This post is by James Thomson, Partner of Buybox Experts, a consultancy supporting brands selling on Amazon and other marketplaces. James is also president of PROSPER Show, a continuing education conference focused on developing training and best-practice materials for early-stage online sellers.
Why is it so hard to get your pricing right on Amazon?
You want to win the sale, but you also want to make profit. Any decent MBA student will tell you that no matter how skilled a business owner is at building, marketing and distributing products, only those efforts around pricing will bring revenue (and hopefully profits) into your business.
Correspondingly, no matter how attractive the Amazon marketplace may look to a third-party seller, long-term success is not possible without a comprehensive understanding of how to price products profitably. Unfortunately, the vast majority of retailers/sellers – whether online or brick and mortar – under-invest in building effective pricing strategies. But we can fix that right here, right now.
Having worked first-hand with several thousands of Amazon sellers over my tenure in Amazon’s marketplace business and later as a consultant, I am comfortable saying that pricing is easily the most miscalculated, under-optimized activity of Amazon sellers every day.
When Web Retailer asked me to write about effective ways to price on Amazon, I was excited about the opportunity to discuss what actions and insight enable sellers to use “strategic pricing” to drive their businesses towards superior margins.
General Approaches to Pricing
Let’s start with a review of pricing approaches commonly used in retail settings. There are basically three overarching approaches to pricing. You can use:
- Competitor-driven pricing,
- Cost-driven pricing, or
- Value-driven pricing.
If you use competitor-driven pricing, you gauge what other sellers are doing with their pricing, and you try to stay aligned (using some standard range above, at, or below their prices).
While you need to be aware of competitors’ general prices, the competitor-driven pricing assumes that a) your competitors know that they are doing with their own pricing, b) you have a cost structure consistent with your competitors, and c) your business objectives are consistent with your competitors.
If any of those three aren’t true, you’re likely in trouble and not going to make the levels of profit you expect or deserve for the risks you are absorbing as a seller. Now look at many of your competitors on Amazon: how often would is it fair to say that these three implicit assumptions are not all true?
If you use cost-driven pricing, you’re taking your own costs, marking them up some level, and using that as your means for pricing. The challenges you may face here are a) you may not be explicitly including all of your costs, b) your costs may be very different than those of much more efficient competitors, or competitors with more buying power, or c) customers don’t care about your costs – they care about the value that the product bring them.
Cost-driven pricing is a very common approach on Amazon, with sellers buying products, marking them up some fixed amount, and holding on for dear life, hoping that positive profitability follows.
If you use value-driven pricing, you’re trying to establish some overall value that customers get from your products. Essentially, you’re assuming your products are so positively differentiated from alternative offerings that you are able to extract higher prices from customers.
The primary challenge with this approach is that, with more than two million sellers on Amazon, there already exists a massive catalog of alternatives for most products, including well-known national brands. So unless you have an exclusive sourcing relationship on a brand that everyone wants, you’re not likely going to get unusually higher prices from customers.
Instead, we are seeing a lot of sellers able to make more margins because they own and develop the brands they are selling – so by sourcing directly from the manufacturers, the sellers get products at much lower costs, giving themselves more margin opportunity, even when pricing competitively with similar products in the Amazon catalog.
So, let’s review the market conditions on Amazon:
- Competition continues to grow, with more than 100,000 new sellers joining Amazon each year.
- The number of competitors with business costs lower than yours continues to grow.
- The number of product alternatives for almost every brand and category also expands rapidly each year.
- It’s getting easier every day for companies to develop and source their own brands.
- Customers are getting more sophisticated with finding good deals, and asking questions about how products differ from one another.
- Amazon’s return policy favors the customer, who can try out products, only to return them immediately if not fully satisfied.
- The recent advent of inexpensive third-party re-pricing tools (combined with sellers not fully factoring in all appropriate costs) is leading to the downward spiralling situation where too many sellers are actually unknowingly chasing sales units and sales revenue ahead of positive margin.
The Buy Box
To understand which pricing approach makes most sense, we must first understand Amazon’s Buy Box – the mechanism used to decide which offer among competitors will be “awarded” the sale when the customer decides to buy a product, and clicks the “Add to Cart” button.
Because Amazon prefers to display all competitive offers of the same product on a single product detail page (rather than let each seller create a separate product detail page for its own offer), it is critical for each seller to know how competitive offers are getting displayed, ranked and given priority by Amazon.
Today, over 90% of all sales in non-media categories go to the seller whose offer is “in the Buy Box”, meaning its product will be added to the customer’s cart when the customer clicks the “Add to Cart” button.
In the example above, the company Buy 4 Less Shop is the Buy Box winner, such that when a customer clicks on the “Add to Cart” button, a unit of product from this seller will be added to the customer’s cart, rather than a unit from any of the other sellers with offers on this same item.
Bottom line survival on Amazon: if you’re not driving towards winning the Buy Box, your business on Amazon isn’t going to flourish, regardless of your choice of pricing strategy.
Unlike most sales channels where, if you offer a product at one price, anyone with a higher price for the same product is likely to get less traffic, that’s not necessarily the case on Amazon. So what factors impact your ability to win the Buy Box on Amazon?
There are five major factors to consider:
- Initial Sales Volume,
- Type of order fulfillment used,
- Customer Metrics,
- Amazon Retail offers, and
- Pricing (that’s right, Pricing is only one of the factors)
Initial Sales Volume
When a seller joins the Amazon platform, that seller’s offers won’t be eligible to win the Buy Box until the seller has generated enough sales history on Amazon that Amazon gets comfortable enough to enable the seller to win the Buy Box.
It’s basically a probational period during which this new seller with an unknown history of meeting Amazon’s high bar of performance gets to show that it is ready for the bigger sales opportunities that come with being eligible to win the Buy Box.
The problem initially, though, is for the seller to get any sales when it’s not yet eligible for the Buy Box, that seller is likely going to need to price much lower than competitors to get customers to select that new seller’s offer ahead of offers from any of the Buy Box-eligible sellers. Or this new seller is going to have leverage social media activity off Amazon to drive customers to its offers on Amazon, thereby generating some initial sales (and opportunities to show Amazon that the seller can perform at the high-enough level to warrant Buy Box eligibility).
Type of Order Fulfillment Used
Fortunately, a new seller can rapidly accelerate its path to Buy Box eligibility by putting its offers into Amazon’s Fulfillment by Amazon (FBA) program. Now, because Amazon handles the order fulfillment process for customers, a lot of new-seller risk is removed: Amazon has the seller’s product in hand and actually available for sale, and can ensure that it’s shipped out to customers on time with a corresponding order confirmation sent to customers.
Amazon likes controlling this order fulfillment process so much that it has updated its Buy Box algorithm to favor offers that are in FBA ahead of offers fulfilled by sellers, all other issues being equal. So, if a new seller wants to start off quickly on Amazon, it basically has to use FBA.
In fact, whether new or existing to Amazon, every seller must recognize that there is a very high cost of not using FBA, as the use of FBA has such a positive correlation with a seller’s ability to win the Buy Box.
Furthermore, because Amazon customers can easily filter products to those that are eligible for Prime or Super-Saver Shipping (products using FBA qualify for both), any product that doesn’t use FBA could get suppressed from a customer’s consideration set, even though that product’s price may be much lower to competitors’ products fulfilled through FBA. Yes, Amazon has forced the hand of sellers to use FBA; but this way, Amazon is able to create a more consistent, high-quality order fulfillment process for all of its customers.
Because being eligible to win the Buy Box is a privilege – rather than a right – every seller on Amazon has to meet minimum performance requirements on Amazon.
There are six major types of performance criteria on which each seller must meet to earn a clean bill of health from Amazon: order defect rate, cancellation rate, late shipment rate, on-time delivery, contact response time, and policy violations.
- The order defect rate is a single metric that looks at what portion of orders has received a negative feedback, an A-to-z Guarantee claim or a service credit card charge-back.
- The cancellation rate looks at what percentage of orders a seller had to cancel before shipping
- The late shipment rate looks at what proportion of orders aren’t shipped out within Amazon’s acceptable timeframe.
- On-time delivery tracks whether a seller’s orders arrive to customers during the promised delivery timeframe.
- Contact response time evaluates whether the seller responds to each customer inquiry within 24 hours.
- Policy violations encapsulate all other issues a seller may have with its account, including inappropriate communication to customers or competitors, and unacceptable product quality (counterfeit, illegal or Amazon-regulated products).
While I refer interested readers directly to Amazon’s Seller Central for exact performance levels of each of these criteria, the important issue here is that a seller can lose their ability to win the Buy Box – regardless of its pricing strategy – if the seller doesn’t meet Amazon’s performance criteria.
If Amazon’s own retail business carries a specific product, it’s more than likely that it will keep lowering its price to whatever level needed to win the Buy Box over a third-party seller’s offer, even if it means that Amazon Retail loses money on that transaction. This point is very important to know, as it’s extremely difficult to compete directly with Amazon Retail.
Typically, Amazon Retail is able to update its prices at least once every 30-60 minutes, so Amazon can respond quickly to any pricing change you make with a pricing change of its own. Yes, we know some sellers have figured out ways to update their pricing within that 30-60 minute range so as to beat Amazon Retail for the Buy Box for at least some small portion of the time.
But realistically, unless Amazon Retail has stock-out problems with items, it’s not likely that you are going to win the Buy Box on products where Amazon Retail is your competitor – even if you price lower than Amazon.
Making problems worse: chances are Amazon Retail has more buying power than you, so can source the product at a lower cost than you. With Amazon Retail’s own internal operations costs likely lower than yours, it again can afford to offer lower prices to customers and likely eke out a profit where you could not.
And finally, Amazon Retail does more sales volume than you, so can afford to make less profit per transaction and still come out ahead in the end. Bottom line – it’s really hard to get profitable sales when you compete directly with Amazon.
Oh right, pricing. Here we are at issue number five, and only now do we bother worrying about your choice of pricing strategy.
So whether you price high/medium/low, or whether you price for big margins, low margins, no margins or negative margins, there are all of these other issues that will impact whether your prices even matter as part of the likelihood you win the Buy Box.
But of course, pricing does matter: and you need to know that the prices of competitive offers on the same items are grouped into zones of indifference. Basically, the Buy Box algorithm will crunch all of these five Buy Box factors, including price levels, and identify if there is more than one Buy Box-eligible seller that has a price level within a tight range.
If there is more than one such seller, those sellers’ offers will likely take turns winning the Buy Box. That zone of indifference among Buy Box-eligible sellers will vary depending on whether one of the sellers is Amazon Retail, whether the sellers are using FBA, and what the actual prices of the sellers are. Basically some range between 1-8% is typically possible for offers from Buy Box-eligible sellers to qualify for Buy Box rotation.
So all of those tradeoffs of using one pricing approach over another get put under more stress when you realize that the Buy Box algorithm is basically a mechanism that says that it doesn’t matter how high or low a seller prices its product, the seller first has to earn its way into having its product offer evaluated for consideration to win that coveted Buy Box.
If you aren’t factoring in all of your costs today, most likely:
- You are stuck with too much slow-moving, low-margin inventory.
- You will run out of capital to invest in inventory that would actually benefit your bottom line.
- You are allowing your suppliers to dictate terms that may be hurting your business.
- You spend your time working really hard to make money for yourself, only to find you made a lot of money primarily for Amazon.
Let’s assume your products are eligible for the Buy Box. What should you do to price more effectively on Amazon? How will your cost structure play into pricing for success on Amazon?
I think of a seller’s business not as one business, but many businesses – in fact, every product should be evaluated in terms of its own P&L – it has different costs, competitors, competitive alternatives, customer demand, and so on.
If you clump your whole catalog into one overall business, you will almost miss out on clearly understanding where you are making profits, and where you are bleeding. And that means you’ll probably spend your time trying to grow your overall business, rather than focusing on growing the profitable portions of your business, while reducing the unprofitable portions of your business.
If you take the approach of looking at your business as a collection of individual products, each with its own dynamics, you can pinpoint your efforts much more effectively, and price accordingly. I call this strategic pricing.
With strategic pricing, you develop a SKU-level profitability model for each product in your catalog. Then you make pricing decisions that will grow your profits faster than you can grow your sales revenue. If you know the profitability of each SKU in your catalog, you can make much better decisions about which products to continue sourcing, how to negotiate with vendors (more volume vs. lower prices vs. more selective sourcing), what to do with existing inventory you have on-hand, and when to hold off a pursing a sale in order to make profits later.
Start with your product acquisition cost – what did you pay your supplier for the product? Did you pay extra for shipping, customs, or payment wiring? What did Amazon charge you for sales commissions?
All of these are the typical costs that Amazon sellers use for calculating margins. But many more costs are needed: we must layer in less obvious Amazon costs (including state tax collection fees, returns-related commissions, FBA fees related to customer return shipping costs, FBA storage fees), your own returns-related fees (including product write-down/write-off fees, handling fees, return shipping/disposal fees) and finally your overhead allocation costs.
If you factor in all your costs, that should help you figure out the floor price at which you can operate profitably. Your competitor’s prices – or more exactly, the prices of your Buy Box-eligible competitors – should help you identify the upper range (though sometimes up to 10% higher than these Buy Box-eligible competitors’ prices).
Only now are you really ready to be using re-pricing tools to automate the process of adjusting your prices with an acceptable range so as to compete with your competitors for the Buy Box, but remain in positive margin territory at all times. For more information on specific external repricing solution providers, see Web Retailer’s repricing guide.
Example of Impact of Indirect Costs
Let’s say you sell an item on Amazon for $80/unit – you paid pay $50 plus $5 shipping per unit. Amazon charges you 15% commission plus $2.50 for FBA fees. You net out $80 – $50 – $5 – $12.50 (15% of $80) – $2.50 = $10 apparent profit on this item.
But, what about an overhead allocation cost of, say, $2/unit?
And let’s assume this SKU has a 25% return rate, where you recover only 60% of the expected new selling price, due to customers returning products rarely in new condition, or in its original packaging. So return-related costs are 25% x (1 – 60%) x $50 wholesale cost/unit = $5/unit.
On all returns, Amazon keeps 20% of the original commission as a return fee. So add 25% (return rate) x 20% (Amazon return fee) x $12.50 (original commission) = $0.63/unit.
So for a product you have refunded once and then sell, your apparent profit of $10.00 has fallen to $10 – ($2 + $5 + $0.63) = $2.37, a drop of more than 75% of your believed profit on this item.
And, if that product is a softlines item (clothing etc.), you’ll have to add the cost of paying the customer’s return shipping to the FBA fulfillment center (e.g., $2.50). You could easily find yourself actually underwater on a product you initially thought was contributing $10 of margin to your business.
Tools For Strategic Pricing
If you want to know your SKU-level profitability, you will need data from your own business, and data from Amazon. Compile your overhead cost data by looking at all of your costs of keeping your business open, including wages, warehousing, research, travel, book-keeping, product samples, IT, insurance, licensing and so on.
Add up these costs from the past 12 months, and divide by the total number of orders your business has fulfilled. This will give you an overhead cost per order fulfilled. And if some of these costs were Amazon-specific (like FBA placement fees, Amazon Lending fees), you may want to adjust to make sure you have an overhead cost per order for Amazon orders, vs. non-Amazon orders.
Then you need to know all of your Amazon fees. The easiest place to start is to pull three reports out of Seller Central:
- Reports → Payments → All Statements View.
- Reports → Fulfillment → All Orders.
- Reports → Fulfillment → Returns.
While it’s challenging to do so with these three reports, you can untangle all Amazon-related costs per order and/or per SKU.
Combining all of your internal costs with Amazon costs, you’ll quickly find that many of the SKUs in your catalog are actually losing you money. So why are you are continuing to carry these items? If you can negotiate lower prices from your suppliers, or get sales with higher prices on Amazon, you may be able to shift into positive margin territory. Otherwise, it’s probably time to stop selling those specific items.
Likewise, this same analysis will reveal which SKUs make you very solid positive margins – ask yourself what you are doing to avoid ever stocking-out of those items, what you are doing to protect these items from competitor sourcing, and what you can do to bring in more items just like these to improve your overall profitability.
For automated support on all of these calculations, check out Teikametrics for the profitability of your FBA catalog, or SKUProfit (which I co-founded) for profitability calculations across your whole Amazon business.
Get strategic now with your pricing on Amazon. Here’s a winning combination to drive your profits:
- Maintain solid customer metrics: only then do your pricing decisions matter.
- Figure out and apply your overhead allocation to each SKU you carry.
- Re-examine whether each SKU you currently carry is, in fact, profitable from a total-costs perspective. Modify your approach to sourcing new products so as to keep total-cost profitability clearly in mind.
- Only once you understand your all-in costs should you use repricing software.
Focus on growing your profits faster than your sales revenue. Selling on Amazon should be about you making money, not Amazon. Prioritize your profits over your sales!
Aspects of this paper are based on a June 2015 IRCE presentation by James Thomson with Nathan Franco of Limited Goods.
In previous roles, James was the former head of Amazon Services (a division of Amazon that recruits 100,000 new sellers to the Amazon marketplace each year), the first FBA account manager, a banker and management consultant. He earned a Ph.D. in Marketing from the Kellogg School at Northwestern University.