About five years ago we published an article series entitled “The Case for Pricing Management,” since companies in the manufacturing, distribution, services, retail, telecommunications, and hospitality and travel industries can face a variety of pricing problems. On the one hand, unnecessary discounting and quoting prices below a break-even point can result in a company’s poor financial performance. On the other hand, pricing some items out of the market can result in rebelling customers and high levels of unsold perishable or obsolete inventory.
Back then we believed that to improve pricing was one of the most strategic and powerful ways for companies to improve their business and financial performance. The classic McKinsey & Company’s article from 2003 (“The Power of Pricing”) stated that a tiny 1 percent increase in prices typically yields an 8.7 percent increase in profit margins (which is much more than the profit margin increase that results from a 1 percent decrease in costs). With advanced pricing software, companies were able to identify margin leaks with powerful new levers that improve revenue and profitability, defend and grow market share, and improve business agility.
Pricing Power: Key Competitive Differentiator
Conventional wisdom would suggest that pricing—including promotions—is a critically important discipline within any enterprise, as it touches many departments: from product managers, marketers, sales personnel, resellers, and customers as a matter of course, to financial managers and accounting departments. Pricing is an important component of an enterprise’s business processes and financial performance. And yet, does anyone in those departments know whether their company is making the best pricing decisions?
Do these departments know whether and how much their pricing decisions are costing the company in lost revenues or perhaps whether they are generating hefty profits? In the words of the aforementioned McKinsey consultancy in The Price Advantage,
Every product and service sold since the beginning of time has had a price assigned to it. Setting that price is one of the most crucial, most profit-sensitive decisions that companies make. Ironically, very few companies price well.
Are the sales folks who sell the highest volumes of products—and get rewarded heftily via commissions—making money for the company or eroding its profits? Are they selling the most profitable product mix and volumes, or perhaps they are missing out on margin opportunities? On the other hand, are those customers that buy most of our products also profitable for our business, and what is their total cost to serve? How about offering more profitable product substitutes, and cross- and up-sale opportunities? Why not attempt demand shaping and inventory optimization (IO) opportunities via pricing and promotions?
Companies face extraordinary challenges in today’s international economy, competing for business from every corner of the globe. Executives must continually evaluate the best strategies for increasing profitability beyond the cost-cutting measures that they have likely executed in the past few years—and that everyone else, including their competitors, is also taking. At the end of the day, when one company cuts to the bone, further cuts can be painful and self-destructive. Pricing—or the revenue side of business, if you will—should thus be a key competitive differentiator and an intrinsic part of sales & operations planning (S&OP)/integrated business planning (IBP) processes.
Even more importantly, with the speed at which organizations operate—coupled with dynamic market changes, shorter product lifecycles, and raw materials price and availability volatility—companies can no longer rely on cumbersome spreadsheets and hunches to make mission-critical pricing decisions. Many of you will have heard what Warren Buffet told the Financial Crisis Inquiry Commission in May 2010:
The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.
Look no further than Apple Inc., which recently became the most valuable company in the world in terms of market capitalization, in addition to being the most valued brand. Is it a mere coincidence that Apple can command premium prices for its cool gadgets? Is it plain old luck? By using astute pricing software, companies that are far less valuable and in a less commanding position than Apple are able to identify their own pricing power and achieve extraordinary business advantages. As another example, in 2010, PROS Holdings’ B2B pricing software customers outperformed the S&P 500 returns by a whopping 230 percent. Now more than ever, pricing needs to be a core competency, not a constituent part (e.g., routine price lists creation) of an enterprise system.
Today, with the proliferation of products, suppliers, customers, and segments and the sophistication of buyers, there are more pricing decisions to make than ever before. Because of this proliferation of price factors, the traditional approaches for managing prices are simply no longer adequate. Thus, five years since our article was published, one would expect much more widespread use of pricing software. One would also expect a mature and blossoming market, right?
And There’s More…
Ironically, if one looks at the penetration of various disciplines in the realm of enterprise software, pricing is the least automated. Indeed, human resources (HR)/talent management, sales and marketing, procurement, engineering/product design, supply chain/operations, manufacturing, etc. have all been using automated software tools suited to their respective departments. For evidence you need only look at the market size estimations—several US$ billion—for individual software categories, such as customer relationship management (CRM), sales force automation (SFA), marketing automation, spend management/supplier relationship management (SRM), human capital management (HCM), enterprise resource planning (ERP), and demand planning (DP).
In light of the proven value it provides, it’s even more ironic that, according to Gartner’s estimate, pricing software is potentially a multibillion dollar market, but has market penetration of just a few percent of its potential at best. Indeed, there are just several vendors that target this market, and with the exception of the aforementioned PROS (NYSE: PRO), most are start-ups with budding customer bases and revenues. The combined annual revenues of these companies do not yet exceed US$200 million, and PROS, as the only public company, contributes a significant chunk to this total figure. There is also a dearth of industry analysts and academics covering the market. Gartner offers encouragement in releasing its recent extensive MarketScope report for price optimization and management software for business-to-business (B2B) environments.
The pricing and margin optimization software market is relatively new and still growing and evolving. It is uncertain whether this software category will achieve and sustain high levels of demand and market acceptance. With over 30 percent projected growth this year, PROS would argue that assertion. Rather, as a new entrant to the market, it takes some time to make headway. We’ve seen firsthand the changes at PROS whereby targeted marketing has made a significant contribution to the business of late.
Some businesses may be reluctant or unwilling to implement pricing and margin optimization software, for a number of reasons, including failure to understand the potential returns of improving their pricing processes or lack of knowledge about the potential benefits the software provides. Even if businesses recognize the need for improved pricing processes, they may not select pricing and margin optimization software products because they have previously made investments in internally developed solutions for their pricing and margin optimization practices.
Needless to say, pricing management is still poorly understood and often sounds scary to many companies. Granted, sales folks hate “black-box” pricing methods, and they are not big customer advocates (i.e., most salespeople just want to sell something—they don’t necessarily have the customer’s best interests at heart). To change the mindset of reasonable sales personnel requires thoroughly educating them to explain why consistent, scientific, customer segmentation–based pricing is in their best interests in the long run.
Traditionally, high-performance enterprises that have deployed B2B pricing management/optimization tools have been unwilling to speak publicly about the benefits they’ve realized. For one, they want to hide their pricing capabilities from their direct competitors, and for another, they do not want their customers to think they’ve been taken advantage of. But the fear of upsetting customers, or of appearing unethical, is often not based on reality, given that sometimes pricing optimization software might even suggest price reductions similar to inventory optimization software that may suggest higher inventory levels for certain items.
Pricing management strategy—and the associated software—remains a tough sell because of the mindset that change management requirements go along with it. Other often reported reasons or excuses for companies not having instituted structured pricing initiatives are deficiencies in the following areas:
- Internal resources
- Available technologies and their capabilities, or awareness of them
- Managerial sponsorship support and a pricing champion, e.g., a chief pricing officer (CPO) or chief financial officer (CFO)
- Useful qualitative and quantitative pricing data
Without evidence of clear business value clearly articulated by pricing software companies, some businesses may elect to improve their pricing processes through solutions obtained from their existing enterprise software providers, whose solutions are designed principally to address one or more functional areas other than pricing. These enterprise solutions may appeal to customers that wish to limit the number of software vendors on which they rely and the number of different types of solutions used to run their businesses.
What Pricing Management Entails
Before analyzing why traditional back-office enterprise systems are typically inadequate for pricing management, let’s discuss the elements of pricing management. While TEC’s 2006 article entitled “The Rise of Price Management” talks about the concepts of price setting, executions, visibility, management, and optimization, the aforementioned Gartner MarketScope report states that the price optimization and management software market for B2B commercial relationships encompasses the following three segments:
1. Price analytics supports discovery processes to identify and explain historical trends in realized pricing typically from transactional data, the impact of market dynamics, and pricing anomalies. The main goal here is to identify margin opportunities via metrics such as pocket margin, pocket price, and total cost of sales. As a result of the analytics, enterprises are able to do the following:
- Proactively monitor pricing performance and market conditions
- Determine how individual customers contribute to overall revenue and profitability
- More accurately understand transaction economics, including the impact of discounts, rebates, allowances, shipping terms, payment terms, replacement costs, and other factors that can influence the profitability of a transaction
- Identify and understand detrimental pricing trends and strategies
- Understand the components of margin variance, including price, cost, volume, product mix, and exchange rate effects
2. Price optimization is primarily concerned with supporting segmentation, willingness to pay (WTP), modeling, and forecasting requirements to identify and define optimal pricing strategies and set price recommendations. As a result of performing optimization, enterprises are able to do the following:
- Understand differences in segment purchasing behavior
- Create and manage pricing policies and rules that are aligned with corporate strategies
3. Price execution focuses on functionality that supports the creation and dissemination of pricing information lists, providing guidance on pricing practices and deal development, definition, and administration of optimal pricing rules and models for ordering and quoting systems, and the automation of approval processes. As a result of price execution, enterprises are able to do the following:
- Set up and manage field pricing and discounting guidelines based on pricing policies and benchmarks
- Manage pricing approval and exception thresholds and the pricing approval workflow to ensure consistency in the pricing process and maintain transaction histories
- Communicate price targets, price floors, and profitability guidelines to appropriate decision makers within an organization
- Consider important transaction context to aid in better price negotiations, including insight into customer price history and WTP, current and planned inventory levels, and recent trends in demand, supply, cost, or competition
- Evaluate transaction scenarios and allow comparisons to previous transactions and peer-group benchmarks based on relevant metrics
- Automatically generate mass price updates when pricing inputs change, including costs, competitor prices, market indices, supply availability, and demand metrics
Of the above three areas of pricing, ERP systems can help only in part with the price execution activities. ERP systems do not directly address the myriad of critical price-setting issues. Rather, they assume that a product marketing or sales person simply “knows” the right price.
ERP-based Pricing—Necessary but Not Sufficient
ERP databases have price tables that can then be applied to quotes, orders, or invoices. The catch is that they do not take into account whether or not the price in the table field is the best price for both the company and the customer. Without external help from pricey pricing consultants such as Deloitte, Accenture, McKinsey, IBM, Wipro, etc., how does an organization select the right prices to put in those tables in the first place? Do those prices reflect recent market trends? Are they the most profitable prices to set? And when and why should an organization change its prices?
For companies that negotiate prices with their customers, another question is whether the prices take into account a customer’s specific needs and WTP. Also, how do salespeople acquire the insights to determine discretionary discounts, and what discount is most appropriate to maintain margins and profits? Without sophisticated statistical methods to segment customers and an understanding of each customer group’s WTP, it is basically impossible to establish a profitable and efficient pricing strategy.
A sound, science-based pricing strategy is instrumental in providing guidance for each deal’s so-called floor (minimum), target, and stretch (maximum) price in order to reduce the time to quote for the sales force, and to improve margins and profitability. For their part, analytical tools are instrumental in achieving improved pricing visibility by customer, product, region, etc. so that management can identify underperforming products and customers and take immediate action.
For a company that typically relies on ERP systems for their pricing needs, the end result is that they wind up using a simplified “cost plus” pricing model focused on a single corporate-dictated gross margin target that is applied to virtually all product lines. Unfortunately, this is an unrealistic and inadequate one-size-fits-all approach that doesn’t offer the results companies are looking to achieve. Some “market-sensing” pricing can be offered based on occasional anecdotal feedback from salespeople or dealers that “prices were too high.” This path typically doesn’t stipulate how much too high, nor does it provide any contextual facts. Without pricing software, when market-based price changes are made, companies are unable to make price adjustments on related parts and components to offset the margin loss.
In addition to ad hoc pricing strategy and execution, corporate departments and sales channels are often not aligned. As a result, companies also often lack insight into competitors’ prices, which results in out-of-market prices. Companies must not only understand their market position, but also react to market changes more quickly to capture time-sensitive profit opportunities and risks. The inability to react swiftly to data regarding competitors often leads to further complications, such as delayed notification of competitive price moves, which again results in lost revenue, volume, and margins.
To be fair, some ERP systems can help with price list creation and issuing, and with multilevel approval workflows. But, without the ability to segment customers based on hard data and to determine their WTP—or sensitivity to price increases, in other words—how can ERP systems help users build methodologies to create price lists that are based on predetermined factors and on the company’s strategic goals? That is to say, creating a price list reverts to taking a shot in the dark.
Thus, innovative add-on pricing software products should instead analyze, execute, and optimize pricing strategies using data from traditional enterprise applications, augmented with real-time and historical data. Only specialist pricing software products can enhance an organization’s ability to process and implement pricing policies in a systematic manner. As a result, companies are then able to pursue more sophisticated and effective pricing strategies and make far better, more informed pricing decisions.
Additionally, best-of-breed pricing software products help companies uniformly implement best practices throughout an enterprise, from sales to marketing to finance. On the downside, pricing vendors regularly have to provide professional services to configure, integrate, and customize their software products to meet the specific pricing needs of each customer. Often, this implementation comes on the heels of an involved engagement with a strategic pricing consultancy.
B2B versus B2C Pricing Complexities
Although business-to-consumer (B2C) pricing remains tricky, it is somewhat easier to achieve, as discussed in TEC’s previous extensive series on retail pricing. After all, retail prices and promotional campaigns are visible on shelves and endcaps, and there is a wealth of historical pricing data for consumer goods that is available for an inexpensive fee from various syndication services. In addition, one should expect the uniformity of nominal prices per item at all Kroger’s, Market Basket, or Stop and Shop stores across a given region.
Airlines and hotels conduct some sort of consumer segmentation and deal negotiation, as in the case of group deals. After all, we all expect to pay much more immediately before the departure than if we book our flights well in advance. While it may be possible to get great last-minute deals for those seats that airlines do not manage to sell, who wants to take that chance? It is also understood and accepted that a short return trip during the week will cost more than a trip that includes a weekend stay. That is segmentation at work: desperate business people that must close a deal in person versus less desperate travelers who have more flexible schedules and can comparison shop at their leisure. Some airlines have recently even abandoned the Global Distribution System (GDS) with its fare classes and other idiosyncrasies, and have lately been conducting their own pricing directly with consumers via their corporate Web sites. For its part, Southwest has never been a member of a GDS, always conducting its business independently, and, may we notice, very profitably in comparison.
Still, neither retailers nor airlines/hotels have as many segmentation attributes as in the case of B2B deals. In B2B environments, every business transaction and proposal is shrouded in secrecy, and there is often no consistency in the stock-keeping unit (SKU) pricing that different customers will accept and gladly pay for under different deal parameters. B2B is conducted via the anecdotal wisdom of sales personnel (who, despite the records they keep, are not reliably objective), peer pricing, cost-plus pricing, comparison pricing, etc. These are the traditional ad hoc pricing methods that are proving to be detrimental in this day and age of sophisticated, but fickle, customers.
In addition, a lack of uniform, scientific pricing and goals and a lack of complete, relevant, and timely data further add to the pricing problems that most companies in manufacturing, services, and distribution industries face. B2B segmentation factors can be related to customers (e.g., region, industry, annual volume, etc.), products (e.g., lifecycle stage, product line, use, etc.), transactions (e.g., seasonality, order channel, etc.), and so on. In the B2B world today, customer price sensitivity varies, whereby different customers might receive very different pricing.
For example, high-revenue customers often receive better pricing deals than lower-revenue customers. Segmentation should thus provide a framework to correctly benchmark customers, so that high-volume customers could be compared against other high-volume customers. And bear in mind that regions and geography may matter—e.g., northern versus southern customers—as may many other attributes ranging from product, lifecycle, cost, industry, etc. It is also critical that the plethora of potential segmentation attributes is reduced to a list of significant attributes only.
Additional pricing complexities for B2B sales processes are stemming from formal bid processes, negotiated agreements, and account relationships. B2B models often require cross-departmental collaboration between sales, marketing, and accounting. There are also rigorous deal management processes to communicate, to enforce pricing policies and handle exceptions. Moreover, B2B sales cycles tend to have relatively higher transaction costs and longer sales cycles than B2C transactions.
By using specialized pricing software products, enterprises can gain deeper insight into their pricing strategies, identify detrimental pricing practices, and scientifically segment their customers and markets to optimize their pricing decision making and improve their business processes and financial performance. These software products incorporate advanced pricing and margin optimization science, which includes operations research, forecasting, and statistics.
One should differentiate between the market price, which indicates segment trending, and WTP, or customer-centric pricing that is used to ensure that high performers remain performing. By incorporating customer-speciﬁc WTP metrics, high-performing customers can get their own special pricing on high-performing items, whereas low performers are brought in line with their peer group. For instance, one special type of B2B pricing is the market for spare parts, which is along the lines of WTP, but it also includes the following specific techniques:
- Market data entry, management, and extrapolation
- Price chain survey data inheritance
- Part kit pricing
- Price tiers (single level and multilevel)
- Roll-up elasticity
Servigistics points out that manufacturers and their channel partners in motor vehicle, industrial equipment, and other manufacturing sectors typically run service parts operations separately from parts pricing. The former belongs to supply chain; the latter to marketing. But these companies are beginning to realize that this long-standing division of labor is leaving profits uncaptured. With an integrated approach to parts planning and pricing, companies can use prices as a lever to hit stocking and service level targets across all inventory locations.
The New (Old) Pricing Imperative
A variety of trends is accelerating the need for better pricing by corporations, including increasingly complex market conditions and business models, many of which stem from the fact that demand for products and services cannot be reliably predicted. The factors contributing to these phenomena are in high evidence: volatile commodity costs, greater sophistication of purchasers, proliferation of pricing entities and competitive alternatives, growing quantities of enterprise data, shorter product lifecycles, increased competition, higher price sensitivity, and diminishing returns from traditional enterprise applications.
One element contributing to pricing problems is the limited visibility into effective prices and margins at the time of quote. After accounting for discounts, promotions, rebates, and other discretionary allowances, a transaction’s profitability is significantly impacted, a phenomenon known as a “price waterfall.” Deloitte defines pocket margin as the amount left in a company’s “pocket” after the price waterfall—after all of the costs related to a transaction, as well as the cost of goods sold, are subtracted from the list price.
In addition, a lack of uniform pricing and goals, an unscientific, ad hoc approach to pricing, and a lack of complete, relevant, and timely data further add to the pricing problems that most companies in B2B industries face. The inadequate pricing detriment manifests both in terms of leaving money on the table—in the case of under-pricing and price waterfalls—and disappointing customers—as in the case of grossly over-pricing products and services.
We believe that most companies in B2B target industries have yet to develop or systematically implement pricing technology that can best meet business goals and generate optimal prices. A Wall Street Journal (WSJ) February 2011 article had a self-explanatory title: “Threat Builds on the Margins: Companies’ Profitability Comes Under Pressure From Rising Commodity Prices.” For its part, at about the same time CFO Magazine unveiled the following top concerns of CFOs for 2011:
- The ability to maintain margins
- The ability to forecast results
- Price pressures from competitors
Moreover, Gartner’s MarketScope document cites the following five key underlying market trends that are encouraging the awareness of, and spread of, pricing technologies among B2B enterprises:
- The widespread use of spreadsheets for analyzing and managing prices is increasingly viewed as inadequate, if not harmful. Some strongly and even passionately believe that companies that still manage their pricing in a pedestrian way via spreadsheets are reckless toward their shareholders. By not improving governance and consistency in pricing practices and realized prices—for instance, by eliminating maverick discounting—these executives might even risk overlooking the “materially adverse effects” that are demanded by the Sarbanes-Oxley Act (SOX) and similar regulations.
- The software of many pure-play pricing vendors has progressed sufficiently to satisfy a majority of common customer requirements “out of the box,” or through the configuration of software features, often as a result of productizing work with clients, particularly around price analytics and execution. Pricing software has long been descriptive, that is, in its ability to understand customer price sensitivities, benchmark customer performance, and predict the company’s markets. But in order for users to not second-guess the software’s recommendations, some vendors have made their software prescriptive. This means that the system provides intuitive guidance with next steps in the workflow and explanations for sales folks and pricing analysts, product offering suggestions that offer more affordable replacement products that meet a customer’s requirements and the company’s margin recommendations.
- The professional service organizations of software vendors are acquiring more experience in supporting projects of varying scope and complexity in different B2B segments in different regions of the world.
- Third-party consultancies such as Accenture and Deloitte are increasingly pursuing pricing opportunities with greater enthusiasm, raising awareness among potential users and providing validation of this market. Rather than previously offering their proprietary spreadsheet-based intellectual property, these firms are increasingly recommending the leading packaged pricing software solutions. After all, there will always be some consultative work for these firms and periodical pricing strategy revisions.
- Hosted and software-as-a-service (SaaS) delivery models are increasingly being considered and made available to expedite implementations and improve time to value, especially for small-to-medium (SME) enterprises with lower pricing complexities and IT budgets.
In addition, vendors are doing their part by hosting conferences for pricing and revenue management professionals, hosting informational web seminars, and participating in and sponsoring other industry and trade conferences and organizations. Finally, pricing software customers are slowly thawing and getting ready to talk about their software deployment benefits, albeit in a more general fashion and not in concrete numbers and figures.
In a nutshell, most companies in the manufacturing, distribution, and service industries have yet to develop or systematically implement pricing technology solutions that can best meet their business goals and generate optimal prices. As in any other strategic initiative, executives are looking for rapid return on investment (ROI) from pricing as part of their decision-making process to invest in pricing solutions.
To enable this, a framework for rapidly discovering and validating pricing opportunities is often helpful. The idea is to identify and locate revenue leaks via high-impact and readily available pricing data elements, i.e., the low-hanging fruit. Pricing analytics and visibility that help rapidly define short-term and long-term price waterfalls are often the gateway to more sophisticated pricing technology. For example, a “margin variance waterfall” chart or dashboard, which clearly presents variances of price, costs, volume, product mix, exchange rates, and other margin eroding factors, is eye candy for CFOs. The same holds with “true costs to serve” graphs.
On the other hand, segmentation leads to targeted price guidance for the sales force specific to a particular customer and even product. To that end, “margin opportunity” or “profit lift” information should get buy-in from and adoption by salespeople, especially if it shows them the potential impact on their commissions. The ability to quantify these quick operational benefits and provide defendable and intuitive guidelines—including average price, break-even price, market price, WTP, revenue optimal price, margin optimal price, last price paid—leads to gaining an understanding of the vast data sources the company has available and the challenges it faces in implementing a broader and more strategic pricing optimization initiative. Such early successes might also assure user adoption across the organization.
Other key strategies for managing prices that can complement segmentation are the consideration of competitive pricing data and of value-based pricing. These approaches are advocated by LeveragePoint and Servigistics. Servigistics, for example, not only provides competitive pricing research services as a consulting add-on to its software, but also uses “market-adaptive pricing” to analyze the distribution of competitive and comparable prices to yield suggestions around price movements within the competitive landscape.
Gartner. MarketScope for Price Optimization and Management Software for B2B, 2011. July 29, 2011.
McKinsey & Company. “The Power of Pricing.” 2003.
TEC. “The Case for Pricing Management.” April 3, 2006.
TEC. “The Rise of Pricing Management.” April 4, 2006.
TEC. “The Art, Science & Software Behind (Optimal) Retail Pricing.” January 27, 2010.
Wall Street Journal (WSJ). “Threat Builds on the Margins: Companies’ Profitability Comes Under Pressure From Rising Commodity Prices.” February 14, 2011.
Related articles on leading pricing software providers:
*Access to some articles may require registration.