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Companies say price-optimization software is worth the effort it demands.
John McPartlin, CFO IT
March 15, 2004
Companies have grown accustomed to using information technology to design, manufacture, and ship products, and to slice and dice the numbers in every conceivable way after the fact. But what's less well known is the role IT can play in determining the optimum price for a product or service. Since "optimum" equates to "most profitable," the technology at the heart of these efforts goes by interchangeable names: price-optimization or profit-optimization (PO) software. While not new, PO software is poised to go from the fringe to the mainstream, say analysts, vendors, and, most important, customers. That's being driven by a number of factors, including the pioneering companies going public with their successes and large software vendors taking an interest in adding PO products to their product lineups. Despite the still considerable implementation challenges, the financial rewards from these products may now outweigh the risks—for some customers, at least.
"This year will see practical acceleration, deployment, usage, and value coming out of the use of profit-optimization technology," says Scott Langdoc, vice president of research for the retail industry at Boston-based AMR Research Inc. Langdoc says the success of some of the small companies offering PO software has captured the attention of the big guns, which will try to get into the market themselves by either developing their own products or gobbling up some of the smaller players. Some analysts predict SAP, PeopleSoft, and SAS Institute are likely to join the fray soon.
The entry of the bigger software companies into the market, coupled with the positive word of mouth from some of the technology's early adopters, should help reassure large customers that have been wary about implementing these products. "There will be consolidation later this year and into 2005, and that will offer up the kind of stability that large customers want to have," says Langdoc. IT research firm IDC predicts a 12.5 percent growth rate for the software through 2007.
One of PO's ancestors is the yield-management software that gave a boost to the airline and hospitality industries in the 1980s by squeezing profits from the last-minute sales of vacant seats and rooms. More recently, the retail industry has been an enthusiastic user of such products, often employing PO software as a defensive move against "big box" stores such as Wal-Mart, which have led the charge in this niche. Major retail chains, including J.C. Penney, Best Buy, Home Depot, Gap, and Staples, have all announced that they have PO programs currently in place from retail-oriented vendors such as KhiMetrics, DemandTec, ProfitLogic, and Manugistics. Other vendors, such as Acorn Systems, Rapt, and Metreo, have concentrated on providing PO software to companies beyond the retail sector, including Honeywell, DHL, and Charles Schwab.
The software puts its arms around a lot of data, both internal (some of it builds on work done in activity-based costing) and external (analyzing past customer response to price promotions, for example), to help users determine an ideal pricing strategy.
Early adopters talk about profit optimization with the zeal of religious converts. David Feinstein, CFO of Rochester, New York—based metals distributor Klein Steel, says he's not someone who is easily impressed, but he's been consistently surprised by the information the company's Acorn system has helped uncover. Klein Steel, which distributes steel, stainless steel, aluminum, and fiberglass products throughout upstate New York, has been using Acorn for the past two years. "Now we have a better understanding of where the actual costs occur on a customer and product basis for the purposes of allocation," he says.
The impetus for looking into PO solutions came from Feinstein's boss, who came to him after attending a trade show at which profit optimization was mentioned. "I was very skeptical," Feinstein says, "which I guess is typical of finance, but I agreed to meet with the company. After a two-hour session, I was convinced that we needed to install it. Looking at the software, the algorithms, and the detail at which the software could delve into our business, I was very impressed. They were not approximating our costs but isolating them on a department-by-department basis."
Many companies say the benefits of PO software are not hard to quantify. One of the key things Klein Steel discovered after implementation was that the company had the wrong idea about who its most profitable customers were. "You make a profit at the end of the quarter, but then you find out that you're losing money on a third or half of your customers and you would actually be more profitable without them," he says. By using PO software and having access to more-relevant data, the company found that although it consistently coddled its larger customers, it was actually the midsize customers that were the most profitable. "So we changed our orientation to the customers that fed our bottom line the most," says Feinstein.
In addition to lavishing more attention on certain clients, Klein Steel also made some operational changes based on the data its PO software uncovered. In some cases where customers were receiving several deliveries a week, the company was able to cut deliveries down to one a week. This reduced delivery costs for Klein Steel and cut receiving costs for its customers. The company was then able to lower its expenses while keeping prices flat, essential in its highly competitive market. "If I could not pinpoint where my costs are, I would not be able to do something like that," says Feinstein. "And if I could not pinpoint [the factors underlying] my net profit, then I wouldn't even know we had a problem in the first place."
Canadian apparel retailer Northern Group Retail Ltd. implemented a PO solution from ProfitLogic in September 2002, embarking on a remarkably tight, 13-week implementation schedule so that it could have the product in place for the holiday season, which accounts for 40 percent of its annual sales. The company's CFO, Michael Stanek, says the software, which monitors sales data and inventory levels from Northern Group's 278 stores and performs historical comparisons, helped the company move away from uniform chainwide pricing and discount strategies to an approach more attuned to regional needs, weather patterns, and other trends. As a pilot test of the software, the company offered various discounts across the country and didn't mark down prices at all in some cases. "We saw we didn't need to be so aggressive in marking down in some areas," he says. "We are now managing markdown dollars and generating as much gross margin as we can in certain regions. We are not leaving any nickels on the table."
Pete Algero Jr., CFO of New Orleans—based Conco Food Service, a food service distributor to restaurants, hotels, nursing homes, and hospitals, says PO software from Acorn has helped improve both customer and vendor profitability since its implementation four years ago. "Before we got the software, we created an internal report giving us an average or estimate on customer profitability, but we never had anything to tell us what our actual costs were," he says.
By looking at the detailed information the software provides, Conco salespeople and department heads were able to see certain problems with customers that had once been hidden in rolled-up data. Conco discovered that some of its customers were taking too many deliveries, or their order sizes were too small to justify delivery costs, or they were not ordering the right mix of products to keep the deliveries cost-efficient. "That's the nice thing about PO," he says. "It uses actual costs detailed right down to the item level." Even with a recent revenue drop of 9 percent, Algero says Conco's profit margins have increased 150 percent. He attributes much of this to the company's PO software.
To Gain, Some Pain
Despite their praise for PO solutions, all of these CFOs admit that the implementation process was not without its challenges. Deployment delays, some cost overruns, and technical glitches seem to be a rite of passage before companies can gloat about results.
"When we first started, things were very unstable," says Algero. "We were basically guinea pigs. It also took a lot of time to explain to everyone how it works. It took about six months of meetings before the different salespeople and department heads really understood it."
At Klein Steel, a good deal of work had to be done up front customizing the software to provide the kind of data the company needed. "It takes a tremendous amount of management and IT time to help them design the algorithms correctly, but once that is done, the software is basically maintenance-free," says Feinstein. "All your pain is up front."
The primary obstacle facing any company trying to implement PO software, according to CFOs, vendors, and analysts, is the cultural resistance from those at the front lines—salespeople, pricing managers, and department heads—who have been making pricing decisions on their own largely based on spreadsheet data and gut instinct. Many of these people feel threatened by software that tries to tell them what to do.
"[Cultural issues] represent one of the single greatest obstacles to rapid market adoption," says Tim Manning, vice president of marketing at Scottsdale, Arizona-based KhiMetrics. "You have a new technology that, while proven, makes you no longer reliant on the 'art' of pricing. A crucial part of success has to do with rigorous education."
"Historically, hundreds of millions of dollars have been invested with gut feelings, intuition, historical practice, and little insight into return," adds Scott C. Friend, president of ProfitLogic. "It's been like throwing darts at a wall. In retail, they hand checkbooks to untrained liberal-arts majors and say, 'Go spend this money.' Intuition does not get optimal results. It must be supported by really good insight into customer demand."
The best way to increase user buy-in is to position PO technology as an enhancement rather than a replacement for individual expertise, according to AMR's Langdoc. "Instead of 'price optimization,' it should be looked at as 'price recommendation,' complementing the experience of the people who are using it," he says. "Adoption will increase when users are comfortable that they can combine their pricing strategy with recommendations from the software and then deploy prices that are defended by strong analytics." One other factor will help, he adds: increased profit margins, which have a way of turning skeptics into fans.
John McPartlin is a New York—based writer and former editor of NetGuide magazine.
The Optimal Optimizer
Price-optimization software products are often tailored to specific needs, which can include:
While many vendors play well in more than one category, analysts say none addresses them all effectively. Shop carefully.
Source: Forrester Research Inc.