In an earlier blog post, “The Two Tides of Retail Pricing: Riding with Caution,” we discussed two major approaches to pricing strategy and the driving forces behind them. In short, there are two waves heading in opposite directions

  • One-price policy: driven by price transparency from the increase in customer touch points and the rise in mobile and cross channel shopping
  • Differentiated pricing: driven by price optimization software that maximizes value across customer segments and / or geography and tools that segment price messages to those groups of customers

In this post, we will discuss differentiated pricing and a few of the more common ways it is implemented.

Why Differentiate? 
A dominant pricing strategy among retailers today is differentiated or “zone” pricing. The logos below represent a few examples of retailers who employ zone pricing strategies.

What is the driving force behind zone pricing? Increased profit – price optimization software vendors consistently report 2-5% year-over-year margin improvements among their clients. However, it is noteworthy that not all price recommendations represent price increases – price optimization tools also recommend price decreases aimed at improving traffic, boosting unit sales and potentially opening up highly price-sensitive markets. Retailers utilizing a zone pricing strategy should focus on extracting financial benefit from the software recommendations, while preserving the customer experience. This objective can be realized by leveraging technology that insolates consumers from different price messages and employing customer-friendly price-match policies or disclaimers.

SAAS vs. On-Premise Solutions 
A thorough understanding of the pricing software landscape and providers’ different offerings is vital to ensuring that selected software matches the needs of the business. One major consideration should be the relative total cost of ownership and the organization’s comfort with “software-as-a-service” (SAAS) versus on-premises licensed solutions. In general, SAAS solutions feature lower up-front costs, since licensing fees are paid on a subscription basis and no hardware investment is required. This effectively spreads the costs more evenly over the useful life of the solution. Licensing fees are customarily based on the amount of revenue dollars under management, while hosting fees may be separate. SAAS solutions have the added benefit of always taking advantage of the most current version of the software. On the other hand, customers may be forced to make unanticipated changes to interfaces when the vendor adds new functionality. It is wise to have explicit conversations with SAAS providers about the upgrade process before signing any agreements.

By contrast, on-premises solutions typically have higher up-front costs, since balloon licensing fees tend to be paid when contracts are consummated. Annual maintenance fees augment the upfront costs over the useful life of the software. On-premise solutions also frequently require significant hardware investments, as the software is hosted on the organization’s existing infrastructure. This approach usually adds performance testing to the implementation process, a step that is most often unnecessary or invisible to clients in the SAAS model. Furthermore, taking advantage of upgrades to on-premises solutions typically dictates periodic IT investments, which are often deferred. The result is that many retailers continue to use out-of-date software long after more advanced features are made available to them from their current provider.

Increasingly, the total cost of ownership of SAAS and on-premises solutions typically converges over the life of the software. The decision of which approach to take often hinges on the mechanism the company wishes to use for funding the initiative and the company’s comfort level with cloud-based or hosted solutions.

Solution Evolution and Managing Change
While the strategies behind differentiated pricing have been around for decades, the tools used to deliver those strategies have become increasingly sophisticated and effective. The ability to know your customer and optimally price according to their demand at the store level is a huge driver of profitability through margin and unit sales.

Even more than just better recommendations, price optimization solutions in the marketplace today differ dramatically in the ease with which they enable zone or differential pricing. In some packages, the number of zones has a multiplying impact on the amount of workload. In other words, it would take a price analyst twice as long to manage two zones than a single zone, and ten times as long to manage ten zones. Obviously these packages, while they may have other impressive capabilities, should be avoided if the objective of differential pricing creates unmanageable levels of complexity, labor inefficiencies and risk.

Organizations switching from enterprise pricing to zone pricing often have significant change management hurdles to overcome as well. Merchants, accustomed to having complete control over pricing decisions, will have to cede some responsibility to their pricing team and tools in order to gain full benefits from zone pricing. This change management hurdle tends to be smaller the more transparent the software solution is about how final price recommendations are reached. These “black box” solutions seem to engender suspicion rather than confidence in the merchant community.

Prior to solution selection it is recommended that organization:

  • Build an objective short and long term roadmap (along with business case) either internally or from an external partner
  • Realistically address their IT and Businesses capability to deliver over a selected timeframe
  • Understand their business, and customer’s capacity to accept change – and plan the roll-out accordingly
  • Spend adequate time on education and training – these systems can be new and complex, the more it’s treated like a journey and less like a big-bang, the better the results will be

Differentiated Pricing Execution Options
Software considerations aside, the decision about the zone structure is crucial to success. This decision should certainly be informed by statistical analysis, but also must take into account strategic considerations, such as the need to enable zoned print advertising. In addition, the zone structure needs to balance the desire to capture more profit (abetted by increasing the number of zones) with the organization’s ability to handle the complexity that rises as the number of zones increases. Some potential zone structure options (presented from the perspective of a U.S. based retailer) are listed below from lowest to highest margin capture and complexity:

“Lower 48” Plus
This zone structure presents a consistent price for most of the fleet of stores, but allows for price increases in markets with significantly higher costs-to-serve (due to higher freight, rent, etc.) Examples of high cost-to-serve markets are Alaska, Hawaii and Manhattan.

This strategy sets zones based on a combination of price elasticity and geographic media-buying structures such as Designated Market Areas (DMAs) or Market Service Areas (MSAs). This approach enables versioning of mass media to reflect price differences, ensures similar pricing within a market and does a good job of accommodating pricing against regional competitors.

Elasticity-Based Price Zones
This strategy clusters stores based on their price elasticity behavior and does not take geographic proximity into consideration. This approach allows for a high degree of margin capture through differential pricing, but introduces challenges in isolating price messages that flow to customers, since nearby stores may have different prices on the same item. This approach is also difficult to implement in a retailer that has significant site-to-store sales volume.

Other Implementation Considerations 
Employ Solid Change Management. For a majority of organizations, price optimization tools and systems are a new wrinkle in what may already be complex processes. The technology can lead to fears of job loss, lack of control, and highlighting of poor performance based on the recommendations and reporting that become available with the new software. Robust, forward-thinking and well-planned organizational change management needs to be addressed in detail as well as executed and championed from the highest levels in the company. Numerous touch bases, information sessions, Q&A and individual stakeholder meetings may be required to inform, train and develop the talent and support structures necessary to execute to the most advanced levels of the new system’s capabilities. Anytime there is a reduction in the “art” of pricing and an increase in the “science,” care needs to be taken to ensure that the entire organization is on board and embraces the desired future state.

Embrace Omnichannel. This should be the first priority of the organization as a whole. It is especially important to understand how pricing strategy will affect customers as they move across the channels. This part may seem simplistic, however, it is highly complex in execution. Key inputs into the decision making of your online pricing strategy should include traffic, competition, cross-channel shoppers, fulfillment options offered such as ship-to-store and customer service policies. Any customer experience that crosses channels or touch points should be clearly mapped out to ensure a seamless (and consistently priced) experience.

Execute on the desired customer service level. There are three aspects to customer service:

  • The customer experience you want to provide
  • The experience your customers expect you to provide
  • The experience you are actually providing

As customers begin moving across channels, differential pricing inevitably will be discovered. Well before this occurs, the organization should have thoughtfully designed and clearly communicated customer service expectations to all levels of the organization, with special attention paid to customer-facing roles. Policies could range from “always give the customer the best price” to “we do not match any online prices,” but the policy adopted needs to be consistent and clearly communicated to the customer, no matter which channel they patronize. This is the best way to mitigate any potential discontent in the shopping experience.

Review your incentives. Organizations adopting zone pricing must review their incentive plans to make sure that they do not create motivational conflicts. Price optimization systems frequently recommend prices that trade margin rate for unit volume and margin dollars. Merchants that are measured on margin rate may find it in their best interest to override price recommendations, robbing the company of overall value. Similarly, store operators that are measured on the profit and loss of their site may object if their prices are systematically lowered due to the elasticity characteristics of their market. In customer service as well, it is an all too common occurrence for a company’s “store support center” to decide that they will not match online prices, but leave it to stores to deliver this message to disgruntled multi-channel customers. Those same store operators are then told to protect the customer experience and are summarily reviewed on service scores from those same customers they just upset.

Final Word 
Price optimization solutions have large potential margin implications and their use is both widespread and growing in the industry. Through a strategic decision-making process and firm understanding of software within the space, organizations can provide real value both to their customers and shareholders through integrated systems and rock solid customer service policies.

Published On: March 19, 2015Categories: Josh Pollack, Pricing, The Parker Avery Group