Roadmap to Price Optimization

Retailers use analytics to increase profits and revenue

The ERA of traditional pricing strategies is quickly coming to an end as retailers increasingly implement optimization tools, in some cases to drastically improve financial performance.

Because price optimization systems often provide a substantial competitive advantage for retailers, the use of the technology can be a closely guarded secret. Forward-thinking retailers are using price optimization to turn inefficient pricing processes into real business benefits, which translates into increased revenue and margin uplift.

Wwhat It Means

Price optimization is the process of using demand forecasting to maximize profit. The systems combine sophisticated forecasting tools with optimization algorithms to create high-performance decision support systems.

The technology helps retailers plan pricing strategies and better manage markdown cycles. The applications are designed to maximize profit margins while managing information about price changes that may result from competitor price alterations, cost increases or aging inventory. Retailers who implement price optimization solutions are able to establish prices based on historic, competitive and customer demand information, as well as other analytical factors.

"Retailers are looking for technologies that maximize profit potential of each individual item on their shelves," notes Greg Buzek, president of IHL Consulting Group, in the "Price Optimization -- A Retailer's Guide" report. "Price optimization software uses historical and current sales trends to identify the best price for which to sell that item. This maximizes margin and improves financial performance."

The process has quickly emerged as a high-priority merchandising initiative, since even minor improvements in pricing effectiveness can lead to substantial bottom-line savings.

What's At Stake

Retailers who miss the boat on price optimization are forfeiting substantial bottom-line benefits. Price optimization can generate an impressive ROI, typically five to 19 percent profit improvement. The advantage is in the shift from a traditional two-tiered pricing structure, featuring regular and discounted clearance items, to a multi-tiered program that drops prices only as a factor of sales, says Buzek.

"A number of retailers are now quietly, yet aggressively, deploying RLPM (Retail Lifecycle Price Management) technologies that can add $10 million or more to a major retailer's bottom line within a year of full implementation," says Scott Langdoc in an AMR Research report. "It's creating a competitive advantage that retailers who are not willing to change their traditional pricing and promotion processes will be hard pressed, if not completely unable, to catch."

While many retailers are hesitant to share their results in an effort to maintain their competitive advantage, "AMR Research tracked a number of RLPM-related projects and reported that a typical $5 billion Fast-Moving Consumer Goods (FCMG) retailer with 200 stores averaging $25 million in annual sales will see as much as $50,000 of incremental profit per store," says Langdoc. "Additional improvements in promotion planning, modeling and execution can create enough targeted sales lift to add an extra $1 million in revenue per store. Assuming a fully loaded enterprise RLPM-oriented project cost of $5 million to $8 million for this size retailer, the project has payback well within a year of chain-wide implementation."

How To Succeed

Retailers considering the technology should beware of data quality issues, challenges in execution, lack of organizational alignment, high cost of ownership and technology vendor risk as the primary deterrents to a successful implementation.

"User companies must manage the risk of vendor acquisition by requiring ROI estimates for each project phase, devising contingency plans for key vendor employee departures, and looking into hybrid deployment models," says Noha Tohamy in Forrester's "Pruning the Pricing Landscape" report.

To recoup the maximum benefits from price optimization, retailers must weave it into the fabric of the company's business structure. "Even if different RLPM components are implemented over a long period of time, as long as they are part of a larger, enterprise-wide architecture toward creating a new pricing and promotion platform, the benefits will come," says Langdoc.

A number of early adopters, including The Home Depot, Liz Claiborne and 7-Eleven, have realized the benefits of price optimization. "With hundreds of price zones and thousands of stores selling thousands of items, we needed a solution that would enable us to make optimal pricing decisions," says Kay Trapp, manager of pricing, 7-Eleven.

After an evaluation that included a forecast test and a controlled pilot project, the retailer selected Khimetrics' Customer Demand suite and pricing technology.

"It was important for us to validate the science and models, and we felt a forecast-accuracy test would be a critical first step," says Trapp. "Next was to ensure the solution provided us measurable improvement from our current pricing practices."

Using the new system, 7-Eleven improved store performance without adversely impacting store traffic. The retailer can now measure price sensitivity of each category and determine the strategic role that categories such as profit builders, traffic builders and image builders should play in reaching merchandising goals.

Initial short-term results from price optimization technology should translate into long-term benefits. "The real value won't be realized until price and promotion plans are drawn into appropriate inventory and replenishment planning models," says Langdoc, "as well as into the task management and store operations systems that help ensure that store personnel follow through on required actions to ensure successful price and promotion delivery."