Is your price right?

A primer on dynamic-pricing models and how it applies online. 

 

Return on Assets (ROA) = Margin (M) x  Velocity (V)

According to Ram Charan, the ROA formula is the possibly the measure of the health of any business.  I'd have to agree.  An entrepreneur must follow the fundamental tenet that the return on assets has to be greater than the cost of using one's own money. 

For instance, a retailer will be able to earn more if it is able to clear its shelves everyday.  Wal-Mart has a 360 inventory turn in toilet paper - meaning that the entire inventory of T.P. is sold almost everyday.  Companies with smaller margins should aim for high velocities of inventory turn.  Conversely, companies with large margins (i.e. premium offerings) can maintain a healthy ROA even with slower velocity.  Charan's research demonstrates that the best companies balance ROA above 10% after tax. 

Online effects on traditional pricing models.

The internet changed the game when it caused a structural shift in consumer behavior.  With a click of a mouse, consumers are able to comparison shop.  And just like that, whether they wanted it or not, price transparency become a part of all companies' agendas.  You say you're the low price leader?  Click, click.  Consumers can verify that.  Trying to differentiate on free shipping?  Click, click.  Consumers will see if that's the best value.  In essence, businesses discovered that their old static pricing models were obsolete; they had to formulate a new way to respond to the changes in the digital marketplace.

The effect of emerging online pricing models.

It's been 7 years since Dr. Eric Clemons, operations and information management professor at Wharton School of Business, predicted new emerging pricing models from microeconomics that could be applied online. One example of which is dynamic pricing. 

Dynamic pricing is a model that matches supply and demand through the pricing structure.  This is the model used by stock exchanges and commodities markets.  Think of the way stock prices rise and fall.  As demand increases, so does price. 

Under this umbrella is the concept of dynamic variable pricing which applies mathematical algorithms to sales and inventory data to suggest price changes that meet goals such as maximizing profits or minimizing inventory.  The effect is surprisingly consumer centric - the opportunity to capture sales at a lower price point is valued as much as ratcheting sales to consumers who are less price-sensitive. 

Dynamic-pricing and ROA.

Consumer benefit aside, dynamic-pricing can be a tool that maximizes a company's ROA.  For instance, maximizing returns can be captured with scale or scope; lower margins and higher velocity can move to higher margins and slower velocity.

So why haven't more companies implemented dynamic pricing? 

1. Stigma. Imagine the PR disaster that would occur if consumers perceived dynamic-pricing as trying to pull a one-up on them.  Implementation requires precise movement with all functions.  This includes a smooth transition to the market which frankly, a lot of companies aren't equipped to mobilize. 

2. Pricing is difficult. For many companies, minimizing cost-line expenditures and conceptualizing fun ad campaigns are much sexier (*cough* easier *cough*) than formulating mathematical algorithms.   

Which companies are best suited for dynamic-pricing? 
The hotel and travel industries contain perhaps the most well-publicized and accepted examples of companies that have successfully used dynamic-pricing models.  Aside from those, here are some guidelines for you to decipher whether your company should explore dynamic-pricing: 

• Is your consumers' demand for goods relatively stable? 
• Can you cross-sell other offerings to encourage product adoption? 
• Can you segment your consumers by value- and price- orientations? 

If you've answered "yes" to all three questions, then  your company is a prime candidate for dynamic-pricing. 

How to integrate online marketing tools to implement dynamic-pricing.

1. Incorporate effective, timely cross-sells in the shopping cart, at discounts- Mine your historical customer data and pair offerings to encourage brand adoption.  This is particular to online retail. 

2. Incorporate time-sensitive email marketing - Email marketing was made for segmentation like this.  By segmenting lists to value- and price- orientation, you can manage the sends of email promotions effectively.  For instance, a value-oriented consumer may be exposed to a "sneak-peek" of a product; they can purchase in a timely manner and you can capture them at a more premium price.  Price-oriented consumers can be exposed at a frequency post general launch at a discount rate so you can capture scalability and minimize inventory holdings. 

Final word
Dynamic-pricing models can be a strong tool to maximize returns on assets.  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 volume doesn't drop, according to consulting firm Accenture.  Positive cost-line effectiveness and strong cash generation translates to greater velocity (V) and higher margins (M); a makings of a healthy ROA and business.

Hope you enjoyed this primer. 

 

Capture the dream, folks,

-johnny

Comments

[Anonymous]

Great blog. Your implementation strategies for this dynamic and powerful concept were great.

[Anonymous]

Great blog. Your implementation strategies for this dynamic and powerful concept were great.

[Johnny Chan]

Thanks! ...whoever you are...