Pricing and Revenue Management Driving Profit Improvement from CRM

Transcription

1 5.0 White Paper WRITTEN BY Robert L. Phillips, Ph.D. Talus Solutions Pricing and Revenue Management Driving Profit Improvement from CRM Pricing and Revenue Management has been used successfully in a a variety of industries for over 15 years. Yet its core concept using advanced analytic techniques to optimize the prices being offered for all products and services to all customers through all channels is relatively new in most industries. PRM decisions have often been made in an uncoordinated fashion, based on inconsistent or incomplete data, and with little or no analysis. Now, with the assistance of CRM and ERP systems, a new generation of PRM tools, and the rise of the Internet as a selling channel, it is likely that PRM will remain the highest-value IT investment for many companies for some time to come. Consider the following activities: A sales representative is negotiating an agreement with a customer for discounts that will be applied to all purchases by that customer for the next year. The Pricing Department is determining list prices for the next catalog release. A sales representative is deciding what price to propose in a competitive bid for a major order. The marketing department is planning a promotional campaign aimed at gaining market share among large customers in the Northeast region. The E-Commerce Team is trying to determine what prices to display for key products on the corporate Web site, as well as how to respond to buyer requests coming through an e-commerce broker. A Special Sales Team is analyzing options for disposing of distressed inventory. Options include wholesale outlets and brokers as well as several Internet auction sites. What do these decisions have in common? They are all market-based activities focused on determining what products and services should be offered, to which customers, at what prices, through which channels. This broad corporate function is termed Pricing and Revenue Management (PRM). Note that the definition of PRM goes well beyond the pricing function as it is defined at many companies. It encompasses all the ways in which products and services are offered (and priced) to potential customers. Furthermore, PRM is far from static these decisions need to be updated continually over time as market conditions, inventory conditions, and competitive conditions change. Viewed in this light, Pricing and Revenue Management decisions are among the most critical decisions that a company makes. They are a major determinant of both corporate profitability and the ability of a company to achieve its strategic goals. Yet, too often, these decisions are made in an uncoordinated fashion, in disconnected parts of the organization, with inconsistent or incomplete data, and with little or no analysis. The result is lost profitability as well as a reduced ability to execute strategically. The PRM discipline and PRM Solutions enable a company to coordinate these decisions and ensure that they are being performed in a way that maximizes profitability consistent with strategic goals. Pricing and Revenue Management is a discipline predicated on two fundamental principals: Robert Phillips is responsible for creating new business opportunities by identifying and developing products and services that deliver high customer value in all areas of PRM. An internationally recognized expert in PRM, Phillips has workedwith companies in a wide variety of industries, including hotels, and electric power to help them improve profitability. Phillips pioneered the application of revenue management in the rental car, freight, and manufacturing industries and supervised the development of the first airline origin and destination revenue management system. He is currently helping companies make pricing decisions through e-commerce channels. Phillips received his doctorate in Engineering-Economic Systems from Stanford University and holds undergraduate degrees in Mathematics and Economics from Washington State University. He has published numerous articles and papers on revenue management and holds a patent on "A Method and Design for Determining Marginal Values for Use in a Revenue Management System." 1

2 White Paper 5.0 1) All Pricing and Revenue Management decisions within a company should be performed consistently, with the best information available, in order to maximize corporate profit while meeting strategic goals. 2) In most cases, Pricing and Revenue Management decisions can be substantially improved by the application of forecasting and optimization techniques. Taken together, these two principles imply a PRM function that both coordinates decisions and applies appropriate analytic techniques to specific decisions. In concept, profitability for individual decisions can be improved independently, but the greatest improvement ultimately comes from the effective coordination of all PRM decisions. Pricing and Revenue Management represents a major opportunity for many companies seeking to increase profitability and achieve strategic advantages. PRM solutions incorporate forecasting and optimization technologies to enable the rapid and accurate determination of the right prices to offer in each situation. CRM and ERP systems are providing consistent, reliable sources of data to feed these technologies. CRM and SFA systems enable the rapid dissemination of recommended prices to the right players within the organization. The rise of e-commerce is exponentially increasing the speed at which Pricing and Revenue Management decisions need to be made and updated, drastically raising the stakes. Furthermore, many companies have already made substantial progress in reducing costs and increasing efficiencies in this case, Pricing and W 3 WEB LINK Pricing and Revenue Management is also discussed at the following links: appell.crmproject.com habib.crmproject.com nash.crmproject.com talus.crmproject.com FIGURE The Evolution of Pricing and Revenue Management Revenue Management often provides the highest leverage for improving profitability. Depending upon the industry and the company, successful PRM implementations have led to improvements in top-line revenue of 2-10%. Since the majority of this improvement drives directly to the bottom line, PRM often represents the highest return IT investment available to a company. The Evolution of Pricing and Revenue Management Figure illustrates the evolution of Pricing and Revenue Management technologies. While companies have long applied various types of mathematical analyses to their pricing decisions, the current generation of PRM applications can trace their origins to the airline industry specifically the response of the domestic U.S. industry to its big bang deregulation following the passage of the Airline Deregulation Act of Literally overnight, the airline industry went from a fully regulated environment to one in which pricing and scheduling were up for grabs. A wave of mergers and consolidations followed, as well as challenges from upstart low-cost airlines. The radically new environment meant that the major carriers needed to adopt new approaches to their business if they were to survive. Pricing and Revenue Management : Pricing and Revenue Management Bid Pricing Promotion Pricing Dynamic Pricing Base Pricing : Expansion of Revenue Mgmt. Techniques - Micro market segmentation capabilities - management - Business-to-business demand optimization : Adaptation of Revenue Mgmt. to Similar Environments - Car Rental, Hotels, Cargo, Broadcasting 1982: Airline Deregulation 1978: Production Yield Management Systems - Airlines The Evolution of Pricing and Revenue Management was one of these new approaches. While the need for Pricing and Revenue Management was driven by competitive and market needs, the specific character of its implementation in the passenger airlines was driven by two characteristics of the industry: The instantaneous perishability of inventory (airline seats) and the fixed nature of capacity (aircraft sizes) meant that pricing was virtually the only lever that airlines had to match supply and demand in the short run. There was no way to adjust inventory to make up for overproduction or under-production the airlines have to manage their demand and they have to get it right. Electronic price distribution provided by the global Computerized Reservation Systems such as SABRE and Apollo. These giant mainframe systems the Internet of their day enabled the airlines to distribute prices with a keystroke, monitor customer responses, and update instantaneously. An airline whose price was too high might see bookings plummet. A price that was too low price might result in a surge of more bookings than the airline could handle. Clearly, advanced systems were needed to monitor booking 2 Defying the Limits: Reaching New Heights in Customer Relationship Management

3 Base Pricing Promotion Pricing Bid Pricing Dynamic Pricing Domestic Passenger Airline Published Fares Promotions Corporate/ Group Sales Medium GDS, Telesales, Internet Automobile Manufacturer Wholesale Rebates Fleet/ Volume Sales Medium Internet Electronics Distributor Catalog Promotions Direct/Large Order Sales Telesales, Internet FIGURE Pricing and Revenue Management issues by industry activity and adjust price and product offerings with precision. Initially, the airlines grappled manually with the complexities of revenue management. But, in 1985, American Airlines unleashed the first automated revenue management (or yield management ) system. This system forecast demand for each future flight and used optimization techniques to determine which prices should be offered on which flights to maximize profitability. Furthermore, the system monitored bookings as they came in and adjusted the price availabilities in response to changes in demand. This system was immediately successful in driving substantial improvements in American s bottom line. Furthermore, it enabled American to compete successfully against highly aggressive low-cost/low-price carriers such as Peoples Express. Other major airlines such as United and Continental quickly followed American in developing systematic revenue management systems. By the mid-1980s, every major U.S. airline had an internal revenue management department supported by a sophisticated decision support system and the use of revenue management capabilities was beginning to spread to Europe and Asian characters. Following its success at the airlines, companies in other travel industries such as hotels, rental cars, and cruise lines established Revenue Management programs. Like the airlines, these industries were characterized by perishable capacity and access to electronic price distribution. Hertz adopted the first Rental Car Revenue Management system in 1989 and Marriott the first hotel system in The early adopters in these industries saw the same magnitude of revenue improvements as their airline counterparts and within the next six years; revenue management became ubiquitous within these industries. In the 1990s, companies across a broad range of industries began to look for new ways to grow their revenues and profits. With richer sources of customer and market information becoming available through ERP and CRM systems, PRM began to move beyond its origins in the travelrelated industries. The basic principles of PRM were adapted to situations in which capacity was neither constrained nor immediately perishable. The essential steps in this evolution were the development of more sophisticated techniques for customer segmentation and calculation of price sensitivity combined with incorporation of those into the basic optimization. It also required extending PRM to account pricing, bid pricing, and promotions management situations and dealing with product life cycle considerations in a sophisticated fashion. These steps have enabled PRM to be successful in a wide range of settings from automotive to parcel service to retail to electronic equipment sales. In essence, PRM has become a critical business capability with broad-based application. Fundamentals of Revenue Management The fundamental PRM issue is: what products and services should we be offering to which customers at what prices through which channels, now? The basic goal of PRM Case Study A regional division of a national health insurance company wants to provide its clients with the ability to search for physicians in their network by specialty or location via the Internet. Solution Use legacy extension to provide clients with the information stored in mainframe systems. Benefits Provide clients with 24x7 access to provider directories previously available only via in-house customer services during traditional business hours. Results Reduced calls to customer services; realtime response to client questions; competitive advantage over other regional health insurance companies; and increased customer satisfaction. Conclusion The health insurance company has been able to leverage its legacy systems while providing increased value to its clients. The company intends to extend the amount of information clients can access via the Internet to further reduce costs and provide additional added value. 3

4 White Paper 5.0 is to ensure that this decision is being made based in a fashion that maximizes overall profitability consistent with the strategic goals of the company. Elements that need to be considered in this decision include: of these elements (as well as others) to make a set of pricing and product availability recommendations that maximize profitability while considering all current and future opportunities for selling the The rise of e-commerce is exponentially increasing the speed at which Pricing and Revenue Management decisions need to be made and updated, drastically raising the stakes. product. This requires both statistical sophisticated analysis of the underlying demand for the product as well as the various costs associated with the products across its lifecycle. The optimization core of a PRM system calculates the prices that are to be offered to customers now in order to maximize overall profitability. The principle can be best illustrated by reference to two specific examples. At United Airlines, the key PRM decision is what rate classes to offer to potential customers for each future flight departure. Selling a seat at a low fare now to a leisure customer will preclude the potential for selling that same seat in the future to a higher paying business customer. The United Airlines Revenue Management System (known as ORION) forecasts future demand for all future itinerary/fare-class combinations and determines which ones should be open and closed to maximize system profitability. ORION essentially weighs the revenue of selling a seat now against the future revenue foregone (opportunity cost) by not having that seat available in the future. For the United Parcel Service (UPS), the key PRM decision is how to price customer accounts. UPS renews some 50,000 domestic accounts per year, each with a custom pricing structure. Setting the right price for an account bid requires trading off the higher margin from a higher price with the decreased probability of winning business from that account at the higher price. The key PRM decision at UPS incorporates both margin calculations and price responsiveness to determine the sequence of recommended bids to offer in each competitive bid situation. While the PRM settings at United and UPS are considerably different, the underlying concepts are quite similar both the expected revenue and cost implications (including opportunity costs) of offering a product to a customer through a channel at a particular time need to be calculated. A global optimization approach then needs to determine what prices to offer now and indicate how these prices need to change in response to changing market conditions. What are the demand and revenue implications of selling a product to a customer at a price through a particular channel? This requires understanding both competitive prices and the price-sensitivity of different types of customers buying different products through each channel. What are the variable cost implications of selling a product to a customer through a channel? This includes understanding customer-specific and channel-specific costs. What are the opportunity cost implications of selling a product now rather than later? Opportunity costs occur whenever a product is in constrained supply, in such a case, selling a product now may preclude being able to sell to a future customer, possibly at a higher price. Calculating opportunity costs requires sophisticated forecasting capabilities to understand the evolution of future demand. What are the life cycle values associated with this product? This requires computing the decline in value associated with some products over time. This value decline either due to physical perishability (as in airline seat availability) or obsolesence (as in fashion goods or electronics). These dynamic effects need to be explicitly incorporated in the calculation of prices at each point in the life cycle. The role of PRM systems is to synthesize all When is PRM Applicable? Better Pricing and Revenue Management capabilities can improve profitability across a wide range of industries. However, experience has shown that the following characteristics indicate the potential for substantial gains from improved PRM within a company: Wealth of Products and Services PRM provides the highest level of benefits in situations where a seller is offering a large number of products and/or services to the market. These products can be distinct (as in the case of an office supply company offering a multitude of different products) or variations on a smaller number of base products (as in the case of a heavy-truck manufacturer offering a few base models, each with thousands of possible customizations.) The larger (and more complex) the product offering of a company, the more value that PRM can provide. Segmentable Customer Basis PRM benefits increase when the customer base can be segmented by price-responsiveness. The segmentation can either be explicit (in which very similar products or services can be sold to different customer segments at different prices) or implicit in which case different products are crafted explicitly to appeal to different market segments. Calculating the different price responses of different segments to different products and utilizing these different responses to determine the optimal set of prices is a key element of PRM. 4 Defying the Limits: Reaching New Heights in Customer Relationship Management

5 FIGURE The Evolution of Pricing and Revenue Management Company Rental Car Airline Airline Shipping Package Delivery Automotive Application Dynamic Pricing Improved Dynamic Pricing Improved Dynamic Pricing Bid Pricing Bid Pricing Promotions Pricing Results of revenue management Dynamic Pricing Environment Any environment where prices can change rapidly in response to changes in either the external environment (such as competitive price changes) or the internal environment (such as inventory changes) is an opportunity for PRM. PRM provides the analytic capability to ensure that price responses to environmental changes are immediate and optimal. Complexity complexity increases the value of PRM. An integrated PRM capacity ensures that the prices displayed through different channels maximize corporate profitability consistent with the corporate distribution strategy. Many Transactions PRM is particularly effective when it can be used to guide a large number of transactions. Furthermore, a large transaction base can support better statistical inference about customer segmentation and price response. Our experience has shown that a base of at least 500 transactions per year is usually necessary to support advanced PRM techniques. Once it is been determined that a company is a target for improved PRM, the next step is to determine which PRM decisions within the organization are the most critical. Some examples of PRM decisions include: List Pricing - What prices should we set for all our products in a catalog? Base Revenue $2.5 billion $16 billion $4.5 billion $19 billion $7 billion $86 billion Revenue Gain $125 million $50-$100 million $40 million $30-$100 million $210 million $800 million 5% 3-6% 1% 2-5% 3% 1% Promotion Pricing-- Given a set of list prices, what discounts or incentives should be given to customers and/or distributors? Account Pricing What are the prices that we should quote to a large customer for his account? Bid Pricing What is the price for a bundle of products that we should quote in a particular competitive bidding situation? Dynamic Pricing What price should we charge for this product to this customer through this distribution channel now, given that we have the freedom to change the price in the future? The spectrum of PRM decisions within a particular company will depend both on the industry it serves as well as its overall sales and distribution strategy. In some cases, a company may have only a single type of Pricing and Revenue Management decision. However, it is far more typical for a company to sell through a number of different channels simultaneously, each with its associated PRM decision. This reflects the fact that, over time, companies have adopted a range of pricing and sales channels to enable them to reach different markets. Furthermore, these decisions make interact in a complex fashion. This can be illustrated by the specific cases of companies in three different industries: A typical domestic airline sells the majority of its seats to independent travelers through the Global Distribution Systems and the Internet. Determining the right prices and availabilities to offer to customers through these channels and updating them in real time is a classic dynamic pricing problem (and the focus of most airline yield management systems). However, the airline also negotiates corporate and special fares with certain very large customers an account pricing problem. Furthermore, individual groups receive custom discounts a bid pricing problem. A major automobile manufacturer sells the majority of its cars and trucks through its dealer network. It establishes a standard wholesale price at which it sells the cars to dealers a list pricing problem. However, once the list price is established, the manufacturer can offer promotions such as customer rebates, dealer rebates, and below-market financing in order to increase sales of certain models. How it should most effectively target these promotions is a Promotion and Incentive Optimization problem. Finally, the manufacturer sells a significant number of cars and trucks to major fleet customers at negotiated discounts this is an account pricing issue. An electronics distributor purchases electronics equipment and parts from manufacturers and resells the equipment to retailers and other customers worldwide. The distributor negotiates contracts with each of its customers that (in theory) govern the margin it receives on future sales. This is an account pricing issue. However, the majority of sales are renegotiated with customers based on current market and competitive conditions a dynamic pricing opportunity. The different PRM issues and their relative importance for these companies are displayed in Table 1. The key point is that each company may have a dominant sales and pricing channel, but the highest return can be achieved by ensuring that all PRM decisions are jointly optimized to maximize enterprise profitability. From the organizational side this requires coordinated business processes with synchronized informa- 5

6 White Paper 5.0 tion flows. From the IT side, it requires a suite of analytic decision support solutions built on a consistent information backbone. Implementing PRM Implementing improved Pricing and Revenue Management within an organization requires five steps: 1) Identify the Opportunity This involves identifying all of the PRM processes and settings currently within an organization from List Pricing through Dynamic Pricing and prioritizing them in terms of importance and impact. 2) Market Segmentation and Analysis The next step in implementing PRM is to analyze existing data to determine a statistically stable set of market segments and to estimate their response to product prices in a quantifiable fashion. Sophisticated statistical segmentation and analysis tools are required to perform these analyses. 3) System Implementation System implementation requires clean data feeds from existing cost, sales, and CRM systems and using these feeds to populate a PRM database. The final step is to implement and tune the key PRM analytic modules to reflect the specific industry and corporate situation. These modules will use the market segmentation and price response information gathered in Step 2 to determine the optimal prices to recommend for each transaction or other pricing decision. 4) Implementing Consistent PRM Business Processes Simultaneously with the System Implementation, consistent PRM Business Processes must be established to ensure that the recommendations from the system will actually be used to drive profitability improvements. 5) Updating Over Time A key feature of PRM systems is their ability to learn as they go. Real-time customer response information is fed back into the system and used to update internal parameters. The fundamental PRM issue is: what products and services should we be offering to which customers at what prices through which channels, now? This ensures that the recommendations from the system are always consistent with current market conditions. Measuring the Returns The returns from instituting PRM within an organization are often enormous. The strategic benefits include: Cleaner pricing and sales processes with fewer appeals Reduced sales overhead Better understanding of key markets Better ability to respond to competitive initiatives and market changes Better ability to implement corporatewide sales and pricing strategies. While these benefits are important, for most businesses the most appealing aspect of PRM is its immediate, dramatic impact on the bottom line. This impact is driven by better pricing and availability decisions, ensuring that the highest returns are obtained from existing corporate assets. Unlike many comparable investments, the benefits from PRM are measurable, sustainable, and drive ROI s that are usually in excess of 50% per year. The magnitude of the results confirms that investment in PRM is often the highestreturn investment opportunity that a company has available. The E-Commerce ion The rapid rise of e-commerce is a further driver of PRM. According to BancBoston Roberston Stephens, $43 billion of goods and services were sold over the Internet in 1998 in the business-to-business sector alone. This number is anticipated to rise to $850 billion per year by 2002 a compound growth rate of 110% per year. In the business-to-consumer arena, companies such as Amazon.com that use the Internet as their sole distribution channel enjoy multi-billion dollar valuations. Other companies such as Dell Computer are successfully transitioning a major portion of their sales and price distribution to the Internet. However, many traditional companies are struggling with how to best use the Internet to distribute their products and services. On the one hand, the rapid rise of the Internet as a selling channel, its global reach, and its ability to present products and take orders 24 hours a day make the Internet an indispensable selling channel for most companies. On the other hand, the same companies worry about cannibalizing traditional channels, alienating existing distribution partners, and eroding prices. PRM provides a critical capability for companies seeking to utilize the power of e-commerce in the most profitable fashion. In particular, it enables companies to consistently determine the prices and availabilities of all products to all customer segments through all channels including the Internet. Specific characteristics of the Internet selling channel that make it a logical candidate for PRM include: Immediate Price Adjustment Historically changing prices and distributing those changes to potential customers in most industries has required considerable time, energy, and expense. For example, changing prices at a grocery store requires reprogramming the scanner, retagging the grocery items, and replacing in-store signage. In many cases (trucking, equipment supply, package express), companies negotiate prices to their major customers once or twice a year. The Internet allows sellers to inexpensively change prices at any 6 Defying the Limits: Reaching New Heights in Customer Relationship Management

7 time and to immediately transmit new prices to customers worldwide. Immediate Customer Response Not only does the Internet permit a seller to change prices, it also allows him to immediately see how a customer responds to change. Even if they could change prices daily, many businesses lack the ability to track the direct impact. They change prices without knowing the results for some time. The Internet permits sellers to watch the customer respond to each transaction. Businesses can use this information to evaluate and adjust prices after each exchange. Extensive Market Information The Internet places unprecedented amounts of customer data in the hands of sellers and intermediaries. This information includes not only what customers bought, but also what they considered and didn t buy. For Internet auctions, the seller gains complete information about evolving prices and buying behavior over time. Sellers who can use this data to tailor their product offerings to the unique needs of customers will reap their rewards in increased revenue and profit. Increased Competitive Visibility In many cases, the Internet will enable both customers and sellers to have immediate information on the full spectrum of competitive prices and offerings. This does not mean (as some commentators have implied) that Internet sales will always be transacted at the lowest possible price. However, it does mean that awareness of competitive prices and explicit incorporation of these prices in PRM decisions will become increasingly critical. These capabilities are reminiscent of what the Global Distribution Systems have provided the airlines for years. This analogy has not been lost on analysts. A 1998 Forrester Research report noted: What airlines have been doing for years using computer networks to sell seats at the highest possible price will spread. Using the Internet, companies will vary prices to maximize profit The experience of the airlines in using PRM to monitor and update prices to match market conditions will be a useful guide for e-commerce players. For business-to-business e-commerce players, determining the right price for each transaction over the Web is a key PRM opportunity. Consider a company that sells sophisticated and highly customized computer systems to its corporate customers on line. Each time a customer requests the price of a system, the company can take into account the characteristics of the customer, current costs, and the availability of the system components to determine the right price. This is a classic dynamic pricing problem. Business-to-consumer players such as Amazon.com and CDNow also have PRM opportunities. They can create new products targeted to the specific needs of different customer groups and price those products to deliver the greatest overall return. Books or CDs can be differentiated along the lines of delivery speed or preferential access to constrained inventory. Exploiting this capability to maximize profitability is a core PRM capability. Summary Pricing and Revenue Management is not a new concept it has been used successfully in the airlines and related industries for over 15 years. However, its core concept using advanced analytic techniques to optimize the prices being offered for all products and services to all customers through all channels is relatively new in most industries. The organizational dispersion of pricing decisions and the lack of appropriate tools and information has meant that PRM decisions have often been made in an uncoordinated fashion, with inconsistent or incomplete data, and with PRM benefits increase when the customer base can be segmented in terms of its price-responsiveness. The segmentation can either be explicit (in which very similar products or services can be sold to different customer segments at different prices) or implicit in which case different products are crafted explicitly to appeal to different market segments. little or no analysis. Implementing consistent PRM processes along with supporting Decision Support Systems can lead to substantial improvements in corporate profitability often on the order of 1-2% of revenue or even more. With the widespread adoption of CRM and ERP systems, companies are increasingly getting access to the information they need to perform systematic PRM. Furthermore, a new generation of PRM tools has successfully adopted the underlying forecasting and optimization techniques to a wide variety of industry settings. The rise of the Internet as a selling channel will only increase the returns from applying PRM consistently across and organization. For these reasons, it is likely that PRM will remain the highest-value IT investment available to many companies for some time to come. Additional Reading Cross, Robert G., Revenue Management Hard Core Techniques for Market Domination, Broadway Books. New York Phillips, Robert L., E-Commerce: Revenue Management at the Speed of Light, Scorecard. Winter,