Understanding Velocity-Based Pricing – A Preliminary Investigation
In the age of big data, sales velocity has become a metric for guiding pricing decisions. Vendavo, Pros, Zilliant, Model N, Vistaar, and other pricing software vendors all cite sales velocity as an important factor in guiding pricing decisions. Fortune 500 and mid-tier firms alike are known to practice it (they will remain unnamed to protect their customer relationships). But what does velocity-based pricing mean? Why should sales velocity influence pricing decisions? How should firms use sales velocity to inform pricing? And are there serious pitfalls to this approach, or is it a sound business practice?
After talking to a number of executives of multi-product firms, I interviewed pricing scientists, marketing executives, and sales representatives of these leading vendors of price optimization and management software to compare and contrast their viewpoints on velocity-based pricing. In terms of definition I found near-perfect symmetry, as well as across-the-board agreement that the system works. As for why it works, however, there appeared to be little consensus.
What is Velocity-Based Pricing?
Velocity-based pricing is adjusting the price or margin of products based upon their sales velocity. Sales velocity itself has been found to be somewhat undefined. Common metrics executives use include number of units sold per unit of time, revenue dollars per unit of time, inventory turns per unit of time, and others. In general: frequently purchased, fast-moving goods have a high sales velocity; infrequently purchased, slow-moving goods have a low sales velocity.
This definition, or variants thereof, prevails among all pricing software vendors. It is simple and rather uncontroversial. While it broadly defines the practice, it fails to provide any guidance on when, how, or why prices should be adjusted with sales velocity. On these questions, there is much to be codified.
Who Uses Velocity-Based Pricing?
Velocity-based pricing is practiced by both distributors and manufacturers of products, though appears to be more prevalent among distributors than manufacturers.
It is often practiced by firms selling goods, both tangible and intangible. Though my research is far from exhaustive, it was not detected by firms selling services in which direct human effort constituted a major portion of the value offering, though in theory it could be used by service firms if the service was sufficiently pre-defined and productized.
Velocity-based pricing is practiced primarily among firms selling thousands to millions of different products, or SKUs (shop keeping units), and secondarily among firms selling just a handful of different products.
Though far from being an exhaustive list, industries in which it has been observed include: maintenance, repair and operations distributors, office supply distributors and manufacturers; narrow products line food producers (meat packing, flour milling, and milk processing); fabrication-based manufacturing (flash memory, semiconductors, sheet metal stamping); others.
How are Velocity and Margins Correlated?
As a general rule for velocity-based pricing, firm-level profits are believed to improve overall when, across the thousands to millions of products that the firm distributes or makes, the sales velocity of an individual item and the profit margins on that individual items are inversely correlated. In more common language, managers tend to suspect that firm-level profits are optimized when low-velocity items are associated with higher margins while high-velocity items are associated with lower margins.
While this is appears to be a dominant approach to maximizing firm-level profits with sales velocity, executives interviewed were not committed to this approach. That is, they were aware of many cases where individual products were priced in a manner violating the general rule of velocity-based pricing. Some low-velocity items were associated with lower margins and some high-velocity items were associated with higher margins by firms that used velocity-based pricing.
How Do Firms Implement Velocity-Based Pricing
Sales velocity was seen as one of many factors that could be used to guide pricing decisions. None of the pricing software vendors used sales velocity alone to guide pricing decisions among multi-product vendors. Executives at firms which practice velocity-based pricing similarly were willing to violate the general rule of velocity-based pricing.
As one pricing software vendor indicated, sales velocity can be one of many important factors in optimizing pricing decisions. The approach his firm takes is one of indifference to the relationship between sales velocity margins. He stated that while using sales velocity to make pricing decisions has been empirically found to improve firm level profits, he was indifferent as to whether high- or low-velocity products should receive high or low margins. Sales velocity is just one of many independent variables used by the software’s algorithms to optimize profits.
As a cautionary note, another pricing software vendor mentioned sales velocity as a proxy for pricing suffers from a challenge of correlation without causation. That is, sales velocity is sometimes found to be inversely correlated with margins due to historical pricing practices but provide little predictive strength as to where prices should be because sales velocity alone fails to predict customer’s willingness to pay. Disentangling cause and effect remains a challenge and a point of inquiry.
An approach to using sales velocity to optimize prices across a multiple items involves
- Capturing all transactional history for the past two years at the customer level, including customer market segment descriptors such as
- Customer type
- Customer geography
- Customer size
- Customer wallet share
- Scoring the data to identify not just customer segmentation issues but also issues such as
- Price variances
- Purchase frequency
- Order size
- Order combinations
- Conducting a cluster analysis using all independent variables to identify commonality in the price elasticity of demand or price elasticity of wins across products. It is in this step that sales velocity is often revealed as an important parameter.
- Adjusting prices across products according to the elasticity of demand detected for the cluster in which that product lies.
Note: the above implementation has been done many times using SPSS or Minitab by persons skilled in pricing and statistical analysis. A major value of pricing software implementations over custom efforts is in their automation and repeatability. The value of custom efforts is in evaluating this approach in contrast with others prior to implementing software and standardizing a procedure which may not benefit the firm. Executives often choose a custom effort prior to implementing software in following the old saw “walk before you run”.
Why Have Firms Seen Profits Improve with Velocity-Based Pricing?
While sales velocity may be an important parameter for adjusting prices, none of the pricing vendors were able to definitively state why it is important or why margins and sales velocity should be inversely correlated–only that it was empirically found to improve firm-level profits. One vendor was actually quite adamant about being agnostic about why. That agnostic vendor didn’t care if sales velocity and margins were positively correlated, negatively correlated, or uncorrelated; he only claimed that it was an important parameter within their algorithm.
So why does velocity-based pricing work? From a customer perspective, why should they be willing to grant a distributor or manufacturer higher margins on a low-velocity item than a high-velocity item? Don’t they really just care about value, where the value they care about is the total benefits they receive less the price they pay?
In talking with pricing professionals, vendors, and academics, they readily identified numerous competing conjectures as to why velocity-based pricing improves firm-level profits. These include:
- It is a Simple Proxy Metric for Willingness to Pay: More detailed customer-based pricing focused research may more accurately identify optimal prices, yet such an approach is often cost prohibitive for all products which a distributor carriers or manufacturer produces. As such, firms may selectively price a few items within their product lines through more detailed research approaches where the opportunity costs of misaligned pricing are high, while using sales velocity as a proxy measure for the remaining products. In this sense, it is like retailers offering senior discounts wherein age is often inversely correlated with willingness to pay because it is an easy to detect metric and not necessarily because it is the most reliable or most accurate metric.
- Adjusting to Price Transparency and Opacity: High-velocity items are items which customers may use to “benchmark” a distributor’s or manufacturer’s prices, similar to signpost pricing in consumer markets. As such, distributors and manufacturers may be using sales velocity as a proxy measure of price transparency. For example, an office products company may price reams of office paper extremely competitively to “capture a customer” while pricing literature stands with a relatively higher margins since customers are unlikely to compare prices for literature stands across vendors.
- Better Asset Utilization: Profits earned from a common fixed-cost asset used in distributing or producing multiple items can be enhanced by increasing the use of that asset by high-velocity products, therefore margins on high- and low-velocity items should be adjusted to improve the overall profitability of the common fixed-cost asset. See this note on beer production and velocity-based pricing by Vendavo for an example.
- Capturing the Value of Offering Rare Items. Low-velocity items may be difficult to find by customers, therefore customers may be willing to pay more, in relative terms, to a distributor or manufacture for low-velocity products for holding them and being able to deliver a hard-to-find item in a quick turnaround. From an internal viewpoint, it may be perceived as a means to adjust the margins on infrequently purchased items to account for the risk a company bears in holding an item that may not be sold due to its rarity and infrequency of purchase.
- Addressing Competitive Pressures: High velocity items are items in high demand. As such, many competitors will seek to serve that demand. With numerous competitors each seeking to serve the same market demand, high velocity items tend to become commoditized and margins are driven lower with the more commodity-like high-velocity items than the low-velocity items.
If a rule is empirically suspected to improve profits but the jury is out on the issue of why and the academic evidence is absent, what should executives do? Many have taken the leap of faith and implemented this technique, while others have waited for more clarity and evidence. For myself, it is a call to research.
Executives — I Need Your Opinion.
If you have used velocity-based pricing, I would like to hear your opinion. If you have not used velocity-based pricing but are familiar with the term, I would also like to hear from you. We are conducting research through DePaul University in conjunction with PwC on the prevalence and value of velocity-based pricing. All responses will be treated as confidential. Please contact me at [email protected]