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Price Optimization: Why It’s Important And How It Works

Paul Sansom< Paul Sansom January 6, 2023

Originally Posted: May 18, 2021
Updated: January 6, 2023

Things have changed A LOT since May 2021 when this article was originally published.

Where Picasso had his Blue period, we should call the last couple of years the Murphy’s Law Period. Whatever could happen, did happen: the worst of the COVID-19 pandemic, runaway inflation, exploding interest rates, see-sawing energy prices, domestic political turmoil, crypto’s meteoric rise and catastrophic meltdown, a (still ongoing) land war in Europe, billionaires behaving badly, dangerous and deadly storms, and the list goes on. Hell, a giant boat clogged up the Suez Canal and almost brought the global supply chain to a halt. You see what I’m talking about?  

Each of those events alone could have caused issues for business, but all together? AT THE SAME TIME?!

Companies used to annual or biannual price changes were subject to many more than what their organization could handle, and trusted legacy systems and processes began to strain, stutter, and stop under that pressure. It exposed a lack of automation, an inability to quickly or proactively respond to market impacts, and an ever-widening technology gap. In increasing frequency, Commercial and Pricing Leaders began to ask themselves 2 questions: What technology is out there and is it right for us? 

These questions invariably lead to another issue, one that I like to call The Three Stooges Effect, named for the scene where Larry, Curly, and Moe all attempt to go through a door together and get stuck. There are many different directions that organizations can go, but are often paralyzed by indecision, competing priorities, and a lack of strategic direction.  

One of the first trails that people often tread down is Price Optimization. Two words that, when put together, have taken on an almost-mystic quality in the past few years. Many people use them confidently, but far fewer use them correctly.

Often misappropriated with other elements of the commercial excellence suite, few organizations start their journey with an appropriate understanding of what Price Optimization is, how it works, or if it is “right” for them.  

A senior executive at a company with an effective price optimization program once told us that just one person in their entire organization understood how their pricing solution worked. He then went on to explain, more accurately, there were actually probably two people – each of whom half  understood. 

This lack of understanding is common among companies. The executive’s rationale for being okay with the fact that no one understood the solution was also commonplace. The company was doing well and they were realizing an improvement in profitability. Did it matter  that they didn’t really know how it worked?   

Such a lack of understanding can really limit success. And of course, any knowledge gaps are likely to kill the potential for continued or added improvements over time. That’s why the importance of pricing optimization programs must be understood – and believed in – by everyone who uses them.   

When utilized effectively, Price Optimization can be one of the biggest barriers to margin erosion and lost business brought on by market factors. By understanding your customers’ Willingness-to-Pay in a variety of market conditions and placing guardrails to prevent any course deviation, your organization can implement a dynamic pricing solution that fits any pricing methodology or commercial strategy.  

Within this article, we seek to explain 2 things: (1) what Price Optimization is and (2) how it works, and as our collective understanding of the subject improves and we realize that SkyNet will not be in control of a company’s prices, you will also begin to ascertain if Price Optimization is right for you and put you on the right path to a successful implementation.  

What is Price Optimization?

Price optimization is the practice of deciding upon the most effective pricing strategy for a product or service. It is the process by which an organization seeks to find the optimal price that its customer is willing to pay for a product. Not so high that they risk losing that customer’s business, not so low that they sacrifice margin, but just right.  

Reliant on crystal clear data, great pricing optimization enables companies to offer their products at the price points that are most likely to be picked up on by customers.  

Optimal price points will deliver the best possible profits for the company, and may also be designed to achieve additional goals such as assisting in improving the company’s market share or enabling expansion into previously unexplored markets. 

What Does Price Optimization Involve?

Pptimizing price covers a wide range of different factors, and companies looking to ensure that their prices are all fully optimized will be managing a combination of these. The first thing to consider is which pricing areas the company needs to optimize.

  1. Starting Prices
    The starting price of a product or service is of course fundamental to its success, so pricing optimization is key here. Pricing optimization software will analyze data to reveal the best possible starting prices, taking a wide range of internal and external factors into account. 
  2. Discounts
    Many companies opt to push their products out to larger audiences, or tempt back past customers, with the offer of discounts. Well-managed software can also be used in these instances, to ascertain the optimal price points. 

The Benefits of Price Optimization

Graph Illustrating The Benefits of Price Optimization

Measure ROI
-Maximize Profits
-React Faster
-Gather Insights

Pricing optimization brings a multitude of benefits, which are evident throughout the sales process. Take a look at some of the main advantages of pricing optimization strategies. 

  1. See fast, measurable ROI improvements
    With pricing optimization software, it’s easy to see how things are improving. ROI can be closely monitored, with all changes available to view in real-time. This data-driven approach enables teams to respond to fluctuations in demand quickly, maintaining the best possible ROI for the company. 
  2. Maximize sales and profits
    The best possible price points allow companies to achieve their true potential, particularly when it comes to maximizing sales and profits. Customers are more likely to pick up on products and services when they’re priced optimally, and companies soon reap the benefits. 
  3. React faster to market changes
    Pricing software makes it possible for companies to react quickly to changes in the market, outsmarting their competitors by offering goods and services at the best possible prices for any given circumstances. 
  4. Gather insights into customer behavior
    The more data a company has, the better it can understand its customers. And with this understanding comes immeasurable opportunities. Data allows companies to offer products they know their customers will love – at prices they’re sure customers will respond favorably to.

Price Optimization Models

-Science and Strategy
-Blackbox vs Clear Box
-Simple Rules Engine
-Clever Math Angle

Business Professionals Discussing Price Optimization Strategies

Data is incredibly valuable when it comes to pricing, however, it can fall short if not used effectively. When it comes to price optimization models, there are a couple of different approaches – each with its own set of challenges:   

  • Combining “Science” with “Strategy”
    Remember SkyNet and all the phobias it created? Well, I’ve got news for you: we are way passed that. Algorithms are here to stay, they control almost every aspect of our digital lives, but as their ubiquity expanded, so too did our understanding of how they work. Therefore, modern optimization systems should give immense control to the users. Gone are the days of letting the algorithm make all the decisions. Now users should be able to combine their business strategy with the unlimited potential of an optimization model, overriding decisions when it makes sense and guiding the system to better outcomes. This should be done within the UI, and should not require a data science background, or knowing how to code.  
  • “Black Box” vs “Clear Box”
    Black Box AI refers to an antiquated philosophy where systems take in data and spit out guidance, without any transparency. Historically, this has been a hurdle for many organizations that would otherwise be good candidates for Price Optimization, as they lack trust in these technologies. When the system does make decisions, it should be completely transparent as to why that decision was made, and that background should be both easily accessed and defensible. This includes all of the math and actions that led to that guidance.    
  • Simple Rules Engine
    Business Rules enable organizations to set broad and/or scenario-specific guardrails that mitigate any risks associated with science-based price optimization, such as capping price changes for a customer group. Individually, a rule is easy to understand, but as the number of rules builds up over time, they conflict with each other which means new rules are then created to fix erroneous combinations. The result is often many layers of conflicting rules which are far too complex to visualize. 
  • Clever Math Angle
    Algorithms are used to try to solve the issues that the rules engine creates. While the solution may work, it’s difficult to validate at a granular level. Users are asked to simply trust the answer. High-level statistics, operational research, and dictates from a “black box” aren’t feasible for most organizations. 

The simple rules engine approach is fiendishly difficult to manage, but the “clever” approach is often just too opaque and doesn’t deliver real control to the business. Neither option builds confidence among the sales team so that they can fully deliver on the promises of the software vendor.  Regardless of whatever the black box recommends, it’s only the confidence of the front-line sales and deal negotiators that can deliver actual business improvement. 

This is where strategy comes into play. While the models above deal with the number crunching, the execution is where real gains can be found. Smarter price optimization solutions allow developments in AI-driven pricing technology to infuse with the intuition of humans in order to deliver when it counts. 

How to Develop a Price Optimization Strategy

Price Optimization Strategy Success Illustration

-Solidify Your Strategy
-Know Your Customers
-Organize and Analyze Your Data
-Measure Value Through Real-Time Insights
-Look to AI and Automation

How a successful optimization strategy looks will vary from company to company, the core ingredients include a strong understanding of the customer base and access to data and real-time insights that ensure teams don’t have to rely on guesswork or hunches. All of this can of course be aided by technology. 

Take a look at our team’s recommendations to successfully optimize your pricing.  

  1. Solidify your Strategy
    Listen, we get it, implementing a Price Optimization strategy can be a big step, which is why it is crucial to have a comprehensive business strategy that includes value expectations for the new system. What data is necessary to understand differences in price? Do expectations differ from Division to Division, Product to Product, or Channel to Channel? What does your roll-out plan look like? Does your sales team’s compensation align with the new strategy? These questions and more should be answered within your business strategy prior to implementation.  
  1. Know Your Customers
    The key to knowing how to optimize pricing rests within each potential audience. Users of pricing solutions and price management software  must have some understanding combined with a relevant level of control. Likewise, teams must have a good understanding of their target customers to achieve the best pricing optimization strategies.  
  1. Organize and Analyze your Data
    Make use of specialist pricing optimization software to organize and analyze data with ease. By keeping a careful eye on the most important metrics, teams can tweak strategies and provide a fully flexible and dynamic service. Tracking transactional metrics, such as both the optimized price and the final invoice price, will give insights into performance and effectiveness and highlight what is and isn’t working.  
  1. Measure Value Through Real-Time Insights
    Far too many companies make the mistake of compiling data and only looking at it from time to time. Beat the competition by leveraging insights in real-time. In doing so, you’ll put your company in a position where it can respond to any changes in demand at lightning pace – and profits will soon soar as a result.  
  1. Look to AI and Automation
    Technology has so much to offer here, so keep an eye out for the latest developments in pricing optimization. AI and automation can help companies offer the best possible pricing at any given time. They can also cut down on time spent managing processes manually, freeing up teams to explore even more advanced optimization options.  

Price Optimization Examples 

It might be helpful to take a look at some real-life examples where price optimization might be impacting your daily lives 

  • Car Insurance
    Automotive insurers used advanced gathering techniques for both personal and market data, including your loyalty to other service providers and shopping behavior to arrive at an optimized price. Optimization has been shown to punish consumers who do not shop around and compare prices.  
  • Airfare
    The airline industry has been one of the most prevalent users of price optimization over the past decade or so. Unlike car insurance, airlines are far more reliant on active aggregation of competitor prices and the comparative price elasticity. This is why tickets for most major airline move in similar patterns. Even “budget” airlines will take advantage of major airlines’ higher prices by making themselves more attractive during highly competitive periods. 
  • Rent
    Rental price optimization has drawn major scrutiny recently and is an excellent example of an algorithm running amok. By controlling such a large market share of rental prices, software from a single company drove prices up so high that it pushed away loyal renters, created higher vacancy rates, and drew the ire of the US District Court with alleged price fixing. The point of price optimization is to improve pricing while keeping your customers happy, not drive them into bankruptcy.  

Why Price Optimization Sometimes Fails

Many failed strategies are the result of poor understanding, but there are other aspects of pricing optimization which – when overlooked – can spell trouble. These are the most common pitfalls to avoid. 

  1. Guesswork
    Pricing optimization relies on the clever use of carefully compiled data. If it’s based on guesswork and subjective data points, it’s doomed to fail. Make sure your prices are fully optimized with the help of consistent, well-managed data to avoid such problems.  
  1. Data Errors and Inaccuracies
    Another issue we often see is failure due to errors and inaccuracies in data. We recommend that companies make use of specialist pricing optimization software, which will filter out problem data and ensure the success of optimization strategies.  
  1. Pricing Isn’t Value-Based
    Price optimization strategies should always take value into account. Value-based pricing is of course vital to the success of any sale, no matter which external factors a brand is taking into consideration.  
  1. Heavy Discounting
    Discounts can be a real secret weapon when it comes to drawing in customers, but heavy discounting can put a spanner in the works of even the best pricing optimization strategies. Instead of discounting products too quickly, or by too much, offer products or services at the optimal price point for your target market.  
  1. Overcomplicating the Ask
    As with any system or process, added and unnecessary layers of complexity will bog down the optimization and create contradicting guidance. Furthermore, too much granularity in your models can quickly lead to diminishing returns.  

What to Look For In Your Price Optimization Solution

A price optimization solution must be able to handle massive complexity, but not be any more complex than necessary. Sophisticated price optimization algorithms are fast becoming critical to success and while the math may not be accessible to all; optimization solutions should be structured in such a way that it is controllable and understandable. The idea of price optimization is a ‘complex’ solution, but it can be visualized simply, in ways that are meaningful to different users. 

Good Price Optimization software solutions should have the following features:

  • Competitive Monitoring
    Pricing optimization software can help to monitor prices for you to help ensure you are not left behind by changes in the market. With the software monitoring the markets for you, you’re left with more time to focus on other important tasks.
  •  Data-Driven
    With price optimization solutions, your prices are set with help from data on all of the metrics that matter. This includes data that might otherwise be difficult to interpret and use.
  • Forecasting Abilities
    The best solutions will have advanced algorithms that help you to forecast market changes. Forecasting will help you stay ahead and potentially take advantage of any slow reactions but the competition.
  • Infuse Automation with Human Expertise
    As powerful as computers can be, human insight and expertise is still often needed to make the right decisions. The best price optimization solutions will let you make the best of both worlds and infuse the computing power of powerful algorithms with human input.

10 Tips for a More Successful Price Optimization Project

A price optimization project is a major undertaking for any company. There are often multiple internal stakeholders, and it is likely to affect a wide range of internal systems and processes, from basic product management systems to cost and profit allocation and customer relationship programs. When done right, it can be one of the most profitable activities a company can undertake. But when done wrong, the dangers are equally significant.

Based on my experience working on hundreds of projects, here are some final tips I have for any company that is about to embark on a price optimization project with the target of sustainable improvements:

  1. It starts at the top. C-level support is critical
  2. Excel is a great tool for ad-hoc analysis, but not for operational pricing
  3. Distribute central and local responsibilities within a common framework
  4. It is a change management project, not a price list project
  5. Communication is key
  6. Focus on your desired business outcome rather than a specific platform or technology
  7. Setup a well-planned pilot, measure results quickly and comprehensively, then apply learnings in full, rapid implementation
  8. You need the right cross-functional competencies on the team including price management, product sales, business analysis and intelligence, and IT
  9. It is a full-time job, whoever is running this should be focused on running this project and have little other responsibilities
  10. Create a reference framework in order to understand local and segment differences

Summary and Key Takeaways 

Price Optimization can be a powerful tool in your mission to price better, react to market conditions, and keep your customers happy.

But that doesn’t mean it’s a simple concept to understand, though hopefully this article has helped you gain a better understand of both Price Optimization and how it works, as well as determine if your organization is a good candidate for this kind of solution.  

But if you are still unsure if Price Optimization is right for your organization, Vendavo’s international team of pricing scientists, industry experts, and technology consultants are here to help you assess your company’s readiness and viability. If you are not ready to speak to someone and would still like to know where you are in the journey toward reliable, optimized profitability, feel free to take our Commercial Excellence Maturity Assessment  to compare your company to other B2B firms and identify areas for improvement. 

As we said at the beginning, any kind of commercial transformation should be seen as a journey, one that is filled with many different directions and routes you could take, and itis our job to help you find the right one.