Introducing B2B Price Optimization to Improve Air Cargo Profitability

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1 TM Introducing B2B Price Optimization to Improve Air Cargo Profitability By Lynn DeLain INTRODUCTION: THE PRICE OPTIMIZATION OPPORTUNITY If every contract and spot price you charge for air cargo is systematically derived, nets the maximum value for your company and is retained accurately to avoid revenue leakage and customer complaints, read no further. You ve done it. It s unlikely, however, that many of us can claim these ideal pricing capabilities. Your own situation may more closely resemble this scenario: Contract rates for your largest customers are negotiated without full knowledge of the customer s value or the profitability of the negotiated prices you most likely assume they are important customers with market power and you are reluctant to negotiate aggressively. Sales incentives to maximize business volume or revenue can often drive spot pricing, and those spot prices are usually lower than contract rates. Rates for similar customers for similar products are widely divergent. Sales people cannot see the impact on the company or on their own targets from each spot or contract rate they set. On the flip side, sales managers cannot track the progress of their sales people toward targets, and cannot intervene in a timely way to halt sliding prices. Market information is not readily available, so sales or other pricing functions cannot judge if their negotiated positions are reasonable. Customers chip away at your profits by renegotiating rates after capacity has been set aside and even after the shipment has been delivered. The good news: Business-to-Business (B2B) Pricing Optimization technology can help you curb or eliminate these profit-damaging processes and tendencies. B2B Pricing Optimization software can help you take control of your pricing: Give your sales staff a quick picture of customer value for any customer; identify low-performing customers; review customers in different markets, their prices, and their relative ranking both regionally and globally. Give your sales people a negotiation tool to help them see the impact of each customer s potential price changes on company margin (based on that customer s business in the network)

2 Provide sales with scientific, statistically valid, optimal prices for each customer segment. These prices are presented as floor, target, and expert prices to help improve pricing, answering these questions: Where is this customer relative to its peers? Where should this customer be? Control sales deviation from the optimal price window (subject to explicit approval workflow). Provide sales staff, sales managers and executives with up-to-date key performance indicators (KPIs) that show current achievement of targets and projected achievement if sales meets objectives. Integrate external market data to compare your cargo rates with your market. Retain and send agreed rates as the freight basis for your rate sheets to prevent rate changes midstream. But, to take advantage of this price optimization opportunity in air cargo pricing, it s important to understand how the industry has changed and how price optimization can make a significant difference in boosting rates and profitability in a highly volatile and competitive market. WHAT DRIVES AIR CARGO RATES Air cargo has been undergoing a shift toward increasing commoditization for the past several years, with pricing driven toward marginal costs. Trucking and ocean freight have become competitive with air freight for many products, depending on inventory levels. Huge drops in world trade, relatively high capacities, and higher fuel prices have hit the air cargo industry hard. Air freight rates have also become highly volatile and are often reduced to offset high fuel surcharges. The IATA [International Air Transport Association] reports show a gradually rebounding sector after a devastating 2009, but prices are still only gaining lost ground. Figure 1: Air Cargo capacity has been recovering since 2009 After careful management in recent years, capacity is on the increase ASKs, billions AFTKs, billions Available Frieght Tonne Kilometers (AFTK) Available Seat Kilometera (ASK) Source: IATA

3 One of the key factors driving rates downward is excess capacity. Demand and supply are highly cyclical. As carriers add capacity, rates drop. As rates drop, capacity decreases. With low capacity, rates rise, and we start the cycle over again. Over time we can expect to see increases in both capacity and demand, but the challenge in setting rates is to get the timing right. Significant increases in cargo-carrying capacity have occurred in the past few years as indicated in Figure 1, particularly in serving high-demand Asian markets. At the same time, recovering capacity has had a negative impact on cargo rates as shown in Figure 2. While worldwide capacity shows some growth overall, the addition of new freighter service or new passenger wide-body service at a particular origin can also have strong impacts on the carriers serving that origin. To add to this cyclically sensitive industry, localized markets are often concentrated, with just a few larger customers dominating the market and wielding substantial market power. Figure 2: Recent capacity increases have driven down cargo rates Cargo rates have been affected by capacity increases Cargo rates, $ per kilo SE Asis-Europe SE Asis-Europe (incl other charges) Global - LHS Global - LHS (incl other charges) $ per kilo Source: IATA In this formidable environment, it becomes essential for carriers to find better ways to protect cargo rates and increase profitability at any and every opportunity. And, one of the most important tools to maximize revenue and create incremental value is price optimization software. HOW CAN PRICE OPTIMIZATION IMPROVE RATES? At the heart of price optimization is the concept of customer and market segmentation. For example, assume you manage a complex flight network with 5,000 customers. Each of those customers has a price history. Segmentation requires putting those markets and customers into peer groups groups of

4 customers, perhaps in an origin-destination market, with similar characteristics. These characteristics might include overall network business level, importance of the customer regionally or globally, the products or commodities they ship and even the level of competition in the market. Within each of these customer segments or peer groups, there is a range of cargo rates. The goal of price optimization software from companies like PROS (www. prospricing.com) is to help identify the lower-performing members among the peer group and gradually bring those customers in line with their peers. PROS price optimization software, for example, helps distinguish smaller customers from larger customers and those customers that support weaker markets. PROS has built-in scientific analysis that can separate customers into segments by any data element such as special handling codes (do they ship a large portion of perishables or pharmaceutical products?), how much is shipped via standard general cargo or priority cargo, or what markets they support. This is not a one-size-fits-all approach. Rather it is a scientifically tuned methodology based on your data that ascertains which characteristics impact pricing and provides guidance to capture additional revenue from customers who are under-performing relative to other customers who display similar behavior. HOW IS PRICING OPTIMIZATION IMPLEMENTED? To implement cargo price optimization, PROS helps to execute two key functions: 1. PROS will work with you to identify the key variables and characteristics that can be used to effectively segment your customers and develop your pricing strategies. Figure 3: Illustrates the type of purchasing characteristics included in a typical segmentation analysis. Segments Customers Annual Volume Geography Regional importance Expert Products Product, SHC Density Loose, unitized Price Target Transactions Seasonality DOW Frequecny Floor 2. The Cargo Price Optimization system from PROS also provides pricing guidance to help set rates through an envelope of three prices floor price, target price, and expert (stretch) price. The envelope is contained by the range of prices you charge customers in a specific peer group

5 Figure 4: Pricing guidance helps set air cargo rates within a range of floor, target and expert or stretch pricing Better Prices Segment-based Based on Customer willingness to pay Includes optimal segment price Future prices for Yield Management Start Expert Target Better Decisions Market information Customer Value Specific cost-to-serve Determine deal profitability Terms and contract information Walk-Away - Floor The Price Envelope Price optimization supplies price guidance for individual cargo customers based on scientific analysis that is designed to improve profitability by bringing lowperforming accounts in line with their peers. However, in many cases, carriers may not want to dramatically increase prices for the low performers immediately, but rather introduce price changes gradually. By using the pricing guidance envelope recommended by PROS, at annual contract renewal time, carriers can make gradual price increases that are more acceptable to customers. For example, if a customer s current price for an origin-destination shipment is 1.15/kg, but the customer s peers average a higher 1.28/kg, it may not be advisable to raise the price to match peers all at once, particularly in an excess capacity or highly competitive market. In this case, the carrier could set the rate for this customer at the current price + 5% or within some range of the pricing guidance envelope. Figure 5: Price optimization example for cargo shipment with pricing guidance. Customer Name ABC Freight, Inc. Customer Account Number Origin FRA Destination LAX Product General Current Freight Rate, /kg 1.15 Current Surcharge Rate, /kg 0.75 Current Total Invoiced Rate, /kg 1.90 Current Peer Group Freight Rate, /kg 1.32 Current Peer Group Invoiced Rate, /kg 2.07 Floor Freight Rate, /kg 1.21 Target Freight Rate, /kg 1.28 Stretch Freight Rate, /kg % Raise Freight Rate, /kg 1.27 Current Surcharge Rate, /kg 0.81 Total Invoiced Floor Rate, /kg 2.02 Total Invoiced Target Rate, /kg 2.09 Total Invoiced Stretch Rate, /kg % Raise Total Invoiced Rate, /kg 2.08 Customer Information Current Rates Pricing Guidance Total Invoiced Rates

6 The table in Figure 5 shows the possible prices for a hypothetical customer cargo shipment from FRA to LAX. In this situation, our customer s freight rate is below that of his peers by 0.17 / kg. A 10% price increase would put the customer at 1.27/kg plus surcharges. While ideally you want to bring a customer up to his peer group price as soon as possible, a smaller 5% price increase, which would get this customer to the desired floor price of 1.21 /kg plus surcharges, would probably be more acceptable. By gradually introducing price increases in order to bring a customer in line with his peer group, a carrier can achieve the desired target price over time. WILLINGNESS TO PAY: THE SECRET TO PRICING GUIDANCE One of the keys to setting pricing guidance through PROS software comes from highly sophisticated calculations of what we call the customers Willingness-to-Pay (WTP). Willingness-to-Pay, or WTP, is automatically calculated based on customer segmentation data. These calculations provide key information, including the elasticity of demand, or how that customer is expected to behave as price varies. These pricing techniques, developed over years of price optimization experience, enable PROS to derive the win rate or expected demand as a function of rate, and then identify the optimal price sweet spot where profitability is highest. See Figure 6. Figure 6: PROS software uses multiple dimensions to supply pricing guidance for individual customers. Win-Rate Use segment win-rate to determine optimal pricing. Low Price Very High Revenue Calculate price that maximizes revenue. Low Price Very High Once you determine a customer s willingness to pay, you can identify the optimal price for that individual customer. PROS price optimization can use this price point to then calculate the envelope of price ranges from floor to expert used in producing pricing guidance

7 HOW YOU CAN TAKE ADVANTAGE OF PRICE OPTIMIZATION Research Demonstrates 6% Revenue Uplift Potential with Air Cargo Price Optimization Based on more than two years of shipment data from a major Asian air cargo carrier, PROS has calculated the potential results from applying price optimization. Using PROS pricing guidance and moving customers up to the floor price for their segments, this carrier would have experienced a 6% revenue lift. Results were based on conservative estimates of revenue increases and incorporated using a gradual adoption rate over two years. PROS Price Optimization software offers two options for helping to improve cargo rates. One option uses your own or existing business rules to generate recommended rates. The other relies on PROS system of pricing guidance to suggest recommended rates. OPTION 1: Use your business rules. PROS can automatically calculate and retain future freight rates in rate sheets for most customers based on your cargo business rules. Examples of business rules include increasing prices from EU to Asia by 3%, or increasing prices from Asia to EU and US by 7% and decreasing rates from China to Southeast Asia by 1%. OPTION 2: Use PROS pricing guidance. PROS can provide pricing guidance as a sales negotiation tool to help cargo sales focus on the key opportunities and best pricing options as they renew rate contracts for allocations or for freesale. Sales staff can use PROS to see floor prices for individual customers, along with recommended price increases that will move the customer account gradually towards target prices. Cargo sales can also mix different origin-destinations into a single-rate contract to increase customer rates overall and bring them in line with peer pricing. PROS can also create a draft of a rate contract renewal (or the spot price if needed) and send it to the customer. Upon customer approval and receipt of the signed contract, PROS software will register those prices into your rating database or other system of record. Regardless of which option you choose, all rates are recorded and transmitted to the carrier s system of record (usually as rate sheets for a revenue accounting system) to assure price consistency and avoid contract disagreements in the future. s may be dispatched to customers with rates and terms of condition. PROS cargo pricing experts can also work with you to specify several methods for quantifying the incremental value of optimized and automated pricing. We help you choose the attributes that best match your customers and simultaneously record how we should measure incremental value. PROS will develop customer segmentation, request business rules to control each segment as needed and provide the pricing guidance for each customer segment. The PROS system also offers a configurable workflow so you can choose which rates you automatically approve and which you need to review. CONTACT PROS FOR AN INITIAL ASSESSMENT To learn how you can take advantage of price optimization technology to increase revenue, understand true customer value, eliminate revenue leakage from rate changes and empower your sales staff with pricing guidance during customer negotiations, contact PROS at info@prospricing.com or by calling

8 PROS will meet with you to make an initial assessment of your pricing needs and explain how pricing guidance can help you increase bottom-line returns and negotiate rates that are more profitable for you and satisfactory to your customers. ABOUT THE AUTHOR Lynn I. DeLain, Ph.D., serves as senior product manager, Cargo, at PROS, Inc., the leading provider of price management and optimization software. Prior to joining PROS, DeLain worked with Accenture Freight and Logistics Software group managing cargo software requirements and client business consulting and training. She has more than 20 years cargo revenue management and pricing experience, working with clients around the globe to help implement revenue management, pricing and process changes that align business objectives. WORLD HEADQUARTERS 3100 Main Street, Suite #900 Houston, TX Phone:

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