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So What's the Bottom Line on Price Segmentation?

Written By: Predrag Jakovljevic
Published On: May 28 2007

The core principle of price segmentation is that pricing should be consistent for deals with similar attributes, particularly in business-to-business (B2B) enterprises. Price segmentation is a process that quantifies similarities by empirically determining which deal circumstances affect price response. To learn more about price segmentation, please see Know Thy Market Segment's Price Response, Advancing the Art of Pricing with Science, and Price Segmentation—Outlined and Explained.

In general, almost every company can benefit from deploying a relevant pricing solution and from improving pricing practices. Organizations should approach the management of selling prices and increases with the same rigor they use to curb upstream supply chain and manufacturing costs. Certainly, if a company has a handful of customers and a few products only, it can probably live without sophisticated pricing management software. However, such a company can still benefit from encouraging its sales force to diligently break down each order (that is, by customer, product, and order size) to figure out where money is being made or lost, or "left on the table."

The truth of the matter is, the more complex the pricing environment is, the more valuable pricing software becomes. For larger B2B companies with complex pricing requirements, price management software is essential in order to automate price execution processes, optimize price strategies and guidance through modeling, and provide insight into price improvement opportunities that may have significant impact on earnings and margins.

Prospective user companies should well understand that there are no shortcuts on the path to pricing excellence, nor can effective pricing be accomplished through the age-old practice of guesswork and tactical competitive reactions. Before embarking on a project, a prospective company should conduct a thorough, soul-searching exercise to ascertain its current pricing competence, and consider what changes will provide the most significant impact on the bottom line. Companies should seek honest answers to the questions below:

  • Do we understand how our customers react to price changes or discounting policies?

  • Have we segmented our customers, markets, and deals when it comes to pricing and discounting? If yes, then how many different market price segments do we currently serve, and do we charge different prices in each one?

  • Is our pricing and promotion strategy driven primarily by costs and perceived competitive prices? Or is it based on the final measures of value—market prices and margins?

  • Are we measuring customer response to and effectiveness of promotions?

  • Do we analyze our pocket prices in price waterfalls to understand the costs that are eating away at our margins?

  • Do we have a centralized, unified place that brings all the pricing, margin, and transaction data together for analysis?

  • Do we provide our sales channels clear, segment-specific discounting guidelines and targets? Do our salespeople offer discounts outside of these margin guidelines?

  • Do we have processes to enforce guidelines and handle exception review and approval?

  • Do our sales channels and management understand the difference between a "good deal" and a "bad deal"? Do we proactively score our deals and contracts against this measure?

  • Can we quickly adapt to any market or strategy changes to achieve short-term objectives without sacrificing margin or damaging long-term growth?

  • How have our nearest competitors adjusted their prices over the past year, and why?

  • Do we have real-time visibility into profit performance by channel, product, and customer segment?

  • Are we able to quickly sense and respond to emerging opportunities and competitive threats as they arise?

The idea here is to create a documented price strategy and rollout plan that a company will execute. The price strategy and rollout plan should include the following information: what the discount strategy and target profitability will be, whether and how customer segmentation influences pricing decisions, what approval levels exist for pricing decisions, whether the company will sell unprofitable product lines to unprofitable customers (that is, whether volume and revenue are more important than profit and earnings), and the degree to which the company can differentiate prices across its markets.

For example, before sending a salesperson into a sales situation, the company should well understand how a customer will likely respond based on the known characteristics of that customer, the products the company plans to sell that customer, and the relative economic value the company provides to that customer. Perhaps a customer or a deal is so important that the company will yield to any demand. This is fine, as long as there is a rationale, or "rule," for making that decision. Conversely, another customer may not receive any discount, even if it means the deal will be lost. That rule is fine too, as long as there is a rationale based on data and analysis that supports this decision.

As said earlier on, on its own, price management might improve revenue (by a few percent) and gross margins (by ten percent and more). But the true benefits will only come when price management is integrated with business strategy, sales execution, finance and supply-demand planning, and operations. Companies that participate in markets with wide variations in price response, or that have the ability to shape demand through price changes, should focus on a combination of price optimization and price enforcement. Other companies might want to start from price enforcement first.

Because of the potential gains, many innovative companies have already made significant investments in price management initiatives, while their direct competitors are feeling the pressure to embark on their own pricing management deployments. A "litmus test" for a company to learn whether the solution is needed would be to ascertain 1) how pocket margins vary across its different businesses and regions; 2) how many pricing decisions are outside of existing guidelines and the extent that these exceptions require approval; 3) how long it takes to process a special pricing request (how convoluted is a pricing approval workflow, for example); and 4) how long salespeople spend looking up, inquiring about, and communicating prices.

User Recommendations

As price management is an emerging and therefore fragmented space, selecting vendors based purely on their viability is not possible, as the space has yet to experience consolidation. Thus, appealing projects with proven paybacks and proof of concept are advised, as well as on demand deployment where possible. Since price execution functionality (price list management, discount management, price configuration, etc.) is often delivered as an adjunct to price administration and order management capabilities in enterprise resource planning (ERP) functions and data, it is essential that the selected price management product be easily integrated with such tools as master data management (MDM) and data integration to achieve smarter, seamless order-to-cash execution processes.

It is important to insist that every pricing application vendor provide references and a demonstration of their application using a subset of the prospect's actual data rather than a generic demo. At the end of the day, every vendor should be challenged to prove whether and how it can enable users to specifically measure the margin lift, or return on investment (ROI), of the application. As for the pricing application easily connecting to the existing enterprise infrastructure, prospective users should check whether the application is built on modern and globally accepted software standards and protocols, and whether all of the applications from the vendor interact for a cohesive pricing suite, or if they are stand-alone modules.

In reality, not all businesses are ready to benefit from profit and pricing optimization, but all these products and services are, in turn, either driven by information from the users' existing systems, or they can be economically generated. Pricing and profit optimization is not magic; it starts with information. If users do not have the right information, they will not get the right results. Typically, in business-to-consumer (B2C) markets, a few years of data history is needed to prime the system (meaning lots of data capturing, quality testing, and interaction with the vendor). But some companies will still make errors about data they do not have, which brings us back to the need for balancing pricing with demand management and consumer research (that is, whether the consumers feel ripped off and resentful towards the last price hike).

In B2B environments, one price does not fit all—quite the contrary. In these industries, it will often be the case that customers will never respond to price shifts under one set of circumstances, and therefore slashing prices only leaves profit on the table. However, under different circumstances, some customers may always respond to shifts in price, while others will vacillate. Price optimization should give the company the insight it needs to react appropriately in each situation, thereby maximizing profit margins in each transaction.

A company needs to divide its transactions into different segments because each segment has its own unique customer price response that reflects its assigned value to the product or service under the given circumstances. In these cases, price segmentation should be the foundation for implementing a successful pricing initiative; it is a deal-by-deal process that often results in hundreds to tens of thousands of differentiated and identified segments. In general, these prospective users should discern whether the pricing application, including price optimization, can provide value to their businesses across a meaningful range of transaction types—from single, spot-on to high velocity (lots of transactions)—or whether it can add value to businesses that have low transaction volume or contract-based deals (which requires more of a deal-by-deal analysis and optimization).

This is the last part of the series Know Thy Market Segment's Price Response.

 
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