Proponents of optimisation systems say that introducing them to merchandising departments can increase gross margins by several percentage points. Joanna Perry looks behind the science

You can’t turn on the TV nowadays without seeing a retailer advertise its low prices or promotional events.

Now the appetite for systems to optimise decision-making around pricing, promotions and markdowns is increasing as retailers fight harder
for customers while they also battle to protect margins.

Clare Rayner, managing director of consultancy Retail Acumen, says that while companies track gross margin, sales and stock, it is still rare for them to consider other measures such as net margin for individual products or for the whole assortment after making an individual product change.

She adds that at present there are five or six retailers in the UK particularly interested in this type of optimisation technology, including fashion retailers, despite grocery being the area where it has been used most so far.

The systems work by modelling the result of individual price, promotional or markdown changes, taking the guesswork out of merchandising, and allowing retailers to assess the wider effects of single decisions.

SAP senior vice-president of trading industries Verlin Youd says that these systems should be seen as a money-maker. The projects it works on all break even within a year with gross profit improvements of between 3 and 5 percentage points. He says that one retailer SAP has worked with has also achieved revenue increases of between 5 and 9 per cent, and rises in units sold of between 9 and 13 per cent.

The systems are useful because customer behaviour can often be counter-intuitive. For instance, Rayner says: “When Woolworths launched its Worth It range it thought that it would cannibalise sales of more expensive items, but actually it created incremental sales as it suggested a higher value for other lines.”

DemandTec vice-president of marketing Marc Dietz explains that the company’s optimisation system allows pricing rules to be created, for instance so that prices always end in 99p, or maintain a certain percentage margin. The goal might be to optimise profit or to lower prices in a tough economy to ensure that demand is maximised.

Best Buy vice-president of merchandising operations and pricing Dan Moe spoke at NRF at the beginning of the year on how the DemandTec system had helped the retailer set its pricing.

He explained that back in the late 1990s, Best Buy’s pricing strategy was simply to beat everybody on price, on everything it sold, every day and everywhere. Now it has moved to a customer-focused pricing strategy.

It has developed distinct customer profiles to inform its pricing decisions using DemandTec’s optimisation systems. For instance, Best Buy will look at the price elasticity demonstrated by different customer segments and, in the same way that its service offering or assortment will be different in stores with different target segments, it can also adjust pricing.

Moe said that whereas pricing used to be an art dictated by simple formulas, in the era of science, Best Buy is now able to put the customer at the centre of its pricing decisions.

He added: “I think in our space, in terms of pricing analytics, we have pioneered quite a bit. We do price optimisation, we do strategy through the pricing analytics, we have engaged in this to ‘put a price on it for the customer’. We do clearance price management through scientific tools so I think we are pretty advanced.”

For other retailers the impetus for introducing these types of systems is different. Oracle Retail industry leader Sarah Taylor says that Oracle has found this kind of optimisation system is most appropriate for retailers with complex assortments, such as footwear retailers, and those selling seasonal items, though not fast fashion.

Best foot forward

US shoe retailer Famous Footwear, for instance, which operates about 1,000 stores, has been using a price optimisation system from Oracle for a couple of years. It introduced it to maximise sales and reduce inventory, while also reducing markdowns to improve its margins. By reducing inventory it has also been able to keep merchandise fresh in its stores, to try to fit with its overall brand proposition.

Famous Footwear has used the system to look at sales in relation to inventory, and suggest a best possible price within a season. From here it has then worked out how to most effectively add promotions to the mix.

Spanish department store retailer El Corte Inglés is in the process of introducing systems from Oracle to help it expand profitably. It wants to ensure that it has the right products, in the right stores and at the right price, and also wants to get a grip on margins. Taylor says that its implementation will go live in July this year, and it will be interesting to see the results it is able to achieve.

The success of these systems is, in part, dependent on the quality of the information that feeds them.

Brian Hume, managing director of retail consultancy Martec International, says: “For price optimisation to work you need a very accurate database and systems around it that work.” He adds that if you have changed the price of a product 15 times in the past few years then you can build reasonable price elasticity curves, but everyday low-price retailers may have only three or four data points to compare in the preceding three years.

Rayner says that it can be difficult to map an SKU to another a year later – especially for fashion. In comparison, in consumer electronics an entry-level product can be compared with an entry-level product a year later, she explains.

Dietz says that price elasticity is just one driver of demand and a price optimisation system will consider many variables.

He adds that the system will correctly predict demand across a retail chain with about 95 per cent accuracy. The more data the retailer has to feed the system the better, but a good system will be able to build a model even where data is incomplete.

Hume points out that whether a retailer chooses to invest in an optimisation system or not, at the very least it should have processes in place to make pricing and promotions decisions. “The alternative is to shoot in the dark,” he says. “Having some kind of process does a better job than having no process at all.

“It could be a fixed mark-up over cost price, and then you can ask if the price looks plausible. Then if a customer will pay £5 will they pay £6 or £7? But the mistake would be to make that the only step in the process.”

He adds: “If you go to any supermarket the margin on tobacco is terrible, maybe 3 per cent gross margin, but on sliced meats in the deli it might be 35 to 40 per cent gross margin. So you don’t have to just follow one set of rules.”

Pricing and promotions are set to continue being the weapons of choice for retailers battling for customers’ hearts and minds, and this makes optimisation systems more appealing. But once the upturn gathers pace they could prove even more valuable to help capture growing customer demand.

Pricing parlance

Price elasticity: A measurement of how much any given change in price will affect demand for a product. By plotting the relative price and demand for a product on a graph you can create a price elasticity curve.

Halo effect This describes the uplift in sales of complementary items when an item is put on promotion or has its price cut.

Cannibalisation: The reduction in sales on an item when a competing item drops in price or is on promotion. This should be taken into consideration when deciding the effectiveness of any price change or promotion.

Known value items: Consumers have a good idea of the fair price for these products, such as milk, eggs, bread and sugar. They are normally competitively priced, as they affect consumers’ perceptions of the retailer’s overall price proposition, and are rarely on promotion.

High-low pricing: This pricing model involves retailers setting high regular retail prices, and then running promotional pricing events to encourage more regular repeat custom and attract new customers. However, consumers can learn to simply wait for promotional pricing, whereby they won’t buy goods at full price.

Everyday low price: Pricing to attract customers whose primary concern is price rather than factors such as customer service or store convenience. Retailers that follow this model run promotions less often, focus their message on constant price competitiveness and tend to mark down goods only to clear ageing stock.

Full retail pricing: Retailers that follow the full retail pricing model have consistent pricing with periodic clearance Sales.

Source: Martec International