Price management is costly, but well worth the investment

September 1, 2003
By Emily Kay

Two weeks after launching a multi-million-dollar price-optimization project, Northern Group Retail Ltd. achieved $60,000 additional gross margin on one product by replacing a hunch with technology. The 278-store Canadian apparel retailer would have typically reduced the price of winter outerwear by 30% during the 2002 holiday shopping season, but instead followed the recommendation of its ProfitLogic Pricing4Profit price-optimization software and kept the merchandise at full price.

"Traditionally, companies mark down items before Christmas," says Antony Karabus, chief executive of Karabus Management Inc., a retail consulting firm based in Toronto, Ontario, Canada, that helped Northern deploy Pricing4Profit. "The system told them, based on consumer demand, to sell at full price. They trusted the system and got a much more meaningful margin."

The technology employs "advanced statistical modeling, forecasting, data mining, pattern recognition, and optimization techniques" that help companies determine how to achieve merchandising, financial and operational goals, says Greg Girard, vice president of retail strategies with AMR Research Inc., Boston.

The "science" of price optimization is replacing what has been an "art form," says Eric Mitchell, president of the Professional Pricing Society in Atlanta, Ga.

Implementation and adoption challenges
Software that lets companies optimize pricing to maximize revenues and profits is not new. Airlines first employed it to maximize profits by modifying seat prices on flights. Yet, despite airlines’ and a handful of retailers’ successes, retail-specific technology is relatively new. ProfitLogic, DemandTec Inc., KhiMetrics Inc., and Spotlight Solutions Inc. sales account for more than 80% of the nascent market, according to Girard.

That the software goes by several different names-including retail merchandise optimization, price optimization, enterprise profit optimization, margin optimization, and demand and revenue management-may help explain the lack of widespread deployment. AMR, for example, groups price-optimization functionality under "retail revenue management." To Karabus, "merchandise optimization"-which he says describes the new breed of dynamic, predictive software that fosters decision-making based on current customer demand patterns-represents the most proven of several emerging optimization systems that include promotional planning, initial price optimization, assortment planning, replenishment and allocation.

"There are definitely organizations we run into where there's confusion at first glance," concedes Garrett Sinclair, vice president of marketing and strategic initiatives with Spotlight Solutions in Mason, Ohio. Additionally, drug store and grocery chains, which offer products with long life cycles, require different solutions than apparel retailers, mass merchants and computer manufacturers, all of which sell products with short life cycles. Cambridge, Mass.-based ProfitLogic, for example, offers software that helps retailers mark down non-negotiated prices for seasonal items such as Halloween candy. Metreo Inc. aids industrial manufacturers in optimizing negotiated pricing for industrial products such as electrical control and power distribution equipment, says Daphne Carmeli, co-founder, president, and CEO of Metreo in Palo Alto, Calif.

Such systems don't function in a vacuum. They must tightly interoperate with purchasing, replenishment and other enterprise and supply chain operations, says Kevin Scott, an AMR senior research analyst. Pricers also need access to at least two years of historical, accurate and timely data on sales, pricing, inventory and margin, adds Todd Hassell, manager of retail revenue management solutions with BearingPoint Inc., a business consulting and integration firm in McLean, Va.

The challenges of implementing the technology, however, are secondary to organizational, process and change-management issues. "It's not about systems implementation; that's the easier part," says Karabus. "It's more about change management, changing processes and rules and getting people to buy in to how they do business will change, how their roles will change, and that a powerful machine is better at analyzing huge mounds of data than any human being can be."

To be sure, organizations in which merchants traditionally make decisions may resist strategic pricing projects. "There's a lot of reluctance to hand over at least part of the decision-making process to software applications because merchants feel they're the experts and they've been doing it for years," says Hassell.

Companies dealing with a poor economy may also shy away from buying price-optimization software from small, privately funded suppliers with little real-world experience. "Coming out of the ’dot bombs‘ and with other companies no longer in business," skepticism is natural, says a marketing executive with a global airfreight company who declines to be identified.

More established vendors Manugistics Group Inc. and i2 Technologies Inc. offer their own price-optimization solutions. Keenly aware of the smaller suppliers’ successes, other mature applications players are sure to join the fray. "There's a lot of interest from major software firms such as PeopleSoft, SAP, and SAS Institute," says Mitchell.

With so many startups actively selling, and larger suppliers eyeing the market, a shakeout is likely. "We've seen increased interest among venture companies and larger application companies to acquire smaller vendors," says Girard. "A consolidation is inevitable." A sizeable, unnamed applications vendor considers KhiMetrics in Scottsdale, Ariz., and Spotlight Solutions to be attractive acquisition targets, notes Girard, who adds that such activity exacerbates risk when companies "combine architectures and products."

Inking beneficial contracts is one way to avoid potential pitfalls of buying solutions from less established vendors. The airfreight firm, for example, insisted on sharing risks and gains with its supplier, and ensured it would eventually own the software.

The next big thing
These days, companies increasingly recognize the need for top-line results, which they can't achieve with current price-setting approaches. The enormous amounts of available information and its sources are growing so fast that company analysts and sales managers must replace spreadsheets with price-optimization technology, says Scott. "Without a centralized database and repository of rules, it would be impossible to successfully manage [demand management, yield management or price/order management], let alone all three," he states

Even merchants skeptical of handing over decision-making to software recognize the enormity of the pricing challenge. Before Hewlett-Packard Co.'s North American Unix Server Group deployed Rapt Inc.'s Price Director, product managers and pricing analysts used spreadsheets to support pricing strategies involving thousands of configurations for hundreds of hardware products. To enhance profits and boost market share, the company needed a more sophisticated approach to devising pricing strategies for existing products before introducing new ones and linking anticipated buyer behavior with product lines throughout the supply chain .

"We had no way to really understand the customer's response to pricing, go to the next level to optimize pricing and fine tune it, and be more strategic in the timing of our pricing decisions," says Monica Lasgoity, HP's senior financial analyst of business critical systems for the Americas in Cupertino, Calif.

While the $1 million to $5 million price tag for price-optimization projects is daunting, some observers believe such solutions would be less popular in a better economy because companies have done all they can to enhance their supply chains by cutting costs. "When the market tanks, companies completely retrench and cut costs as far as they can be cut," says Carmeli. "When they think about the top line, that's where price comes in. Price is the number one profit lever in any company."

Several studies show "a 1% improvement in price drives a 7.5% improvement in profit and a 1% improvement in inventory management drives about a 3% improvement in profit," Carmeli adds. In a sound economy, many companies "wouldn't be focused on price nearly as much with this kind of aggressiveness, and would not have made price a strategic imperative."

AMR's Scott confirms that few companies other than airlines and hotels even considered pricing software two years ago. "Now, after a few early implementations estimating returns in the millions," he says, "companies are looking at pricing applications as a way to do the unthinkable in a sluggish economy: Grow profits by increasing revenue, not cutting costs."

Software suppliers are enjoying the fruits of such interest. Since the start of the year, demand and revenue management products represent one third of Manugistics' $310.1 million business, says Neil Hooper, the company's group vice president of demand and revenue management in Rockville, Md. "A lot of this is new sales activity, but it is an enormous shift," he says. "It's the hottest thing we have going right now."

Vendors report a slew of potential customers. Claiming six active customers including ShopKo Stores Inc., Sinclair says 20 additional retailers are evaluating Spotlight's software. ProfitLogic, which boasts nine big-name, operational customers-including J.C. Penney Co. Inc., Gap Inc., Bloomingdale's Inc., and The Home Depot Inc.-expects to announce five new customers in the fourth quarter, says Scott Friend, the firm's vice chairman and president.

Independent analysts’ findings support the escalating appeal of price­optimization solutions. AMR projects that the retail revenue management software will explode from $75 million in 2002 to $500 million by 2005 and $900 million by 2007. "Revenue management is poised to be an integral part of the next technology boom," says Scott. And while only 12% of respondents in a recent BearingPoint/National Retail Federation Foundation study say they use markdown-optimization software, 53% plan to deploy it within two years.

Quick ROI
Though few companies publicly discuss their price-optimization projects, it's clear that such technology can deliver tangible advantages. "It's incredible software. No software out there gets ROI this fast," says Karabus, who notes that companies can implement the software within 16 weeks and attain full payback within 12 months.

In a 10-week price-optimization trial involving six categories in 30 stores for a total of 1,600 SKUs, Longs Drug Stores Corp. deployed DemandTec 3 Price and Promotion to improve sales dollars 1.9% and enhance gross profit 5.1%, according to DemandTec. Published reports indicate that Spotlight's Markdown Optimizer helped $3.2 billion ShopKo post a 25% increase in gross margin dollars on markdown items during a software pilot.

While such gains are impressive, observers caution companies to maintain realistic expectations about how quickly the software can deliver benefits. "We saw improvements within two to three weeks, but not what we were hoping for," says the airfreight company's marketing manager.

Other variables, such as the economy, can wreak havoc on estimated results. Published accounts of HP increasing revenues by $15 million per quarter through better pricing decisions were too aggressive "because the whole economy's tanked since then," says Lasgoity. "That was an estimate for a worldwide number two years ago so we're not saying that now," she says.

Lasgoity expects that Price Director will still help HP achieve the same percentage return on revenues. She also believes that, while price-optimization projects are especially costly in today's economy, "the benefits, every step of the way, are well worth it."