Pricing and revenue optimization (PRO) techniques have been used successfully by companies to improve profitability and meet strategic goals for more than 20 years. For many companies, PRO is probably the highest-value IT investment that they can make at the present time.
Posted Feb 28, 2002
Pricing and revenue optimization (PRO) techniques have been used successfully by companies to improve profitability and meet strategic goals for more than 20 years. Despite this success, some industries have yet to adopt PRO. Now, with the wealth of information provided by enterprise information and transaction systems, the rise of the internet and extended trading networks, and a new generation of PRO solutions, it is likely that PRO will become ubiquitous across industries. For many companies, PRO is probably the highest-value IT investment that they can make at the present time.
Scientifically Managing Prices
Pricing and revenue optimization enables a company to bring the same level of scientific analysis and organizational discipline to pricing decisions as it does to its financial decisions and its supply chain decisions. PRO manages prices dynamically through all sales channels to all customers based on costs, competitive actions, and what customers are willing to pay. This can help enable a company to achieve the highest level of return from its fixed asset base.
Simply put, for most companies, better management of pricing is the fastest and most cost-effective way to enhance profits. That was the conclusion of a pioneering study by McKinsey & Company as long ago as 1992. Examining the economics of more than 2,400 companies, the McKinsey researchers concluded that a 1% improvement in price creates an improvement in operating profit of more than 11%. By contrast, 1% improvements in variable cost, volume, and fixed cost produce profit improvements, respectively, of 7.8%, 3.3%, and 2.3%. And, as the McKinsey researchers note, given the enormous gains in profit from even small improvements in pricing, all companies could find some opportunities for improvement.
A Major Determinant of Profitability
Consider the following activities:
- A national account manager is negotiating an agreement with a major customer that will determine the discounts to be applied to all purchases by that customer for the next year.
- The pricing department is calculating list prices for the next catalog release.
- A local sales representative is deciding what price to quote in a competitive situation for a major deal.
- The marketing department is planning a promotional campaign aimed at gaining market share among large customers in the Northeast region.
- The eCommerce team is trying to determine what prices to display for key products on the corporate website as well as how to respond to RFQs being forwarded by an eCommerce broker.
- A special inter-departmental team is analyzing options for disposing of distressed inventory for a set of obsolete products.
What do these decisions have in common? They are all market-based activities focused on determining what products and services should be offered to which customers at what prices through which channels. Viewed in this light, these decisions are among the most critical that a company makes. They are major determinants of both corporate profitability and the ability of a company to achieve its strategic goals. Yet, too often, pricing decisions have been made in an uncoordinated fashion, based on inconsistent or incomplete data, and done with little or no analysis. The result is lost profitability as well as reduced ability to execute strategically.
Managing Pricing More Effectively
The discipline of pricing and revenue optimization and a new set of tools help enable a company to coordinate these decisions and help ensure that they are being performed in a way that optimizes profitability consistent with strategic goals. As a discipline, PRO is predicated on two fundamental principles.
1. All pricing decisions within a company should be managed consistently, utilizing the best information available, in order to enhance corporate profit and meet strategic goals.
2. In most cases, pricing decisions can be improved by the application of forecasting and optimization techniques.
Demand forecasting technologies - an essential element of PRO - have improved dramatically over the last few decades. Modern statistical analysis techniques, including neural networks and statistical classification algorithms such as classification and regression trees (CART), enable stable and predictable demand patterns to be extracted from voluminous sales data more effectively than ever before. Further, dynamic eCommerce applications have brought new flexibility to pricing. In this environment, the use of statistical analysis to forecast demand and to understand customer behavior, combined with advanced techniques used to calculate and update optimal prices, provides a powerful tool for helping to ensure that the right prices are being offered to the right customers at every point in time.
PRO powerfully complements customer relationship management (CRM), sales force automation (SFA), and enterprise resource planning (ERP) systems. CRM and ERP systems provide the data needed to support pricing and revenue optimization. CRM and SFA systems enable the rapid dissemination of recommended prices to the right players within the organization. But while CRM, SFA, and ERP systems are often critical pieces of IT infrastructure needed for consistent data flow and efficient business processes within an organization, PRO leads to directly measurable, improved decisions with bottom-line impact. PRO enables companies to drive real benefits from their customer information. Depending upon the industry and the company, successful PRO implementations have led to improvements in top-line revenue of 2 to 8%, with the majority of this improvement going directly to the bottom line.
Fundamentals of PRO
The fundamental PRO issue is: at each point in time, what products and services should we be offering to which customers at what prices through which channels? Keeping prices aligned with the market is a complex, dynamic process that may require continual adjustment of thousands or hundreds of thousands of prices through multiple channels. PRO helps ensure that this process is managed to enhance profitability across all decisions and channels. To do this, PRO considers the following factors:
- What is the underlying demand for the product? This requires a comprehensive demand forecasting model that can track historical demand and predict future demand, including seasonal and special-event driven impacts.
- How will customers respond to changes in prices for this product through different channels? This requires an analytic model that relates changes in price to changes in customer demand, including cross-price effects with other products. Advanced statistical techniques are required to establish parameters for the model and ensure that the parameters are continually updated to be consistent with recent market behavior.
- What are the variable costs of selling a product to a customer through a channel? This includes understanding product-specific, customer-specific, and channel-specific costs. For example, the channel costs of a product sold through a company's website may be
significantly lower than the channel costs of telesales.
- What are the opportunity costs of selling a product? Opportunity costs occur whenever a product is in constrained supply, which means that selling to a customer now may preclude selling the same product to a future customer. By incorporating opportunity costs explicitly in price, a company can use its constrained capacity or supply to serve the most profitable customers.
- What is the life cycle value associated with this product? Some industries have products with naturally short product life cycles - fashion items and consumer electronic products, for example - and their value declines rapidly with time. Other industries such as airlines and hotels have products that decline due to time-based availability. In these cases, the opportunity to maximize revenue exists at certain points in the life cycle. These dynamic conditions need to be explicitly incorporated in the calculation of price.
PRO systems integrate all of these elements to make a set of pricing and product availability recommendations that enhance profitability while considering the current and future opportunities for selling the product.
How PRO Works
The basic steps in the pricing optimization process are:
- Segment the market. Statistical clustering and categorization techniques are employed to determine stable and predictable market segments. For example, we may find that large corporate customers in the Northeast are less price-sensitive than small corporate customers in the West. This information can be useful in guiding the direct sales force or in planning and executing promotions. If there are strategic or institutional constraints on cross-segment price differentials, these constraints can be specified and honored.
- Estimate customer price response. For each customer segment and each product, powerful analytic techniques are used to estimate how that segment will respond to pricing changes for that product. For example, we may find that a 5% increase in price for a product will result in a 2.5% decrease in sales.
- Optimize prices. Based on the predicted customer responses, the system determines which prices to offer to which customers for each product through each channel in order to enhance profit, market share, or other strategic goals. It recommends the optimal prices -not the lowest prices - to achieve those goals.
- Learn and adapt. The system tracks customer responses to the price changes that you make and continuously 'learns' from the results. PRO systems are dynamic adaptive tools whose operation is based on continuous improvement.
PRO systems form part of the ongoing process of pricing, sales, and marketing support. They do not stand alone, but provide an indispensable set of capabilities for guiding pricing and revenue decisions.
Balancing Supply and Demand
In addition to their direct impact on profitability, PRO tools provide the critical missing link for many companies to balance their availability of supply with ever-changing demand. Historically, supply chain management solutions have been used to help companies meet their current and anticipated orders at the lowest cost. However, these solutions have generally accepted current and future demand as fixed and have adjusted supply and production decisions to meet this demand. PRO tools are designed to enable companies to manage the demand stream as well as the supply chain. By coordinating the two activities (a discipline known as Enterprise Profit Optimization™), companies can realize unprecedented levels of revenue and return on assets.
Increasing Pricing Efficiency
It is no secret that the velocity of pricing and marketing decisions is ever increasing. With the advent of the internet, companies that used to update their catalog prices once per quarter now have the capability to continuously update and distribute prices. RFQ streams are increasing and buyers expect response times measured in days or hours rather than weeks. Increasingly, companies need to be able to price efficiently and effectively in an ever-accelerating environment. The sheer volume of decisions necessitates automated decision-support tools. 'Time to price' and 'time to quote' are becoming as critical as 'time to market' in determining corporate success.
Fortunately, PRO solutions can help. By performing systematic analyses almost instantaneously for hundreds of thousands of customer/product combinations, they eliminate the need for manual, ad hoc spreadsheet analyses. By quickly producing price recommendations that are consistent with profit maximization and strategic goals, they also reduce the need for repetitive proposal review and appeal cycles. For example, a transportation company using Manugistics NetWORKS Target Pricing™ to support direct corporate sales saw its average 'time to quote' decrease by 2 to 3 days. This not only translated into better customer response, but also reduced costly sales overhead.
Bottom line: the ability to generate the right price for every customer in every situation in real time will become a critical competitive capability in most companies in the future.
The Solution: Manugistics Pricing and Revenue Optimization
Based on more than two decades of experience in some of the most demanding pricing environments imaginable, Manugistics Pricing and Revenue Optimization solutions are bringing the benefits of scientifically managed prices to a wide variety of industries. Manugistics PRO solutions address such critical pricing challenges as adjusting price lists in response to changing market conditions; predicting the optimal price for each component, module, or system in a competitive bid; and developing and targeting effective promotions for each product, customer segment, and distribution channel.
The spectrum of PRO decisions within a particular company will depend both on the industry it serves as well as on its sales and distribution strategy. In some cases, a company may have only a single pricing channel - for example, a price list. However, it is far more typical for a company to maintain several different pricing channels, each targeted at a different market segment. Consider the following examples:
- A major automobile manufacturer sells the majority of its cars and trucks through its dealer network. It establishes a standard wholesale price at which it sells the cars to dealers - a list pricing problem. However, once the list price is established, the manufacturer can offer promotions such as customer rebates, dealer rebates, and below-market financing in order to increase sales of certain models. How the manufacturer should most effectively target those promotions is a promotion and incentive optimization problem. Finally, the manufacturer sells a significant number of cars and trucks to major fleet customers at negotiated discounts - this is an account pricing issue.
- An electronics distributor purchases electronics equipment and parts from manufacturers and resells the equipment to retailers and other customers worldwide. With each of its customers the distributor negotiates contracts that (in theory) govern the margin it receives on future sales. This is an account pricing issue. However, the majority of sales are renegotiated with customers based on current market and competitive conditions - a list pricing opportunity.
- A consumer product manufacturer produces a large number of items that are sold through national and regional retailers. The company spends a significant amount of trade dollars to drive sales and revenue through retailers. The challenge is to understand how to allocate the trade funds to generate the maximum profit and develop promotion programs that are win-win for both the manufacturer and retailers.
- A typical domestic airline sells the majority of its seats to independent travelers through the airlines' Global Distribution Systems and the internet. Determining the right prices and availabilities to offer to customers through these channels and updating them in real time is a classic revenue optimization problem (and the focus of most airline yield management systems) in which prices are changed daily. However, the airline also negotiates corporate and special fares with certain very large customers and with individual groups that receive custom discounts - both bid pricing problems. Finally, airlines also run many promotional programs - requiring promotion optimization technologies.
The key point is that the highest return in each of these cases can be achieved by ensuring that all PRO decisions are jointly optimized to enhance enterprise profitability. Because Manugistics PRO solutions are designed to help solve a particular pricing or revenue challenge or address multiple pricing and revenue issues and integrate their solutions, they can meet the unique requirements of companies in diverse industries and diverse selling environments. No matter the industry, our solutions can help ensure that you take central, comprehensive, and consistent pricing actions and coordinate pricing across selling channels for maximum impact.
Business and Financial Benefits
With Manugistics Pricing and Revenue Optimization solutions, your pricing decisions are treated not as offshoots of operational issues or as disconnected outputs of various functional areas, but as a key generator of value across the enterprise. PRO solutions can help provide a broad set of business and financial benefits, helping companies:
- enhance revenue and profits
- derive more profits from existing assets
- leverage data from existing enterprise systems (CRM, ERP, SCM) and derive immediate value from those investments
- make smarter and faster pricing decisions, improving responsiveness to customers' needs and to competitive pressures
- reduce sales overhead
- predict demand and improve forecasting for products and services
- generate bottom-line increases of up to 2 to 8% of revenues annually
- reduce promotional spending as much as 5 to 10%, with same or improved revenue and volume
For most businesses the most appealing aspect of Manugistics PRO solutions is their rapid impact on the bottom line. This impact is driven by enabling better pricing and availability decisions, helping to ensure that the highest returns are obtained from existing corporate assets. Unlike most IT investments, the benefits from PRO are measurable, sustainable, and can drive ROIs in excess of 50% per year in selected industries.
The Next Wave in Value Creation
Manugistics Pricing and Revenue Optimization solutions do more than help you make the most of every pricing and revenue decision. Their ability to work with Manugistics Supply Chain Management solutions represents the next global wave in enterprise management - the integration of pricing optimization and supply chain optimization.
Manugistics pricing optimization engines help develop product, customer, and market segment pricing strategies that help to enhance profit in a repeatable, objective manner that is easy to validate and monitor. Frequent and accurate inputs from supply chain systems enable Manugistics pricing engines to more precisely predict optimal prices based on product availability and costs. In turn, accurate predictions of sales volumes become key inputs for increasing the effectiveness of supply chain planning and optimization. Finally, joint management of the supply chain and the demand stream can lead to significantly higher levels of profitability than individual management of both.
This is the emerging discipline of Enterprise Profit Optimization (EPO), which combines the proven power of cost-reducting solutions with the revenue-generating capability of pricing and revenue optimization tools. By tightly integrating pricing actions and supply chain optimization, Manugistics can help provide you with the tools you require to help ensure that you have the right product at the right place, at the right time, and at the right price. Combining the best in supply chain optimization with the best in pricing optimization, Manugistics, with its comprehensive solutions, is leading the way to this powerful new means of value creation.
For more information about Manugistics and Profit and Revenue Optimization, visit our website at http://www.manugistics.com or call 877-331-0728.
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