Getting Pricing Just Right

Retailers tap analytical applications.

Like almost every retailer, ShopKo Stores Inc. is holding its breath this holiday shopping season. The chain of 141 discount stores depends on the last two quarters of the year for the majority of its sales. This year, however, with the economy lagging and war ongoing, officials at ShopKo dont know exactly what to expect.

Thankfully, though, this year executives at ShopKo, in Green Bay, Wis., can take some comfort in knowing that even if they must discount their seasonal merchandise to make it sell, they wont be leaving as much money on the table as they might have. Thats because ShopKo in January began implementing a new class of analytical software from Spotlight Solutions Inc. that will help it make smarter decisions about when and how much to discount holiday-oriented merchandise as the season ends. Already, in pilot testing of the software—known as price optimization or retail revenue optimization applications—ShopKo has seen impressive gross margin increases, according to Bob Stanich, ShopKos vice president of systems development.

"Clearances are a necessity of doing business the way we do it," Stanich said. "Anything that improves the bottom line is important."

With consumer confidence at its lowest level in seven years, retailers are increasingly turning to analytical price optimization software to get smarter about when and how much to mark down surplus goods or how to price any and all merchandise. The applications, which crunch through mountains of historical point-of-sale data and apply programmable rules and algorithms to come up with optimum pricing, can help retailers boost margins and reduce inventory costs. In fact, even a small price increase can do more to boost retail profitability than just about any other improvement.

But, warn experts, simply deploying price optimization software alone isnt enough. To get all the potential benefits of smarter pricing, retailers must also make sure their pricing processes and systems are integrated so that, for example, a change in price is quickly and accurately reflected on the store shelf and at the cash register. Longer term, retailers will need to integrate price optimization systems with demand and supply chain planning applications to ensure that, if a price change causes a spike in demand, they and suppliers can meet it (see story, Page 48). And, perhaps most importantly, merchandisers will need to be willing to listen to pricing suggestions coming from the new optimization systems that may break decades of convention.

Nick DAgostino never would have thought that the shoppers at his familys chain of urban supermarkets would pay more for vegetable baby food than for fruit baby food. He always figured that since theyre both mashed food packed into the same-size bottles, they should be priced the same.

DAgostino put aside his preconceptions, though, and decided to follow the advice of analytical price optimization software that he installed in June to crunch recent sales data at New York-based DAgostino Supermarkets Inc. Following suggestions such as charging even a few cents more for vegetable baby food helped the chain of 23 supermarkets increase its profit margin from 1 percent to 3.5 percent during a two-month pilot of DemandTec Inc.s Price Center price optimization software. The trial was limited to 10 stores and about 10 product categories ranging from chicken and potatoes to toothpaste and bottled water. But it convinced DAgostino that his stores could not only reap more profits but also better meet the expectations of customers by pricing products based on the analysis of historical sales data.

"Its coming up with a pricing scheme that seems to make the customers happier so that theyre willing to buy the same or more, while at the same time giving us a larger gross profit percentage," said DAgostino, vice president of corporate administration. "Its great to know what the customer is actually thinking, and thats who were there to please."

DAgostino decided this month to roll out the price optimization software—hosted by DemandTec—over the next 10 months throughout its chain.

ShopKo also became sold on price optimization after conducting a pilot, a step that analysts say is necessary to prove the ability to achieve better profits and return on investment. ShopKo conducted a pilot of Spotlights Markdown Optimizer software from August 2000 to last January. It more than paid for itself by increasing gross margins by 24 percent on the 370 markdown items compared with the year before, Stanich said. The implementation of the software should be finished by spring.

DemandTec and Spotlight, of Cincinnati, are just two of a growing number of price optimization vendors in a space that is even beginning to attract some major enterprise application software providers. Last month, for example, supply chain planning software vendor i2 Technologies Inc. entered the market with its Markdown Optimizer. Like Spotlights application, i2s and systems from ProfitLogic focus on the pricing of markdowns and initially targeted department and specialty stores as well as mass merchants with seasonal merchandise. DemandTec, of San Francisco, and competitors such as KhiMetrics Inc. and Knowledge Support Systems Group plc., have rolled out analytical applications to address overall pricing of commodity merchandise at mass merchants and drug and grocery chains. All these applications analyze historical and current point-of-sale data to help a retailer find the right price for merchandise. The applications typically can specify optimal pricing of individual items at specific store locations.

While price optimization software can boost margins, it isnt cheap. Licensing alone can cost between $300,000 and $1 million a year depending on the amount of merchandise included and the number of users, according to Forrester Research Inc. Most of the vendors offer the software on a licensed basis or as a hosted service.

For many retailers, using analytical software to aid in pricing decisions will be a new experience. Traditionally, retailers have priced items and determined markdowns based on gut feeling and the experience of their merchandisers, said Dale Achabal, director of the Retail Management Institute at Santa Clara University, in California. That had been the case at DAgostino Supermarkets, where prices have been based on a best-guess, across-the-board markup. Such a method didnt allow for much variation among the companys stores, which are spread around Manhattan and suburban Westchester County. The rollout of the DemandTec software will allow the company to begin to implement different pricing on specific items in various locations, DAgostino said.

But experts warn against following the advice of price optimization software too blindly, particularly if it leads to wild price swings that could confuse customers. To avoid that, DAgostino added customized business rules to the DemandTec software during his companys pilot. The rules dictated, for example, that no price could increase by more than 15 percent or decrease more than 30 percent, he said.

Officials at Longs Drug Stores Corp. were also concerned that using price optimization software might cause large and sudden pricing fluctuations. When Longs conducted trials of DemandTecs software earlier this year, though, officials found they were able to both increase prices on some items to improve margins and also lower prices on others to increase sales or shift demand, said Steve Roath, Longs CEO, in Walnut Creek, Calif. Most price changes were only pennies on the dollar but still significant enough to boost profits and sales. He declined to provide results from the pilots.

"We really felt we couldnt allow for any kind of wild swings in prices," Roath said.

Frequent pricing changes also can tax a retailers process for physically changing prices within its stores. Retailers deploying price optimization software must make sure their processes and system are well integrated so they can quickly change prices, said Greg Girard, an analyst at AMR Research Inc., in Boston.

Getting data into price optimization software is typically a batch rather than an interactive process, involving downloading data from existing point-of-sale data warehouses into the system every week or two. After the optimization software offers suggestions on prices for specific items and stores and the retailer has approved the price, the information would be set up to flow into a price management system such as those from Retek Inc. or TCI Solutions Inc. or those developed in-house by the retailer. But from there, experts say, retailers need to make sure that their people processes are tuned to executing the price changes, so that, for example, clothing tags and shelf labels are changed and point-of-sale systems are updated, Girard said. It can be a large task, so its not surprising that most retailers using price optimization systems arent necessarily changing prices more frequently. ShopKo, for instance, reconsiders the price of merchandise no more than every two weeks. DAgostino Supermarkets plans to change prices on each category a minimum of only every six months, though some changes likely will occur each week.

"Youre talking about thousands of SKUs and thousands of stores," said Girard. "Youve got to get your store managers and operations people brought into the process."

For now, most retailers have focused their pricing optimization efforts at physical stores and not on their online e-tailing site. Thats because, for most retailers, e-commerce still represents only a small percentage of sales and, therefore, a small potential bottom-line impact.

Online efforts havent been totally left out, however. Penske Truck Leasing Co. LP, a joint venture of Penske Corp. and General Electric Capital Corp., used a real-time online price testing tool from Zilliant Inc. during a three-month trial this summer to experiment with different prices on 12 popular routes for its consumer truck leasing business. The results helped Penske identify four changes it could make to its pricing practices, such as offering bigger discounts during slow times so more trucks are in use, said Mike Browna, vice president of pricing, in Reading, Pa.

Yet most of Penske business continues to be booked though its call centers, not online. So the company still is deciding whether to use Zilliant or to build an in-house system so it can conduct price tests through that channel as well.

With most implementations of price optimization software still in the pilot stage, its unclear just how large the impact of smarter pricing will be for most retailers. What is clear, however, is that, with a slow economy pressuring retailers bottom lines, they increasingly will need to squeeze more profits from their sales. Setting a better price based on analytics could become an important strategy, especially if an economic Scrooge creates post-holiday blues for retailers.