The pricing strategy that you choose plays an important role in determining how profitable your business will be. You owe it to yourself to examine the various options available to you and pick the one that best matches your product, business strategy, and goals. In this post, we'll talk about a popular pricing strategy called velocity pricing and explain why many businesses have chosen to adopt it for their products.
What is velocity pricing?
Velocity pricing is defined as a pricing method that derives the price of a product or service off of the velocity of its stock turn. Under velocity pricing, the slower the turn of a product, the higher it is priced. Today, big data allows companies to analyze every aspect of their business. Machine learning algorithms will automatically account for variables and dissect the data at a very granular level. What this data has taught us is that velocity pricing works. Businesses that follow what the data has revealed can achieve increased revenue.
3 Reasons why velocity pricing is important
Understanding all of the pricing strategies available to you is always an important part of picking the best one for your situation. Examining a given pricing strategy, such as velocity pricing, causes you to engage in some thought processes that will help steer the direction of your business. Before we take a deeper look at this strategy, let's examine three reasons why it may be beneficial to your business.
- Defines business health and position - Every pricing strategy has pros, cons, situations where it works, and situations where it doesn't work. Examining a new pricing strategy forces you to take a close look at the health of your business and your current market position. Regardless of what pricing strategy you end up with, knowing more about where you are is the first step to getting where you want to be.
- Sets goals for the future - After you know where you are, the next step to getting where you want to be is deciding where that is. What are your goals? Only by having a clearly defined destination can you hope to reach it. Velocity pricing is known to increase revenues for companies who adopt it. If you've chosen to do the same, then setting a realistic goal of increased revenue in the near future is a good place to start.
- Increases revenue - We've already mentioned that the data shows an increase in revenue when velocity pricing is adopted. This is possibly the most important benefit that it can provide for you. Unlike other revenue growth methods, velocity pricing takes very little time and money to implement and yet it can yield results just as powerful as those other tactics. This frees up those resources for other things and makes your business more efficient.
Which industries use velocity pricing?
Velocity pricing relies on knowing, or being able to make a very educated guess about the total volume of sales that a given product does across an industry. For this reason, it is a strategy that works best for companies that sell high-volume products which can be reasonably grouped into categories for evaluation. It is used mostly by companies that sell thousands of products or more, though some companies with a smaller product portfolio have adopted it as well. Companies with a small number of products, or with a one-off or very niche products will not have as much success with the method.
Because of these realities, the companies that do the best with velocity pricing tend to be distributors. They have a catalog of high-volume products that are all easily classifiable. They also have their own in-house data on how all of these various product categories sell. Although the primary users of velocity pricing are distributors, the model has seen some adoption among manufacturers as well. It works equally well for firms that manufacture intangible items as it does for those that manufacture tangible items.
Below is just a small sampling of the types of industry that use velocity pricing
- Parts Distributors - These are large distributors that make parts for OEMs and repair shops that operate on a variety of different products around the country.
- Office Supply Distributors - In addition to office supply stores, these distributors sell directly to large companies that are outfitting huge office complexes and various contractors that are hired to do the same.
- Semiconductor Fabricators - There are only a few semiconductor fabricators in the world. These companies handle a massive amount of products that represent the bulk of semiconductors used by the world's largest technology companies.
How to calculate velocity pricing
Up until now, we've talked generically about how velocity pricing is calculated. Now it's time to talk about the actual numbers and where they come from. To calculate velocity pricing, you want to take the total dollar sales for a given product and divide that by the Annual Industry Volume where the product is selling—in other words, the collective annual industry sales of the stores that carry the item/brand/category.
You can see now why velocity pricing is recommended for people selling high-velocity products. Product categories that appeal to fewer people are priced higher to make up for the smaller sales number and products that fly off the shelves are priced lower and let volume make up the difference. This means that if your product is so niche that you are the only one selling it, then you will not have reliable data regarding the prices that people are willing to pay for that category of product.
Common examples of velocity pricing
Now that you have a good idea of what velocity pricing is and how to calculate it, let's take a look at some examples of how the strategy has been used so you'll be able to get a better idea of how it works in practice.
You can see a much more detailed analysis of this example in our blog post on the subject. There exists a large enough market for niche peanut butter products, such as fully organic or GMO free, to justify their sales. They do not have nearly the same sales velocity that regular peanut butter has. As a result of this, the more niche peanut butter is priced higher, regardless of whether it takes more to make it.
You see the same mechanism in business software, especially before software as a service became popular and the full cost of the software was presented up front. It may take millions of dollars to make a modern video game, but it sells for $50 or so. Compare that to the thousands of dollars that business class software can cost, and you'll see very quickly that they are being priced based on sales velocity.
In each of these cases, the people paying more for the niche product saw more value in it. Health-conscious eaters are going to prefer organic food and be willing to pay a premium for it. Businesses need software to make money and are therefore not as reluctant to pay high prices as a consumer would be.
Our take on velocity pricing
For the types of industry where the data is clean and dependable, setting price points based on sales velocity is a proven strategy. If you can get dependable data on product prices and sales figures across the industry, then velocity pricing is well worth implementing. One of the things that makes it a compelling strategy is that it looks at the prices that people are paying per unit, so it isn't concerned so much with hitting a specific profit margin, but is instead based on the value that consumers place on a category of product when they make their buying decisions.
Ultimately, product prices must match the value that consumers place on the product or it will not sell. One important thing to note in that regard is that pricing should never be a "set it and forget it" endeavor. Companies, on average, spend far too little time evaluating their pricing strategies. The same data that showed us the effectiveness of velocity pricing can also drive your own pricing decisions. Making use of it will guide you in tweaking whatever pricing strategy you end up with so that it maximizes your revenue.
Over time, velocity pricing should help companies with high-velocity products match prices with market demand in a more meaningful way, and increase the sales velocity of products that might not have been priced effectively. As velocities change in response to price alterations, the process must be repeated until an equilibrium is found. Even then, you should monitor your pricing strategy regularly.
Our free ProfitWell Metrics tool can give you many insights into how your business is working. These insights can help guide you in pricing decisions and aid you in your marketing efforts. If you are ready for a much more detailed analysis of your pricing strategy and a larger pool of data from which to draw conclusions, we invite you to check out our Price Intelligently service. We have been trusted to optimize the pricing of some of the largest software vendors in e-commerce.
Pricing software correctly can feel like a hit or miss problem, but it is a science to our team of experts and they are eager to get working on your pricing strategy. If you aren't sure whether velocity pricing is the right option for your product or your business, let our team of experts evaluate your current pricing model and make recommendations that will help you reach your revenue goals.