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Pricing Management in a Down Economy -- Part 1

Written By: Predrag Jakovljevic
Published On: August 22 2008

Not long ago, I wrote about the pricing management and optimization software market, and in particular depth about two bullish vendors and fierce competitors in the business-to-business (B2B) manufacturing and distribution segments: Zilliant and Vendavo. Look for similar write-ups down the track on DemandTec, Symphony Metreo, and on the Servigistics pricing solution (whereby the last will focus solely on spare parts pricing and planning).

While I do not plan to cover the esoteric pricing solutions used by airlines or hospitality companies (e.g., Rapt or PROS), there is also a vibrant pricing market in the retail sector, as seen with SAP's acquisition of former KhiMetrics and Oracle's similar acquisition of ProfitLogic. In addition to TEC's article entitled "The Retail Battleground for Pricing Management", you can find more information about SAP's perspective on the pricing market here, and Oracle's pricing offering here.

But, the dates of all these articles will indicate that they were done during a still-solid economic milieu worldwide. It doesn't take a genius to realize that we are now in quite a down economy. Given the dreaded “R” world hovering over us, are there any trends (or hunches) on how manufacturing, distribution and retail organizations use pricing solutions? Namely, do the enterprises have different pricing approaches in good vs. bad economic times?

On one hand, soaring gas prices force (or at least tempt) everyone to instinctively raise their prices too, but, on the other hand, the buying power of (soon to be) unemployed and/or disconcerted consumers and enterprises is quite limited. No one can just get carried away with increasing prices to compensate for costs given that folks have less and less buying power (plus the pervading belt-tightening psychosis).

This is certainly too complicated an issue to have a single correct answer. While luxury consumer goods like caviar or Rolex watches are not really impacted (i.e., their demand is inelastic, since rich folks always have money), for most consumer goods that are discretionary, price is a big deal and demand is elastic.

We can see even more discounting and promotions here, since the base price doesn't do a lot, whereas promotional discounting lets consumers know that the price is lower and that it is a limited time offer. For necessities (food and over the counter [OTC] and generic drugs) we can see a change in buying patterns -- people still need the product, but will likely switch to a lower price-point offering.

Thus, for example, the profitability pictures of large food manufacturing and distribution companies do not really suffer, since these giants sell fewer of the higher price-point items but will compensate with the higher volume of the lower price-point items in a downturn. If a food (or a specialty retail) company only has a premium brand (e.g., Ben & Jerry's ice cream or Starbucks' coffee drinks), it will likely suffer, as seen in recently announced closures of 600 Starbucks stores in the United States --US (luckily, none of them in my neighborhood). Conversely, if companies mainly have low price-point brands, they might even gain sales these days, as is the case with many discounters.

Spare Parts Pricing

Spare parts are somewhat like food and drugs -- in most cases, the customer must have the part but may want to buy a lower priced alternative. Yet the healthy margins on parts (usually around 25 percent) can absorb even some price reductions if necessary (or simply not raising the prices) as the suppliers' prices go up. Hence, I suspect the spare parts' prices will not go up as fast as some might expect.

Servigistics claims that while a down economy certainly curtails the purchase, and hence, the production of new products, the demand for service actually increases. That is because businesses want to save money and get more out of their initial investments. Consider the airline industry as an example. Many embattled airline companies are deferring the purchase of the newer, more expensive planes, which forces them to fly the cheaper and aging planes (and which might be a disconcerting thought to us flyers).

This means more service work is needed, hence more service parts are required. So it goes with the heavy industrial, high-tech, motor vehicle, medical equipment, and, especially, consumer durables sectors. Trying to sell new products in a down market is difficult, but selling service (and accompanying parts) is much easier.

At the same time, more and more companies are realizing that service has shifted from being a cost center to becoming a profit center. While products have become commoditized, service is difficult to replicate and can be a competitive differentiator. In fact, field service is quite a different business model story, with profit margins as high as 50-60 percent. Plus, while service providers can be more flexible towards absorbing suppliers' price increases, it is also often harder for the customer to get a lower priced option for service in many cases.

So how can companies capture more of the service business? Well, one way is through optimizing business processes using well-attuned software packages, and the service parts pricing ones would be a great example. Maximizing profitability on every part is a strategic way to boost profit.

Many service parts have an elasticity curve: bring a part price down a bit and it should sell more, thereby increasing volume and profit.  Or, maybe a business is leaving money on the table because a part is priced unnecessarily too low? So, logically, raise the price, and once again, capture more profit. In a nutshell, service parts pricing is all about intelligently pricing yourself in the market.

For example, one world leader in the agricultural and construction equipment businesses relied on the outdated and manual cost-plus method to determine the price for service parts on its construction equipment. The formula was simple: every quarter the company increased the service parts prices; however, over time, the managers noticed that demand began to drop considerably.

After a corporate mandate to increase service revenue, this original equipment manufacturer (OEM) conducted in-depth market research to discover the source of decreasing demand.  The managers found that the vast majority of their service parts were priced well-above the market averages across all categories.  This overpricing attracted competitors to the market.  And the competitors were beating the OEM out because of the lower prices. Why buy an OEM part if there’s one that’s cheaper, while the quality goes without saying?

In order to increase demand for their parts, the OEM set up a program for market research to be conducted on a quarterly basis in order to bring prices back into the competitive zone.  However, research was along the “set (prices) and forget” theme, since there was no tracking of competitive response over time. Therefore, the complex spreadsheets were left to collect dust after just one use.

With a new pricing software solution in place, the construction equipment manufacturer could now systematically measure and calculate price sensitivity on a regular basis. This is especially important when new product orders are down and service orders are up.

The pricing solution also enables differentiated market strategies, since without it, companies may end up competing against themselves.  For example, some buyers might purchase parts in North America where the price is lower than in Europe.  Since exchange rates change all the time (and the current weak US dollar doesn’t help either), buyers can then re-sell these parts in the European market for even less than what the OEM is charging.

Better Management of Contracts

Furthermore, whether it’s purchasing a new car or a new server, companies often encounter a disconnect between sales and operations, since much service business is now done on long term contracts.  So, when the salesperson throws in a discounted service contract with that new office phone system, for instance, the company cannot determine if it is losing money or making money from that service contract, as it includes not only the price of the service parts, but also the cost of the field technician’s time and expertise.

Historically, companies have not tracked whether these contracts have been profitable or based on hard data.  With a service parts pricing solution like Servigistics',  companies can track previous contracts and then forecast over the life of future contracts, including data on breakage rates, locations with higher usage, seasonality, and other customer requests to determine the profitability of the contract.

Finally, pricing also goes hand in hand with service parts management (planning and inventory optimization), since maximizing pricing profitability while reducing inventory is a significant boost to the bottom line. The business can not only save money, but also make money by optimizing the service parts. Servigistics is currently the only global provider that provides both capabilities. Well, to be fair, Syncron does both too, but currently mainly for small-to-medium companies and only in certain regions (e.g., Europe).

Part II of this blog post will analyze the pricing software market's current state of affairs and also report on the current pricing approaches and findings of retailers. Your views, comments, opinions, etc. about any above-mentioned pricing solution and about the software category per se are welcome in the meantime.

We would also be interested in hearing about your experiences with this nascent software category (if you are an existing user) or your general interest in evaluating these solutions as prospective customers.
 
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