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Managing prices has always been an activity of keen interest to businesses, but it has become even more critical to do it well. Over the past decade many companies have found their ability to raise prices has been constrained by intense competition resulting from Internet commerce, global competition and other factors. One tool for dealing with this pressure is price and revenue optimization (PRO), an analytic methodology that calculates how demand varies at different price levels and then uses that algorithm to recommend prices that should optimally balance revenue and profit objectives. Computer-supported PRO began in earnest in the 1980s as the airline and hospitality industries adopted revenue management practices in efforts to maximize returns from less flexible travelers (such as people on business trips) while minimizing the unsold inventory by selling incremental seats on flights or nights in hotel rooms at discounted prices to more discretionary buyers (typically vacationers). Price and revenue optimization algorithms are designed to enable a company to achieve fatter profit margins than are possible with a monolithic pricing strategy. Using PRO, airlines and hotels catering mainly to less price-sensitive business travelers found they could match discounters’ fares and rates to fill available seats and rooms without having to forgo profits from their high-margin customers.
PRO has expanded into other industries as computing power and data storage become ever less expensive, as software vendors have improved their techniques and algorithms to deliver better results and as the software has grown increasingly user-friendly. While the concepts underlying all PRO software are the same, there are different categories in which it is customized to meet the needs of specific industries. Retailers in particular have requirements that are best met by using applications that manage markdowns.
At the heart of price and revenue optimization is the concept of demand-based pricing. As its name suggests, demand-based pricing is a method that sets a price that is controlled by the seller’s assessment of what the buyer is willing to pay, which in turn is based on an estimate of a good’s or a service’s perceived value to the buyer. Companies use demand-based pricing to optimize – rather than simply maximize – their pricing to achieve revenue and profitability objectives. It uses data to estimate where the prospective buyer sits on a demand curve and therefore how much the individual is likely to pay. In some respects this is similar to what happens daily in souks, bazaars and other markets in cultures that do not insist on set prices. However, software makes demand-based pricing practical in large businesses and facilitates its introduction in societies used to set pricing.
Advanced analytic applications – especially for price and revenue optimization – have been gaining ground in corporate management because they have demonstrated to work. Significantly, they have the ability to deliver results that are unobtainable otherwise. Such software can crunch through very large data sets rapidly, apply purpose-built algorithms and automate the repetitive mechanical steps needed to put decisions into action. It also ensures consistency and supports objectivity in how executives and managers make decisions. Price and revenue optimization applications have benefited as the cost and complexity of the computing resources needed to use them have declined.
The adoption of PRO software is part of a broader trend of using applications to support fact-based decisions that once depended on experience and hunches. However, our benchmark research on the Office of Finance finds that just 20 percent of companies use price optimization analytics extensively. Only one-third look at product profitability. We think that more of them should do both. Analytic applications can digest a considerable amount of data to segment markets into useful groupings, pinpoint correlations and divine trends, to name a few tasks necessary for pricing management. However, companies investigating PRO software should narrow their search to applications that are appropriate for their specific business. While some offerings have broader applicability than others, no software product now available performs well in every industry.
Retail businesses that have multiple outlets, especially those that deal in trend- or fashion-driven products, face unique price and revenue optimization challenges and this affects the design of pricing management applications aimed at retailers. Many of these businesses are self-service, exclusively so if they are Internet-based, so there is no face-to-face contact during the product selection process. Negotiating prices isn’t feasible in most multiple-outlet retail settings in developed economies because of cultural norms and the hazard of delegating these decisions to front-line staff in even a midsize company. Unlike business-to-business transactions that involve ongoing relationships with established products, most stores today know little about most of their customers, so there is no direct way of judging an individual’s price sensitivity for the specific purchase at hand. In other words, most of the elements that support PRO strategies in analytics used for other types of businesses aren’t available to multiple-outlet retailers.
Since they usually cannot gauge the price sensitivity of their customers, retailers take a different approach: Let the merchandise do the talking. Products that aren’t selling well are by definition overpriced in that market. Retailers have used markdowns as a crude tool of price optimization for a long time. Offering a 30 percent discount near the end of the season is usually better than having to take a 60 percent haircut from a close-out specialist. Yet deciding when and by how much to reduce prices and then implementing the reductions at the store level in an optimal fashion is complicated because of the number of variables that must be considered. There are different types of merchandise, including long-life categories of goods that can be offered for sale for years, short-life fashion and fad items that are offered only once and those somewhere in between. There are differences in demand patterns and price sensitivity between regions and even at the store level. Seasonality, weather and movable holidays such as Easter and Thanksgiving must be considered.
Using analytic applications is superior to relying on experience and intuition because applications often demonstrate that the best decisions go against the grain of established practices. For example, retailers have found that smaller markdowns applied earlier and more frequently produce better results (that is, greater volumes sold at a lower aggregate markdown) than the common practice of making one or two big moves. Until the data became available, minimizing the number of markdowns was reasonable because of the cost in staff time to change prices at the store level. However, retailers using smaller and more frequent markdowns more than pay for these costs and then establish processes to facilitate price changes. Some retailers have found to their surprise that early small markdowns reduce the overall cost of markdowns. Analytic applications also are able to deal with a range of variables that retailers can use in markdown management. For example, they can vary percentages and frequency by size and color as well as by location. The software can monitor sales and inventory levels by the SKU at each store and automatically make detailed recommendations on how to adjust pricing. The software also enables retailers with multichannel operations (usually an online presence) to manage pricing decisions optimally across different types of outlets.
PRO software designed for markdown management also enhances the ability of a multiple-outlet retailers to run their business in a way that maximizes the productivity of their stores measured in sales or gross margin per square foot (or meter) or per linear foot (or meter) of shelf space. Items taking up space in a store or on a shelf have an opportunity cost in that they could be replaced by faster-moving or more profitable goods. Modeling the cost of the uplift required to free up space can result in a more attractive mix of merchandise that will improve returns.
While usability and capability of markdown management software have been improving, retailers face internal challenges in being able to utilize it. Analytic applications are only as good as the data available to feed the systems. Our research consistently finds that data accuracy and availability are significant challenges that almost all midsize and large companies face. Using markdown management software successfully also involves a change management effort requiring heavy involvement by senior management to endorse changes in how the organization handles day-to-day business as well as changes to processes and training and considerable amounts of follow-up to ensure compliance with the new ways of doing business.
Information technology is playing an increasingly important role in how companies conduct their businesses. Analytic applications can transform how entire industries operate. Today, airline and hospitality businesses operate very differently from how they ran in the 1980s because of the Internet and analytics. All sorts of businesses are finding that price and revenue optimization software enables them to improve their results measurably. Retailers should look into markdown management software as a way to fatten their bottom line. Other types of businesses also should consider PRO tools as applied to their particular needs.
Robert Kugel – SVP Research
It’s stating the obvious to say that how well executives manage planning processes has a big impact on how well a business unit or company plans. However, one significant source of the value of our benchmark research is that it establishes hard evidence – the numbers – that transforms mere assertions into proof points. This is particularly important when people within an organization want to improve a process. Change management is facilitated by providing senior executives with facts to back up assertions related to solving a business issue. Our recently completed next-generation business planning research provides insight into the importance of managing the planning process well and identifies some components of good management.
We use the term “business planning” to encompass all of the forward-looking activities in which companies routinely engage. Our research covered 11 of the most common types of planning that go on in businesses, including sales, production and head-count planning as well as budgeting. In the research fewer than half of participants said their organization manages processes well or very well. Overall, the research finds that the best managed plans are those covering capital spending, workforce planning and demand planning. The ones at the bottom the list are sales forecasting, sales and operations planning and supply chain planning. To some degree, these findings reflect the difficulty of having to take into account external factors such as market demand. By contrast, capital spending plans involve mainly internal decisions made by a relatively small group, and the process from planning to execution is highly controllable. And while workforce plans may be subject to changing market conditions, in a stable economic environment staffing needs are relatively predictable.
The research also quantifies the impacts of important ingredients of a well-managed process. For example, communication is an essential element of successful planning. Nearly all (85%) companies in which executives communicate strategy and objective well or very well said their planning process works well or very well. By contrast, only 18 percent of companies in which executive communication is only adequate or poor have a well-functioning process. All aspects of business involve making trade-offs in allocating resources, and clear communication of strategy and objectives works to keep everyone on the same page. When the strategy is not plainly laid out, individuals must rely on tacit understanding of or guesses about it and the trade-offs that support it best. These assumptions may not be accurate or consistent across a company and can prevent concerted effort in the required direction.
Unfortunately half of the participating companies said their management doesn’t communicate strategy and objectives well. Often this is because executives think they’ve made this clear without confirming that is. An email message at the start of the annual budget process isn’t enough. Ambiguity also is inevitable when strategy is laid out are at such an abstract level that the way to achieve results is open to wildly different interpretations.
The solution to the communications issue is consistent repetition of objectives and their strategic context and framing planning and review discussions in that context. The research demonstrates the need to maintain clear, effective messaging. Companies in which executives communicate well the need to adapt plans during the planning period have a planning process that works well or very well (83%) more than three times as often as those that don’t (25%).
I’ve stressed the importance of integrating planning across business silos because it can make all planning processes more effective. One key aspect of integrating planning is having ready access to other business units’ plans. For example, Manufacturing and Operations should be able to see the latest plans of Marketing and Sales either as they create their initial plans or perform periodic revisions to them. Almost two-thirds of organizations in which planners have a good understanding of how decisions they make about their plans will affect other parts of the organization said they have a planning process that works well, compared to just 17 percent that don’t have a good understanding.
Those are some of the ingredients necessary for a well-managed planning process. The research also demonstrates the value of a well-managed process. One of the most important objectives for effective planning is accuracy because correctly anticipating how the business will evolve and perform over time can lead to optimal allocation of resources and coordination of efforts. The research confirms the perhaps obvious assertion that companies that have a well-managed planning process produce plans that are more accurate. The numbers also illustrate the stark consequences of not managing the process well: Most (80%) of those that do it well create plans that are accurate or very accurate, while just one-fourth of those that only adequately manage the process and almost none of those that do a poor job achieve such accuracy.
An important measure of planning efficiency is the appropriateness of the time spent on the process. Spending too much time obviously is wasteful, but so is spending not enough time, since a hastily constructed plan is likely to be subpar. Indeed only 16 percent of companies that spend too little time have plans that are accurate or very accurate, compared to two-thirds of those that spend the right amount of time and one-third that spend too much time.
Using the right software to support the business planning also is a factor in managing the process well. I have noted that desktop spreadsheets work well for individuals who create planning models and work with limited sets of data, but they are not well suited for recurring collaborative enterprise processes. Our research shows that companies that use a dedicated application more often have a process that works well or very well than those that use spreadsheets (60% vs. 47%). To be sure, technology is only one factor and simply buying software designed for planning without changing the people and process elements or failing to address data availability, consistency or timeliness issues makes it difficult to improve results. Still, a dedicated application is an essential component to support a change in planning processes. Companies need software that facilitates access to other business units’ plans, simplifies the collection of data, facilitates analysis and the ability to drill down into detail, offers dashboards that are easy to create and modify as well as supports automated and self-service reporting eliminates many barriers to more effective integrated planning in organizations. We advise them to evaluate such products as part of a comprehensive effort to improve all facets of business planning.
Robert Kugel – SVP Research