Robert Kugel's Analyst Perspectives

Price Optimization: Cover Your Bases

Posted by Robert Kugel on Jan 13, 2020 6:00:00 AM

Pricing is an eternally vexing issue in business. Over the years, organizations have used different strategies to establish prices for their products, depending on custom, the nature of the business and the degree of competitiveness in the market. The most straightforward approaches to price setting are a cost-plus calculation (cost plus some mark-up) and follow-the-leader (charge what competitors are charging). More recently, demand-based pricing has achieved a following as technology has made this approach more workable. It’s a method that uses buyer demand, based on an estimate of the good’s or service’s perceived value to the buyer, as the central element in setting price.

Pricing strategies are important because they can have a disproportionate impact on a company’s bottom line. This is because the ability to add incremental revenue with no associated costs directly adds to pretax profits. More recently, how to set prices has become an even greater concern as internet empowerment has shifted the balance of power in price discovery from sellers to buyers. Once this was Ventana_Research_2020_Assertion_Price&Revenue_Management_2only a concern for B2C companies but increasingly it is affecting B2B businesses. Consequently, by 2023, competitive pressures will force three-fourths of B2B companies to adopt technology-supported strategic pricing strategies to achieve volume and margin objectives.

At the heart of demand-based pricing is the technique of price and revenue optimization (PRO). It’s a business discipline that uses market segmentation techniques to achieve strategic objectives such as increased profitability or higher market share. PRO first came into wide use in the airline and hospitality industry in the 1980s as a way of maximizing returns from less flexible travelers (such as people on business trips) while minimizing the unsold inventory by selling incremental seats on flights or hotel room nights at discounted prices to more discretionary buyers (vacationers). Today, it is a well-developed part of business strategy in the travel industry and increasingly is being used in others. Software plays an important role in supporting PRO but it is just one of several factors on which companies must focus to use the technique successfully.

However, it remains the case that few companies outside those industries utilize price and revenue optimization techniques. According to our Office of Finance benchmark research, just 23 percent of organizations have adopted Ventana_Research_Benchmark_Research_Office_of_Finance_19_36_Limited_Adoption_of_Advanced_Analytics_191007-1advanced analytics for this purpose. The research also finds that only one-third use the associated analytical approaches of measuring customer profitability (34%) and product profitability (30%). You can’t manage what you don’t measure.

In my view, there are six components that corporations must consider and manage well to be successful in using PRO: strategy, external factors, people, process, information and technology (software).

Companies must have in place a realistic pricing strategy that is well aligned with the company’s capabilities, product strategy and competitive position. In a scale-driven business, for instance, it probably doesn’t make sense for a small player to try to be the low-cost provider. Instead, these companies can choose an approach to maximize pricing in a price-conscious market by designing offerings with valued features and services that add margin.

A pricing approach also must take into account external factors. In particular, different cultures and businesses have different attitudes toward fixed and negotiated pricing. In some cases, especially in consumer markets where fixed prices have been the norm, people may consider price optimization “unfair.” Companies that try to implement a PRO strategy thus may encounter resistance and so must approach pricing carefully. Also, there may be local or national legal and regulatory issues that impinge on a company’s pricing flexibility. That noted, despite some annoyance, people have grown accustomed to highly variable airline and hotel pricing.

As to the people dimension, management needs to ensure all relevant parts of the organization are aligned with the effort. It’s extremely important that incentives (especially sales compensation) are properly aligned with price optimization objectives and strategy. In many if not most cases, organizations will require ongoing training to continually apply optimized techniques and deal with issues that arise. For some organizations, a “center of pricing excellence” may be a useful way to build on its experience and entrench a culture of price optimization. Exactly how this is handled depends on how a company manages pricing and to what extent it is centrally managed.

The effective establishment and ongoing evaluation of price-setting processes requires a cross-functional team that includes all stakeholders. Initially these people will meet frequently (at least once a month) but as PRO matures organizations may require only a quarterly review. There also must be a well-defined price analytics review process to ensure that methodologies remain sound.

Easy, rapid access to historical deal data (including pricing, volumes, add-ons, cross-sales and terms and conditions) needed to support the use of pricing algorithms is a prerequisite for successful implementation of a pricing strategy. This data is required to feed the analytics and facilitate rapid pricing decision cycles. Our research consistently shows that most organizations lack sufficient access to the appropriate data and this issue grows in proportion to a company’s size.

Lastly, an organization must have the right software — that is, software that not only enables the needed pricing controls but that’s tailored to its needs and easy to deploy and maintain — and it must be implemented properly. When it comes to pricing, there can be subtle differences in the needs of different types of business, so prospective buyers should focus on vendors that have strong references in their specific industry.

Pricing has always been a critical issue for businesses and has become more challenging as the internet has shifted the balance in price negotiations to the buyer. In response, using technology for pricing and revenue optimization is now moving beyond travel and hospitality to become a practical technique for B2B commerce, one that companies can use to achieve and maintain a desired balance between market share and margin objectives. I recommend that sales and sales operations groups in B2B companies investigate how technology can make them more effective in pricing and quoting. Furthermore, CFOs should support and even drive adoption of technology-supported pricing optimization.

Robert Kugel

Topics: Financial Performance Management, Price and Revenue Management

Robert Kugel

Written by Robert Kugel

Rob heads up the CFO and business research focusing on the intersection of information technology with the finance organization and business. The financial performance management (FPM) research agenda includes the application of IT to financial process optimization and collaborative systems; control systems and analytics; and advanced budgeting and planning. Prior to joining Ventana Research he was an equity research analyst at several firms including First Albany Corporation, Morgan Stanley, and Drexel Burnham, and a consultant with McKinsey and Company. Rob was an Institutional Investor All-American Team member and on the Wall Street Journal All-Star list. Rob has experience in aerospace and defense, banking, manufacturing and retail and consumer services. Rob earned his BA in Economics/Finance at Hampshire College, an MBA in Finance/Accounting at Columbia University, and is a CFA charter holder.