re trying to do is to make the maximum amount of profit that the market will bear. If we can get the buy box at $19.99 but not at $20, then we’re going to price at $19.99. It really doesn’t matter whether we paid $2 or $10 for the product. If the market will only allow for $19.99, then that’s all we can charge. Now, we might make a determination that in a few months the market is likely to bear $29.99 and so we might choose to not charge $19.99, but again, this doesn’t hinge on whether we paid $2 or $10 for the item.
The salient point: In a competitive market, our pricing strategy is ALWAYS based on what the Market will bear and NEVER based on what you happened to have paid for an item.
There’s an economic term for using how much you paid for an item (that you cannot easily return) to impair your decision-making ability on how much to charge (it’s called the Sunk Cost Fallacy and I’ve written an article on it in the past). If you haven’t read that article, I encourage you to take some time reading it because it’s a very common fallacy that can really damage a business.
Now, back to Joshua. Let it be said that including pricing information or break-even information isn’t necessary harmful. It could be neat trivia. In that case, I would claim that it is taking up space from other useful information. However, most people don’t use this sort of information as ‘neat trivia.’ They use it to affect their pricing and usually to their own detriment. Here’s the thing, when you sell a Revlon brush, your goal should be to charge the maximum that the market will allow. So, if the market allows you to make $10 and you only make $8, then that’s a mistake in pricing (all else being equal). Similarly, if the maximum the market will allow you to sell a product for is a loss of $0.80 then it is a pricing mistake to price it at break-even. Remember, if we have good reason to believe that prices will rise in the future, then we might reasonably hold, but that decision making is not at all contingent on how much we paid for the product. The market doesn’t care whether you make a profit. Just because you need the price to rise 40 cents to breakeven does not mean that is a realistic expectation.
So, what should we do? At all times, we want to price in a way to get the maximum profit that the market will allow, both in the present and what the market might realistically allow in the near future, regardless of how much actual profit that makes for us.
When it is explained like this, I think most people nod and say, “Of course, Mike, I know I’m going to try to make as much money on a product as I can and if there is a loss, I’m going to try to lose as little as possible.” But, this is where sunk cost fallacy creeps in. People see that their break-even price is at $21.40 and the market is only allowing $20.99. Because of loss-aversion, they cannot bring themselves to charge $20.99. They just start hoping. “If I wait long enough,” they say to themselves, “then the price will come back to $21.40” despite having any rationale for this thinking. While they’re sitting around hoping to eventually break-even, the price continues to drop.
I used to be a professional poker player and this is probably the most common thing in an entire casino. A person will sit down at a BlackJack table with $300. They’ll play until it’s about time to leave and they’ll realize that they only have $295 in front of them. Do they pick up the $295 and leave? Of course not. If people did that, casinos likely wouldn’t exist and poker rooms certainly wouldn’t exist. Instead they try to get “their” $5. So they lose a few hands and pretty soon they’re down to $200 and their wife is ready to leave. Do they pick up their $200 and leave? Nope. Now they need to win $100 to get “their money” back. They bet $100 and lose. Now they only have $100 in front of them and they’re pretty irritated. Their wife has told them that they’re going to the car and they better be their soon. He figures luck has been against him so far, but it’s about to turn. If he can just double up twice, he can actually leave with $100 more than he started and show his wife! Unfortunately, he loses again. Now he has $0 in front of him. Mad that he had $295 just 5 minutes ago and now has zero, he jogs over to the ATM, withdraws $300 for one final double-or-nothing bet. When he wins, he gets to go home breaking-even. Guess what. He doesn’t win. When all is said and done, he ends up down $600 all because he wanted $5 more to “break-even”.
In gambling and in business, loss aversion (ie. the desire to do break-even or better) is deadly and will ultimately cost you money. So, I implore you, break free from the terrible plague of loss aversion. Realize that you’re going to buy and sell a ton of products. When all is said and done, you’re going to profit, but along the way you might make some mistakes and lose money. Do your best to charge the maximum allowed by the market on any given product, and fight any and all urges to let sunk cost dictate your pricing decisions. There is no advantage to trying to break-even, only potential for great loss as our unfortunate BlackJack player learned.
As Always, Best Wishes