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Price and revenue optimization (PRO) software uses analytics to help companies maximize profitability for any targeted level of revenues. PRO utilizes data about buyer behavior to gauge individual customers’ price sensitivity and predict how they will react to prices. It enables users to charge buyers who appear to be less sensitive more than those who appear more price-sensitive. PRO is a significant departure from inward-focused, single-factor pricing strategies such as cost-plus pricing or, in the case of financial services, risk-based pricing (using a borrower’s credit score, for example). Instead it offers a multifaceted customer-centric analytic approach to pricing built on analysis of large sets of data.
Price and revenue optimization is a natural fit for the application of big data analytics. Our benchmark research on challenges in big data shows that three-fourths of companies are addressing more than 10 gigabytes of data per day and 10 percent are deal daily with a terabyte or more. Financial services companies in particular can benefit from big data analytics because their core products are essentially numbers. For them, analytics involves sifting through large data sets to collect characteristics of consumer behavior that will enable them to identify customer segments and quantify their price sensitivity. These complex calculations require software designed for the purpose. Big data analytics software can help users manage more granularly the process of defining offers to customers (and the levels of discretion they allow to account managers and sales people to set prices) as well as the terms and conditions of the transaction. Upon identifying characteristics that influence buyers’ price sensitivity companies then combine the most relevant factors to present a price that will enable them to optimize revenue and profits from those customers.
Nomis Solutions provides PRO software and services to financial services companies, including banks, automobile credit providers and credit card processors. In past years at its annual user conference, the company has focused on the science and technology behind its product, as I’ve noted. Those sessions were useful in providing attendees with a deeper understanding of “the why behind the what” of the applications’ capabilities.
Taking a somewhat different approach this year’s conference focused on the challenges that the financial services industry will need to address over the next several years and how information technology generally – and price and revenue optimization software specifically – can help these institutions address them. Presenters at the Nomis Forum covered three main issues facing financial services businesses:
- Increasing velocity and volatility of interest rates
- Disruptive sources of competition in financial services
- Expanded regulation of financial services businesses.
Those charged with setting prices in financial institutions have been operating in a relatively benign environment for the past few years. Interest rates in many of the developed world economies have remained relatively steady and low in inflation-adjusted terms by historical standards; this simplifies the pricing of loans and credit. The recent environment of low interest rates and low volatility has muted the need for the capabilities found in PRO software, although financial services companies that have deployed PRO have improved their results measurably. However, it’s likely that the interest rate environment will transition to a more dynamic phase within a few years. Technology can enable financial institutions to operate more effectively in that kind of interest rate environment, helping financial services companies be more effective when interest rates begin to rise and fluctuate. It can do so by enabling them to automate analytics and reporting as well as facilitating management of the related data. This makes it easier for a financial institution to adapt fast to a challenging atmosphere and set prices in a way that best matches its strategic objectives (such as to be a market share leader in specific product categories or to maximize returns on risk-weighted assets). Using price and revenue optimization rather than simplistic risk-based pricing can provide a competitive advantage in achieving higher returns on assets and lower costs of capital.
However, such technology may present challenges to established financial services organizations. As it has been in many industries, it is becoming a disruptive force, especially as innovators use the Internet and evolving computing devices to change the competitive landscape. The financial services business is feeling the impact of new approaches to traditional methods. Deposit banks, mortgage companies and other lenders as well as major credit card companies all face challenges from entrepreneurs seeking to supplant established business systems. There are new formulations of finance in areas such as peer-to-peer lending (for example, Lending Club), purely online banking establishments, mobile payments systems (such as Apple Pay) and crypto currencies (Bitcoin). To date these new formulations haven’t achieved significant penetration, but when technology-driven market disrupters arrive, Andy Grove’s cautionary advice – “Only the paranoid survive.” – is worth heeding. The upstarts have attracted substantial amounts of investment capital, giving them parity with established players in terms of a low cost of capital and the ability to keep trying.
In assessing the challenge from disruptive innovators, Nomis founder Robert Phillips insisted that financial services incumbents are not defenseless. They are able to match innovators in matters of convenience and (to some degree) cost, two areas where companies such as Amazon, Netflix and online travel booking services were able to use these aspects to quickly displace well-established companies. Existing financial institutions have been adopting technology by developing it internally or by acquiring technology-enabled disruptors. For example, in the United States the camera-equipped smartphone took advantage of the 2003 law that eliminated the requirement that physical checks must be returned to their makers to enable people to “deposit” checks into their account without having to go to a bank or an ATM. Traditional financial services companies have heavy compliance costs and considerable overhead that give upstarts and advantage, but they also have some advantages of scale.
Philips cited two major areas of competitive differentiation. One favoring new entrants and the established organizations. Incumbents are most vulnerable to disruption because typically they are slower in reacting to customers and ponderous in managing processes. Retail and small business banking is a consumer market, and today consumers in developed countries increasingly want transactions to be fast and hassle-free. On the other hand, incumbents have a wealth of information about their about customers, their assets and their past behavior that they can use to optimize pricing in every aspect of their business as well as to improve their customers’ experiences. Using software to manage rates charged or offered is a way to quickly provide quotes to prospective borrowers and depositors while providing effective controls on how front-line representatives set rates. Upstarts that have less of this information available will have to rely more on risk-based pricing.
Increased regulation since the 2008 financial crisis is another major challenge for financial institutions in the developed world. Its purpose has not just as an attempt to prevent future debacles but, particularly in the United States, to promote fairness. For cultural reasons, demanding different prices from some customers or raising prices during periods of peak demand is a sensitive topic in many developed economies. Tightly regulated financial services companies are more vulnerable to charges that some protected groups are hurt in the price-setting process and therefore subject to fines and demands for restitution. One advantage that companies using PRO software have in defending against charges of unfairness is that it makes the price-setting process transparent and based on objective measures related to their willingness to pay.
Price and revenue optimization is a strategic business technique that has conclusively demonstrated its value in travel and leisure, retail and industrial businesses. It is steadily gaining traction in financial services. Yet from discussions with existing users I find that it is rarely easy to implement from a management and process standpoint. One important reason is that the results of the analysis of customer behavior often defies common sense. The use of big data analytics to assess and quantify the drivers of customer decision-making enables a company to apply a more nuanced view of the often complex factors that influence customer decisions. From this analysis it can segment its prospects more accurately than by using simplistic assumptions (that is, what “everybody knows” to be true). For example, it may not be necessary to offer loyal customers the lowest price. Other inducements may be more important to them and may even be costless to the financial institution or seller – for example, maintaining an ongoing relationship or not having to spend time shopping around. Indeed, one advantage of PRO is that it’s often counter-intuitive and therefore offers strategies unavailable to less well informed competitors. PRO also is an operating methodology so it’s not easy to implement the management and process changes necessary to utilize the technique, especially in larger organizations. Nonetheless, companies that recognize its advantages and put it into practice can obtain a competitive advantage over competitors that aren’t able to overcome institutional inertia.
I recommend that companies, especially those in the financial services industry, explore the benefits of using price and revenue optimization tools. It is worth remembering that technology has long been a driver of innovation and change in financial services. Our research on the use of analytics in banking and financial services shows that financial services companies are looking for analytics that will improve their decision-making and business processes as well as enhance their operational efficiency. They want analytics to enhance their competitiveness and provide a strategic advantage. PRO is a technology-driven technique that can underlie a more intelligent and strategic approach to pricing.
Robert Kugel – SVP Research
A core objective of my research practice and agenda is to help the Office of Finance improve its performance by better utilizing information technology. As we kick off 2014, I see five initiatives that CFOs and controllers should adopt to improve their execution of core finance functions and free up time to concentrate on increasing their department’s strategic value. Finance organizations – especially those that need to improve performance – usually find it difficult to find the resources to invest in increasing their strategic value. However, any of the first three initiatives mentioned below will enable them to operate more efficiently as well as improve performance. These initiatives have been central to my focus for the past decade. The final two are relatively new and reflect the evolution of technology to enable finance departments to deliver better results. Every finance organization should adopt at least one of these five as a priority this year.
Close faster. Because the process of closing the books is similar for all corporations, it should be seen as a universal performance benchmark. Our research finds that only 38 percent of all companies with more than 100 employees complete their quarterly or half-yearly close within five to six days of the end of the quarter (which is the generally accepted performance standard), while the remaining majority take longer. And for all the discussion over the years about the need to close faster, our most recent benchmark research on the close discovered that companies on average are taking a half-day longer to complete the process than they did five years earlier. For the most part, much of this increase appears to have been among companies that were already taking more than a business week to close. I’ve written that the close is a good litmus test for the overall effectiveness of a finance department.
Our research into how companies close shows that its common for two companies with exactly the same characteristics (the same size, in the same industry, located in the same country) to demonstrate big differences in how quickly they complete their accounting cycle: Company A does it in two days while company B needs nine days to get the job done. The difference is likely to be due to some interplay of people, process, information and technology. Common issues are poor process design, overuse of spreadsheets in the process, consolidation software that no longer meets current business requirements and too little automation of repetitive tasks. Our research shows the correlation between increased automation, for example, and achieving a faster close. We found that, on average, companies that have automated the process completely close in 5.7 days compared with 9.1 days for those that have automated little or none of the process. Shortening the close is important because it enables finance organizations to provide management and financial accounting information to the rest of the company sooner, reduces overtime and frees up resources that can be put to better use. Addressing such issues in a concerted program with measurable objectives is the best way to achieve progress. Moreover, in the process of shortening the close, broader issues can be addressed at their source, improving the performance of the Office of Finance. Focusing on the root causes behind too long a close process can uncover hidden issues common to many finance processes, including poor data availability and quality, poor communications and training, and too much complexity.
Even if your company is closing its books within a business week, chances are there’s still room for improvement that can come from automating existing manual tasks. For instance, reconciliations are an activity where companies with as few as 250 employees are likely to find savings of time and money using technology to automate the process and enhance accuracy and auditability.
Master Excel. Our research shows that spreadsheets are a problem when used in any repetitive collaborative enterprise-wide task (for example, planning, forecasting, closing and managing sales operations). At the same time, spreadsheets are an essential tool in business and cannot always be replaced by other software and systems. For this reason, it’s important for finance executives to ensure that the people who are designing and using spreadsheets know what they are doing. One of the root causes of spreadsheet problems is lack of competence by those designing models and analyses. Spreadsheets’ lack of transparency easily masks poor design. Typically, people are self-trained. Although they can complete assignments, the resulting spreadsheet may be inefficient, difficult to audit and brittle (difficult to change without making major modifications) and have so many vulnerabilities to mistakes and tampering that they are disasters waiting to happen. It’s common, for example, for people to create dense and complex nested logic expressions because they don’t know how to use lookup tables. Our research found that almost half (45%) of companies provide no training and just 8 percent provide regular Excel training sessions, with the rest providing only initial training or leaving it to the individual to take the initiative. Just as armies march on their stomachs, finance organizations operate in a world of spreadsheets. It makes sense to invest in the productivity of those responsible for creating spreadsheets because that investment is likely to promote productivity as well as reduce errors and the resulting rework and other costs that go with them. Along with training, testing is useful to ensure that people have the necessary skills to create spreadsheets, but almost all companies (87%) do not test their users.
Plan – don’t just budget. I have asserted that annual budgeting should evolve into a process that’s more focused on planning the business. Many people speak of planning and budgeting as if they were the same thing, but they’re not. Budgeting is essential for control, but budgets are focused on money, not things. So while they’re good for finance departments, budgets don’t deliver much value to the rest of the company. Business planning as practiced today is a relic, a process hemmed in by obsolete conceptions of what it should be. Individual business units make plans, but they are narrowly focused and not well integrated. Our business planning research found that companywide planning efforts are not as coordinated as they could be: Just 22 percent of the participants said they can accurately measure the impact of their plan on other parts of the business. While today’s budgeting and operational planning efforts are loosely connected, the next generation of business planning closely integrates unit-level operational plans with financial planning. At the corporate level, it shifts the emphasis from financial budgeting to business planning and performance reviews that integrate both operational and financial measures. This new approach uses available information technology to enable businesses to plan faster with less effort while achieving greater accuracy and agility. The approach addresses a deep-seated issue: Our research shows that in most companies the budget is not collaborative on an ongoing basis and therefore hinders coordination as companies adapt to changing circumstances. It doesn’t enable managers to anticipate how best to adapt to those changing circumstances, so when things change, as they always do, companies lack the sort of coordination they need to make changes quickly and maximize their performance. The data from our research shows that traditional budgeting does not promote strategic and operational alignment, which winds up hurting performance. And because companies take too long to review their results and in these reviews aren’t able to immediately determine the source of variances between their plan and actual results, they do not react quickly to seize opportunities and address issues.
Adopt price optimization and profitability management. For companies that close within a week, have mastered Excel and focus more on planning than budgeting, price optimization presents a new frontier on which to improve company performance. Price and revenue optimization (PRO) is a business discipline used to create demand-based pricing; it applies market segmentation techniques to achieve strategic objectives such as increasing profitability or market share. PRO first came into wide use in the airline and hospitality industries in the 1980s as a way of maximizing returns from less flexible travelers (such as people on business trips) while minimizing unsold inventory by selling incremental seats on flights or hotel room nights at discounted prices to more discretionary buyers (typically vacationers). Today, PRO is a well-developed part of any business strategy in the travel industry and is increasingly used in others. Optimization is not maximization, since the objective of the former is to achieve the best trade-off between sometimes mutually exclusive goals and their constraints. Focusing solely on profit maximization may result in wider margins but lower sales and profits, for example. Optimizing price means using analytics to gain a better understanding of customers’ price sensitivity in order to achieve the best mix of price and volume consistent with the company’s strategy. This allows businesses to achieve the highest possible margins consistent with their volume and mix objectives. Analytical software is available that enables companies to implement and manage a PRO strategy, which I covered in an earlier perspective.
Manage taxes more effectively. Corporations’ largest tax outlays fall into two main categories, indirect and direct. Indirect taxes are those collected by an intermediary such as a retailer or wholesaler and then paid to government entities. This includes sales and use tax (in the United States), goods and services tax (in Canada) and value-added tax (in Europe and other regions). A large percentage of midsize and larger corporations in North America use software to manage their indirect taxes. In the U.S., such indirect taxes are difficult to handle because of the complex and overlapping tax jurisdictions, changes in rates as well as the definitions of what’s taxable at which rates. The issue is not just calculating the amounts at the time of the transaction, but also being able to mount an audit defense as inexpensively as possible at some point in the future. If your company is not using a third party to manage its indirect tax calculations, 2014 would be a great year to start, especially if your business operates in areas where the tax authorities are most aggressive. Direct – or income – taxes are another matter. Because of their size and complexity, many midsize and almost all larger organizations need to automate more of their tax provisioning process using dedicated software rather than spreadsheets. Corporations that operate in multiple income tax jurisdictions with only moderate complexity in their corporate structure can save considerable amounts of time, have better insight into their tax positions and improve their audit defense posture by switching from spreadsheets.
Senior finance executives often spend time fighting fires rather than addressing their root causes to prevent new ones. Companies that take more than one business week to close must determine why it’s taking them so long and address those issues. The same causes behind a longer-than-necessary close are likely to be at work in all or most finance processes. Further, providing employees with Excel training and testing will improve their productivity and the quality of work they perform. And if nothing else, taking a fresh look at planning and budgeting can identify ways to streamline the process, freeing up time to invest in efforts that will improve the department’s performance. Finally, finance departments that already operate efficiently should focus on ways to play a more strategic role in their company’s business, particularly by managing pricing analytics and improving their tax provisioning acumen.
Robert Kugel – SVP Research