Advantages of Dynamic Pricing

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Shoppers who bought a gas grill from the retailer ShopKo were unknowing participants in a pricing revolution that will rock the DM industry over the next decade. While those shoppers paid $189.99 for the grill, others at a store 20 minutes away paid $121.59 for the same grill.


ShopKo was experimenting with price optimization software, the newest weapon in revenue management. Pricing traditionally has been a high-stakes game of guesses about costs and competitive activities, resulting either in money left on the table or lost sales. But price optimization software uses a variety of data, from historical sales to demographics, to cut - and raise - prices for stores and individual items depending on profit, revenue or market share goals. It's easy to tell when retailers are using such software because pricing is historically odd: $1.86 or $2.07 instead of the familiar $1.99.


Forrester Research estimates that price optimization software improves gross margins 10 percent. In its test, ShopKo sold 13 percent more of each product at regular price than it did previously. Gross margin rose 24 percent for test items when same-store sales were flat.


The effect of such software won't be seen overnight. It costs $1 million or more and needs comprehensive data and testing to work well. It also requires advances in point-of-sale technology and widespread adoption of electronic shelf labels. But its inevitable widespread use will create even greater make-or-break implications for the DM industry than the coming of the Internet.


What, for example, will happen to catalogs and FSIs that must be printed weeks in advance? Traditionally, pricing has been consistent within an area or even nationwide. How will catalogs be able to reflect pricing diversity within a city?


Currently, e-mail represents only 1 percent of the $200 billion DM industry. Will a need to reflect current pricing lead the industry to abandon print media and adopt e-mail catalogs, despite all the issues involved in the necessary personalization and opt-in requirements?


These issues are part of a revolution called dynamic pricing, which occurs when prices are free to move immediately in response to changes in supply and demand.


Dynamic pricing can be seen in the operations of eBay, or in any of dozens of auction-based business-to-business exchanges. Sellers benefit from a bigger pool of potential buyers, and buyers benefit from increased choices. IBM and other large computer organizations today adjust prices daily on some computers based not only on customer demand but also product life cycle.


Dynamic pricing is spreading fast. Research organization IDC forecasts that 20 percent of BTB e-commerce transactions will involve some type of dynamic pricing within a few years.


Dynamic pricing inevitably will transform consumer markets. Already, "markdown management" - progressively lowering prices until sold - is common among retailers. Variable pricing by location, quantity, payment terms and other options is also common.


Many fear dynamic pricing because of the convenience of fixed pricing and the fear of commodity-based pricing. However, it's important to remember that fixed pricing has multiple disadvantages. Economists know that uniform prices cut revenue. Some customers would have paid more than the posted price. Others would have paid less, but still enough to generate a profit and increase sales velocity.


Fixed pricing also raises costs. It takes time and research to determine optimum pricing, especially if a product is new to the marketplace. Pricing based on cost-plus or target models usually doesn't capture process costs. Fixed pricing cannot predict depreciation or accurately incorporate the effect of changing demand. The pricing may be right for a target market, but inappropriate for a customer or channel. Pricing also may not reflect market share, revenue or profit goals adequately.


By contrast, dynamic pricing offers several advantages. By pricing products based on market demand, companies have the potential to enjoy greater profitability on each item. Just because prices can move down with dynamic pricing doesn't mean profits also decline. Andale, an auction management company, surveyed eBay's online sellers. The average margin was 40 percent.


Another advantage that will grow more important is real-time information about market forces. This information can let companies immediately see the effect of sales and marketing activities and fine-tune production. It also provides warning signals concerning falling demand, reducing the likelihood of unsold stock.


As a result, both BTB and business-to-consumer companies that use DM must start studying how dynamic pricing will affect operations. It's critical that companies look at dynamic pricing strategically, since it affects supply-chain operations, facility planning, capacity management, channel and salesforce management and, of course, customer relationships. Effective strategies include:


o Work toward integration. Knowing the optimal price based on historical sales data is only a first step. Long term, companies must integrate price optimization systems with purchasing and other supply-chain systems. Systems also should be integrated with CRM and promotional systems.


o Invest in technology. Dynamic pricing requires robust systems and sophisticated software that can handle large volumes of transactions and other data. Technology is also critical to ensure that offline, online and telephone-based prices stay the same to avoid arbitrage by consumers.


o Work on segmentation strategies. Systems will enable time-of-day pricing, enhanced loyalty programs and other capabilities that improve payoffs from segmentation. Using pricing and CRM software together, the gambling industry has raised segmentation to a fine art.


o Expect a squeeze on manufacturers. Wal-Mart helped usher in the customer economy by wresting pricing control away from manufacturers. Pricing systems will give retailers even greater power in negotiations by letting them tell manufacturers precisely what a product will sell for, and when.


o Keep humans involved. Intuition still has value. Moreover, automated systems cannot account for variables like the weather or events like 9/11.


Once, customers bargained for almost everything. Final bills were based on mutual calculations concerning inventory and purchaser requirements. Then, about 125 years ago, Frank W. Woolworth helped revolutionize retailing by introducing fixed pricing into his five-and-dime chain. This pricing revolution was enabled by production and distribution capabilities that help make bargaining for each transaction impractical.


Now, technology advances are bringing us back to the future. Start looking at how dynamic pricing will affect both DM and operations.


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