July 24, 2018
From a growing list of parts to price – which now last longer and require extended life cycle management – to increasing competition in an ever-changing regulatory environment that drives substitution, managing profitability in the aftermarket industry is no easy task. There are a variety of pricing models you could implement to make margin improvements. Price optimisation is one that has made a significant difference for some spare parts distributors but understanding it and ensuring it works well for you can be a challenge.
Price optimisation – known by some as ‘black box optimisation’ has been around for over 10 years, yet while certainly a trend, there remains confusion over how it works. The rise of AI hasn’t helped. While sticking an ‘AI’ label on a pricing algorithm – or even naming it ‘Susan’ – might seem like a good idea, it doesn’t improve the pricing accuracy and it doesn’t broaden its applicability. It does, however, provide a new excuse to avoid explaining how it works. It also side-steps the opportunity to give pricing managers the means to control it.
What is the best pricing strategy for spare parts distributors and can price optimisation work well?
3 Pricing Models
To make this determination, you need to look at the different pricing methods available, and understand their relative strengths and weaknesses to your business. At the highest level, the various pricing concepts can be grouped and ordered as follows:
- Cost Plus
- Market Driven (Competitor Price Driven)
- Value Driven
If appropriate, moving down the list may bring your pricing ever closer to your customers’ willingness to pay, and capture more margin. Staying near the top of the list gives you the simplest control of pricing, the easier justification in front of customers, and the broadest applicability.
Here’s a look at both ends of this spectrum:
- Cost Plus pricing works in environments where a purchase or replacement cost can be easily found. It can be calculated quickly and efficiently across huge product portfolios. Sales teams find it easy to explain to customers that the price is relative to your costs. Controlling prices with cost-plus is also easier. When a business has an overall margin objective, and you manage prices by setting margins (or mark-ups), it’s easy to explain how the prices will support the overall goal.
- Value Driven pricing models range in complexity and sophistication and I will dive into this in further detail in an upcoming post. However, at the most complex level of this group, we see price fully optimised on customer buying behaviour and product attributes. This approach often also generates derived attributes but they are evaluated and selected based on an individual correlation with price performance and then organised into a quantitative segmentation. Rules may be used for refinement but the basis for the pricing guidance is the set of historical transactions for each segment.
Full optimisation doesn’t need to be ‘black box’, it just needs to leverage historical data for a given selling scenario, and use that to generate target prices. Models either implicitly or explicitly measure willingness to pay (elasticity), but the concept can be open, can be understood and can be controlled if you demand it.
Be prepared to accept that while one pricing model may be great for some parts of your portfolio, it may not be appropriate for the entire business, and that a simple approach is sometimes the best. The best strategy is to arm yourself with a good understanding of all the different models, how they might work in your company, and where they would be applicable. This will allow you to identify if improvements can be made, and what will drive the biggest realistic return.
To find out more about the relative strengths, and weaknesses of the various pricing methodologies when applied to parts and aftermarket products, please join our webcast on August 1 What Do I Do With All These SKUs?.