The Price is Right

Maintaining the best prices on the retail floor to produce the best margins is as fickle a process as choosing the hottest teen apparel fashions. In any given week, a merchant may have to make thousands of pricing decisions based on factors like changing demand, special pricing offers from vendors, or competition from the new retailer who just opened down the street.

Changing prices at the right time and for the right amount can produce a windfall of sales and profit margins. But setting prices too high or too low risks upsetting the fine balance between moving products according to a goal and keeping customers both profitable and happy. “It’s critical for us to predict how consumers will react to the pricing moves we make,” says Gary Charboneau, senior vice president of sales and marketing for Duane Reade Inc., a chain of 250 New York-area drugstores.

Getting the nuances

Often, setting prices is as much art as science. But now several vendors of price-optimization systems are trying to make it more science. And they’re basing their efforts on the web. They argue that data that move over the Internet can be both gathered and disseminated in a more timely fashion, allowing retailers to exploit nuances in pricing that could make the difference between profitable and unprofitable.

Analysts agree, citing web-based systems’ ability to integrate with legacy systems and the universal access throughout an organization that a browser-based system affords. “Retailers should make sure that any new pricing system they buy is web-based,” says Hung LeHong, analyst with researchers/consultants Gartner G2. “That’s the wave of the future.”

Duane Reade is rolling out DemandTec Inc.’s DemandTec 3 pricing optimization software platform chainwide following a test last year that showed the system produced increases in unit sales without sacrificing margins, Charboneau says. “The pilot worked very well, close to what we had expected,” he says.

Duane Reade increased unit sales of baby formula by 14% and of disposable diapers by 10% after accepting the DemandTec system’s recommendations for initial prices, Charboneau says. Often, boosting unit sales requires lower prices, which, of course, results in declining margins. But not in this case. “The forecasting turned out quite accurate,” Charboneau says. “While unit sales rose, gross margins remained the same for both baby-care product categories.”

DemandTec hosts the DemandTec 3 system on a web server that Duane Reade pricing managers access via a browser. The system contains historical pricing, sales and inventory data on items and gets a regular feed via the Internet of ongoing sales, pricing and inventory data as the stores sell down the products.

Charboneau says it will take to the middle of this year to get the initial pricing system working in all 250 stores. “There’s quite a bit of work involved to implement this for initial pricing,” he says.

Building trust

Pricing managers can test a series of what-ifs by accessing the appropriate product page and inputting hypothetical prices, based on, say, margin or competitors’ prices, fed into the system by QRS Corp.’s price-tracking service; amount of inventory; time period during which they want the merchandise to sell and other parameters. The system responds with recommendations.

Once the recommendations are finalized, the information can be distributed throughout the enterprise via the web to all applications that need the data, including servers and POS terminals in stores.

A major ingredient of making this all work is that Duane Reade’s managers trust the system. “The trust merchandisers have with an optimization system is a big deal,” says Gartner’s LeHong. “Retail managers have been relying on instincts, their feel of the market, to price things, and all of a sudden they have a computer coming up with recommendations. That requires trust.”

Charboneau says several retail managers spent two weeks of training in how to use the DemandTec system, followed by two more weeks of on-the-job learning before they became comfortable using the system and trusting its recommendations, but that they continue to learn how to better use the system.

The challenges

Managers can easily override the system’s recommendations. But for the most part, Duane Reade prefers its managers to avoid overriding recommendations, Charboneau says. “The more you override the system, the more you handicap its ability to meet the goals set for it,” he says.

Duane Reade tested the DemandTec 3 price optimization software suite in 20 stores, using another 20 as control sites for comparison, from December 2002 to April 2003. Charboneau declines to say what Duane Reade invested in the DemandTec 3 system. But Dan Fishback, CEO of DemandTec, notes that it can cost a retailer $1-$8 million in startup fees depending on a company’s size, including number of stores and SKUs, plus an ongoing annual maintenance fee of 15-20% of the license fee.

Before using the DemandTec system, Charboneau says, it wasn’t possible to come up with effective price strategies for thousands of products in each store. Duane Reade stores carry an average of 18,000-20,000 SKUs. In an effort to set pricing levels, it would gather information on past item sales from its own system as well as prices set by its competitors. “We’d make pricing moves and track what happened, but we didn’t have a real forecasting ability,” he says.

The new system is more effective, though not without its challenges, Charboneau says. Because it factors in more details of pricing and expected customer demand based on historical data and competitors’ pricing, the DemandTec system takes longer to put together a price modeling. “But it gives a map of what we’re looking for to happen, then within four to eight weeks we see the customer response to our pricing moves,” he says. “Then we track how our business is changing in relation to the way we anticipated it would.”

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For now, Duane Reade is using the DemandTec system only to set initial pricing on about 70% of its non-pharmaceutical sales. The other 30% include products such as greeting cards whose retail prices are pre-set by suppliers.  

As Duane Reade perfects its use of the DemandTec system, it expects to also benefit from improvements in the way it sets promotional prices and product assortments, Charboneau says. And by factoring more data on forecasted demand and impact on existing and future inventory, it can expect to operate pricing and merchandising optimization to a higher degree than under earlier systems that weren’t as comprehensive.

The vision

“The vision is that price is tied to demand chain management or inventory management,” says LeHong. “If you run a promotion that takes a product down to a certain price, you have to make sure your supply chain can handle extra volume. The vision is that a retailer should make price decisions based on the impact on the supply chain.”

In fact, while most adopters of web-based price optimization systems are starting with small bites, more retailers are thinking in terms of integrating pricing practices into broader technology applications. “We’re seeing retailers look at the whole optimization space end to end,” says Kent Allen, retail analyst for Aberdeen Group, adding that more merchants are looking at the importance of relying on more comprehensive data to produce solid pricing plans.

This growing interest among retailers is coinciding with a shift in vendors offering price and merchandise optimization systems as well as those offering supply chain technology. Vendors in the price and merchandise optimization market, including DemandTec, ProfitLogic Inc. and KhiMetrics Inc., are expanding their platforms to offer more comprehensive application suites, while companies like i2 Technologies Inc. and Manugistics Group Inc., known more for their supply chain technology, are pushing further into the price and merchandise optimization market.

No single vendor, however, can claim a complete system that covers all aspects of price and merchandise optimization as well as integration with supply chains, analysts say. “No one has a market or technological edge,” says Noha Tohamy, retail industry analyst with Forrester Research Inc.

Gartner’s LeHong says the best-of-breed players have an advantage in the retail industry because they already have retailer clients. “The retail industry edge is with the best-of-breed, because they’ve been serving retailers for three years now,” he says.

Pushed by customers

Scott Friend, president of ProfitLogic, provider of web-based price markdown optimization software used by more than 12 retailers including The Gap, Bloomingdale’s, The Home Depot and Meijer Stores, says several customers pushed ProfitLogic into offering merchandise allocation and assortment planning tools. By better allocating products and assortments among stores based on their expected demand, retailers believed they could avoid markdowns. “We realized the markdown tool was providing a forecast of how customers would respond to markdown pricing,” Friend says. “The next question was, if the technology did a good job of forecasting responses to markdowns, why not use it earlier in the cycle, when buying and allocating, so you don’t have to do so much markdowns at the end of the cycle.”

The web plays a crucial role in making the integration possible, Friend says. “The most effective and scalable way to feed all the information into the various systems that need it is the web,” he says.

The primary benefit is that the web is a common interface that allows retail managers to move from one application to another, gathering and manipulating data, Friend says. “The web enables users to jump from an allocation report to a price change request then to an order change, with the underlying application being transparent to the user,” he says. “Without the web, we’d have to hard code all the connections.”

As more retailers take that step and perform better in planning, pricing and moving products, they’ll begin to raise the bar of performance and draw more retailers into these processes, experts say. “It raises the game for every merchant, because merchants will make better decisions based on quality analysis,”  Fishback says. “If you understand demand, you make better assortment, pricing and markdown decisions.”

But getting to that point will take time, experts say. Although the vendor community is moving toward broader suites that provide multiple aspects of merchandise and price optimization for different product categories and in different stages the overall demand among retailers is expanding slowly, experts say. “We’re still seeing a lot of basic forecasting and rollups of basic spreadsheets,” Allen says.

Some retailers are beginning to take a lead in operating multiple parts of pricing and merchandising optimization systems — J.C. Penney Co. Inc. for one — but most have yet to disclose details of such projects. J.C. Penney, as part of a broad corporate plan to centralize its merchandising operations, has been working with ProfitLogic and DemandTec on price optimization and merchandise allotment and assortment optimization. J.C. Penney also uses a database management system from the TeraData Division of NCR Corp. to flow its sales data into its optimization systems. Although it sees its optimization systems as an important part of its move toward centralizing its operations, the system is still too new to discuss openly, J.C. Penney says.

Not there yet

Other ProfitLogic clients moving ahead with merchandising optimization along with markdown optimization include apparel retailer Lerner New York and Canada’s Northern Group Retail. “After applying the science of merchandise optimization to our markdown decisions, we realized we could gain additional value by using these insights earlier in the merchandising process,” says Michael Stanek, CFO of Northern Group Retail. “If you add science to the art of merchandising, you can do two things: minimize risk in the event of a bad buy or economic downturn, and maximize profits if you’re hitting everything head on.”

Northern Group says its project is too new for the Canadian retailer to comment further on its details. Most other retailers, meantime, are taking things one step at a time—though with their eyes on a grand plan of optimizing multiple pricing and merchandising variables. The game plan is to deploy optimization systems in stages, learning the ins and outs as retailers realize the results of their pricing and merchandising decisions. “Having demand forecasting and price optimization at the same time is the goal,” Allen says. “We’re not there yet.”

paul@verticalwebmedia.com