Not long ago, a major U.S. company embarked on an ambitious Six Sigma program to improve efficiency. The program was a big success, saving the company US$250 million.
Problem was, the sales force, mindful of the cost reductions, increased customer discounts by US$260 million, more than wiping out the savings.
"In many cases, there was no competitive action that required those price discounts," says Matt Johnson, managing director of the office of strategy and marketing consultancy Simon-Kucher & Partners. "The salesmen had margin targets, and when costs went down, prices were systematically vacuumed down to a cost-plus markup."
Johnson says the company, which he won't name, employed the kinds of self-destructive pricing practices and philosophies that are common in industry today. He says that in recent years, IT has made it possible to price smarter, but a company's culture and management often stand in the way of its use of the technology.
As senior vice president for revenue integrity at Seton Healthcare Network, John Elver has a job title that suggests he won't let others give away the store. Indeed, aided by new price optimization and contract management software, he boosted annual revenue by almost US$200 million by improving the sophistication of pricing at Seton's 21 medical facilities.
Previously, Seton had taken a crude approach to pricing. It would, for example, raise the prices of all its 60,000 items and services by 4 percent and then manually tweak the prices of a few selected items. Now Seton uses the Hospital Optimization System from PROS Revenue Management in Houston to model the effects of more fine-grained changes. The pricing models, which analyze some 70 million historical transactions and take into account the terms of complex contracts, can forecast customer demand and the associated revenue likely to result from various pricing decisions.
"Now we can say, for example, that we'll reduce prices for some items 35 percent, increase the others by 10 percent and still get a 4 percent average increase," Elver says. That mix of price changes might be far more effective in stimulating demand and boosting revenue than an across-the-board 4 percent increase would have been, he says.
Rolling out price optimization software required Seton to examine the ad hoc rules that hospital managers had carried in their heads over the years, like such-and-such an item ought to be priced at a certain multiple of some other item. Some of those rules of thumb were scrapped, some were codified into the models, and some new ones were developed, Elver says. "For the first time, we got an understanding of the absurdities in some of those rules," he says.
But Seton's new pricing methods, although much more flexible and powerful than previously, met some resistance from hospital managers, especially when they were told they must reduce certain prices -- and, hence, their revenue -- because the models showed that would improve revenue or profits for the medical chain as a whole. "So the biggest challenge for me is one of change management," Elver says. "There is a suspicion of 'black boxes.' "
Traditionally, companies have focused their efforts to maximize profits on cutting costs and boosting sales. They organize themselves accordingly, with entire departments focusing on one objective or the other. Rarely is even a fraction of that effort put into optimizing the third variable that makes up a company's profit: unit price.
As a result, pricing is simplistic and formulaic at many companies. They either peg their prices to competitors' prices, called pricing to the market, or they add up production costs and tack on a standard markup, called cost-plus pricing.
A third and better approach, value pricing, involves segmenting buyers and setting prices based on the characteristics of each segment. For example, airlines guess that the business executive buying a ticket for a flight across the country next week will pay US$1,000 for his seat, but the man planning a vacation for his family next summer won't pay more than US$250 for the same seat. Value pricing requires good data mining and modeling capabilities as well as good analytic tools for understanding the results of pricing decisions.
Rich Farrell, vice president of information services at Piggly Wiggly Carolina, says that until 2005, the 115-store grocery chain used old-fashioned, ad hoc methods to set prices. "We knew the cost of product from suppliers. We had designated markups. We kind of knew what our competitors were offering, and it was a manual process," he says.
Now Piggly Wiggly uses the Consumer Demand Management service from DemandTec. Piggly Wiggly provides point-of-sale transaction histories and information about its 20,000 products to the model, which is run by DemandTec. It also specifies three objectives: Increase sales x percent, increase margins y percent, and maintain a favorable "price image" (neither too high nor too low compared with competitors). Suggested prices from the model, by product and store, go back to a pricing group at Piggly Wiggly.
The four-person pricing group is new, Farrell says. It has taken over the work previously done by buyers and others throughout the company while also maintaining the models run by DemandTec. "You need some dedicated people to manipulate and operate the model," Farrell says.
He says the pricing automation service has met all of Piggly Wiggly's objectives. However, "this is not inexpensive," he notes, declining to provide numbers.
Nova Chemicals is another company that found it helpful to reorganize people around the pricing function when it replaced mostly manual procedures with price management software. Nova changed pricing from a purely administrative function to part of direct commercial operations. "It was a realignment of the work, realizing that pricing was a strategic function and a strategic tool as well as an administrative one," says Bill Gaughan, director of IT in Nova's Pittsburgh office. "And it was not an IT project; it was a business project with an executive sponsor and a business project manager."
Nova rolled out two price management tools from Vendavo Inc. in Palo Alto, Calif. They helped Nova reduce labor costs and errors in maintaining a huge number of discrete prices that were the result of having 1,000 customers, 300 products, quantity discounts and rebates that varied by customer and product, and prices in multiple currencies.
The tools gave management much greater visibility into pricing practices and their consequences, Gaughan says. "We will announce a 3-cent-a-pound increase in some material, and we'd like to see a month later how much of that did I really get," he says. "Where were the competitive issues, the contractual issues, the administrative issues? The tools we used to have didn't give us the advanced analytics to see if the 3 cents really did what we needed it to do."
Tracking the results of an increase in list price in the chemical industry is not as simple as it might appear, since many discounts and price offsets lie between a price increase and the realized gain.
A total view
A CIO who asked that her company not be named for competitive reasons says price analysis and optimization software from Zilliant cost US$500,000 but is adding US$2 million a year to the bottom line -- representing a payback period of just three months.
She says the US$1.4 billion manufacturer of lighting fixtures used to base its prices on cost, without regard to optimizing margins, and it did so at a very gross level. "Now we take a total view, not just material and labor, but also returns, rebates, promotions, discounts and so on -- things we did not even consider before," she says.
Understanding all the components that affect a deal's contribution to profit provides "a foundation for our negotiations and helps us sustain our price points," she says.
The company is preparing to buy another Zilliant product, called Deal Manager. "This is really where the power of the analytics and the optimization is applied," says the CIO. "It will let us say, 'Can I go higher or lower on this deal?'" She says the company hopes to increase profits by US$1.5 million with this kind of real-time sales support tool.
The CIO advises taking a practical and realistic approach to developing these kinds of systems. "Everyone goes into this thinking their data is clean," she says, laughing. "We were pulling data from 40 different data sources. We went into this way overconfident."
Apartment Investment and Management (Aimco), a company that owns and manages 240,000 apartment units, hired PROS Revenue Management to develop a pricing and revenue management system similar to those used by hotels and airlines. Lee Montgomery, vice president for revenue management and analytics at Aimco, says the idea was to move beyond "guessing -- spinning around three times and saying, 'I think I'll charge this today.' "
He says these kinds of systems typically increase revenue, but not costs, by 2 percent to 4 percent per year. Three percent for Aimco would be US$20 million to US$30 million, Montgomery says. "The payback is off the charts," he says.
"And we understand a lot more about our business now," he adds. "It's sort of the 'Aha!' that everybody has. We've seen things we've never seen before, and it's our own data."
For example, these insights have enabled Aimco to increase profits by varying price quotes depending on the time of year a tenant says he wants to rent, rather than quoting a single rate, just as a hotel might have different rates for different seasons and days of the week.
Montgomery says many people distrust these kinds of systems because it can be hard to understand how they work. "They are very complicated, and if you go in and try to wow them with the science, you'll lose them," he says.
He advises getting the technical and financial people on board first and then using that support to reach out to others in the company.
Todd Mueller, market planning and analytics manager at J&L Industrial Supply, says a new price-analysis tool enables J&L to understand past pricing and its effects as never before. And it puts that capability in the hands of end users for the first time. No longer do users have to ask IT to create some special report and then wait two days to find out it was not what was really needed, Mueller says.
Now, with Vision from Metreo, sales managers can run through "three or four iterations in 20 minutes," he says. "It takes our historical pricing data - on a transaction line-item detail level -- and lets us slice it and dice it on every imaginable attribute. I can look at customers by margin, by sales, by number of items purchased, by geography and so on." Some 200 such attributes can be called out, he says.
The Vision tool allows J&L to understand how the market is behaving, Mueller explains. "You can then see where pricing is not being set correctly and go fix it," he says.
Skeptics in sales
But Mueller echoes a common concern of managers who preside over the rollout of automated pricing systems. "The first hurdle is skepticism on the part of the salespeople. They want to know, 'How is this going to help me achieve my goals?' They are the most tactically oriented people in every company, as they should be," he says. "The second concern is, 'Are you going to take pricing autonomy away from me?'"
J&L did not take pricing autonomy away from its salespeople. And management was able to get them on board by pointing out the benefits of the system in identifying pricing mistakes. "For example, they meant to give a 9 percent discount but accidentally gave 90 percent," Mueller says. "We found things that hadn't been caught in over a year. The salespeople are grateful because that's money in their pocket."
Mueller advises tackling pricing automation one step at a time. The Vision product, a backward-looking analysis tool, paid for itself easily just by finding pricing mistakes. Next, J&L plans to move to a more sophisticated and complex product, Metreo Target, that seeks to optimize future prices.
Finally, Mueller has some advice about selecting a pricing system. "Learn all about it. It's not as plainly evident as you may think. We thought this would be very easy, but we learned that as complex as pricing is, you can't be wooed by the sexy graphics," he says. "You have to really understand how it's going to fit into your business and make sure the tool is designed to solve the correct problem."
Living -- and dying -- by market share
Matt Johnson, managing director of Simon-Kucher & Partners' California office, discussed the right way to think about pricing in a recent interview with Computerworld's Gary Anthes.
In general, should you price a product or service based on its cost to you or its value to the customer?
Cost should be a factor, a floor. But your target price should be based on customer segmentation and the value you are delivering.
So why do so many companies just do cost-plus pricing?
Pricing based on value is harder. Traditionally, companies could track revenues and costs, so looking at those numbers was easiest.
Now ERP and other new systems have allowed them to capture the data at a very granular level, but they haven't yet made the investment in the tools to roll that up and really be able to look -- at anything near real time -- at their profits by product, by market, by channel.
Is it always worth the effort to do that fine-grained real-time analysis?
It's really a green-field opportunity, where little investments have huge returns. I've not seen, in 17 years of pricing projects, a project that has died for lack of ROI. These things can pay for themselves in weeks.
But can the project die for other reasons?
If your culture is built around market share, where you say you want to charge a good price but not lose a single customer, you are kind of stillborn from a pricing standpoint.
It may be healthier for a company to lose some bad customers. But that can be a cultural bottleneck.
What advice do you offer companies trying to overhaul pricing practices and systems?
Companies are terrified of jerking around their salespeople, and frankly, that concern is overrated. If you give them clear data and clear incentives, it's remarkable how fast it can happen. These guys are very adaptive.
The companies that have the most success are the ones that spend the most time upfront, saying, "Here's what we are going to do, here's the value of doing it, and here's how we are going to measure it."