Dynamic Pricing Boosts Bottom Line

Software enables businesses to adjust pricing according to supply and demand

InformationWeek Staff, Contributor

October 26, 2001

7 Min Read

Online retailers struggling to make a profit could take a page from the travel industry and use software to boost their bottom lines by determining just how much they can charge for an item without hurting sales.

It sounds like a recipe for disaster for consumers, right? After all, if stores can more accurately match prices with demand, up to the minute, won't consumers end up paying more money? Not necessarily: In many cases, prices will actually be lower.

Retailers are starting to eye dynamic-pricing software. The products apply mathematical algorithms to sales and inventory data to suggest price changes to meet specific goals such as maximizing profit or minimizing markdowns. Many of the vendors developing the technology, including KhiMetrics, Optivo, Spotlight Solutions, and Zilliant, are venture capital-fueled startups that are just a few years old. Most of their customers are traditional brick-and-mortar retailers.

The concept has been around for a while, though it's been confined mainly to the travel industry. For example, a New York-to-Miami airline ticket could cost $200 in the morning; a few hours later, it could jump to $450, and then drop back to $150 two days before the flight if the plane is only half-full.

Hotels also use dynamic pricing, discounting prices heavily on the weekend and boosting them sharply on Monday--the busiest day of the week. It's all about the law of supply and demand. So why shouldn't retailers that sell sweaters or CDs change prices to more accur-ately reflect demand?

"Dynamic pricing can be used for good as well as for evil," says Ken Cassar, a senior analyst at Jupiter Media Metrix. "Everyone's instinct is, 'Oh, dynamic pricing, they're going to try to take advantage of me.' In fact, the opportunity to capture an incremental sale at a lower price may be as compelling as ratcheting up sales to consumers who are less price-sensitive."

If retailers know which of their products have the highest profit margin, they'll try to sell as much of those products as possible, either with a promotion or at a price that will attract consumers. To do that, though, businesses need to know detailed purchasing histories of their customers so they can tailor special offers. This is exponentially easier online, where a shopper's every preference is recorded in an electronic trail, than in physical stores.

The attraction of maximizing returns is strong: Increasing prices by just 1% can result in operating profit improvements of 11% or more, as long as sales volume doesn't drop, according to consulting firm Accenture.

Buy.com Inc., which began online operations four years ago and has yet to turn a profit, began using dynamic-pricing software from KhiMetrics two years ago, along with its own technology, to monitor prices on competing sites such as Amazon.com and Best Buy. The "bots" search for price changes that have occurred on those sites; software then suggests changes on Buy.com. The process is automated, but it still requires a human to make the final decision about a price change. "You always want to verify the pricing before it goes out," says Brent Rusick, senior VP of the Aliso Viejo, Calif., retailer. His goal is to maximize sales--primarily of consumer electronics and computer hardware and software, which are the most popular of its merchandise and a category that's highly competitive online.

But don't be fooled by the "dynamic" in dynamic pricing. The price checks are conducted on a daily basis, with changes to Buy.com occurring the following morning, Rusick says. "Its not a real-time process," he says. The site could match a competitor's sale price that same day, "but that's not our pricing strategy. We haven't found the need to change prices throughout the day."

Prices can change from one day to the next, depending on category, the season, or a promotion run by a manufacturer or a competing site. They tend to fall more than increase, fulfilling Buy.com's pledge to offer the "lowest prices on Earth," Rusick says. Backing up that guarantee with a price-match refund wouldn't be possible without dynamic pricing. "It's the only way to live up to that promise," he says. Savvy consumers who comparison shop online can easily find the cheapest price for a given item, and Buy.com wants to make sure its prices are always the lowest.

Buy.com isn't a poster child for the success of dynamic pricing; rather, its failures may reflect more a flawed business model. Revenue for the second quarter this year was $94.9 million, less than half of what it had been the year before. Since the beginning of the year, the company has lost more than $51 million, laid off 165 employees, and been delisted from Nasdaq. Its stock now trades over the counter. Founder Scott Blum, who owns a 40% stake, is attempting to buy back the company.

Still, Rusick is undaunted about the merits of dynamic-pricing technology. "It's more important today because margins are thinner and so we're managing margins more closely," he says.

There's still a stigma attached to dynamic pricing, and the king of online retailing, Amazon.com, is partly to blame. In a test last year, the company angered its customers, who later complained and caused a public-relations disaster, by simultaneously offering DVDs at different discounts ranging from 30% to 40%. That flap was for cutting prices. Imagine the outcry had Amazon actually raised them.

"No one is admitting to changing prices based on customers' purchasing behavior. The Amazon case scared everyone off," says Jared Blank, an analyst at Jupiter Media Metrix.

Don't expect to see Gap Inc. using dynamic-pricing technology any time soon. The technology is evolving, but it's still a few years away from commercial use, says Ken Harris, CIO at the San Francisco clothing retailer. "I wouldn't rule it out. Right now, I don't think it's quite ready," he says. "It's important that consumers understand how pricing is determined and that they feel it's fair."

The Internet arm of the QVC shopping network is another high-profile retailer that isn't considering offering different prices to its customers. "One thing we really believe in is unilateral prices. If it's on TV for one price, it's on the Web site for that same price; if it changes on TV, it changes on the Web," says Stephen Hamlin, VP of operations for iQVC in West Chester, Pa., which had $194 million in revenue last year.

Optivo, a startup that makes analytical merchandising software to monitor consumer demand and recommend price changes, is working with undisclosed online retailers in home improvement, consumer electronics, and other industries, testing different products in a six-week period. That research will help companies decide whether they want to capture as many sales as possible or maximize their profits.

"This isn't about trying to change the price every hour," Optivo CEO Robert Drescher says. "Online, there has been this quick shift from 'Give me revenue at all costs' to 'Make me profitable.' The one lever that has the biggest impact on a company's profitability is getting pricing right. Prices change now, but they're highly capricious and not at all trying to match demand."

Because online retailers have slimmer margins than their brick-and-mortar brethren, the majority of changes would lead to higher prices, says Perry Mizota, Optivo's marketing director. "Our customer trials are proving that people are taken aback at how much more they can charge than what they do."

Hewlett-Packard uses what it calls contextual pricing as a promotion to encourage shoppers to increase the total size of their orders. For example, it offers business buyers of its six-way NetServers discounts to purchase a configuration with six processors rather than just two or four.

"In the end, the consumer gets a better deal," says Marc Jourlait, North American director of HP's NetServer business. "Yes, we're requesting to be paid more money to give more stuff, but the incremental stuff doesn't cost as much as if they bought it separately. The more you buy from HP, the more you get."

That idea of using dynamic pricing as a promotional tool could catch on, analyst Blank says. Retailers could keep base prices higher and then send out coupons for certain customers who are more price-conscious. There are plenty of people who care more about being the first to own a newly released CD, or that they can get overnight shipping and dependable customer service.

"People value the transaction differently. Price is big for some people and not for others," he says. "Dynamic pricing is going to have to be done undercover for a while so there's a mass of companies doing it, so that when people find out, there's nothing that can be done," Blank says. "People believe it's wrong to raise prices but not to lower prices. You don't have to like it, but it's going to be a fact someday."

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