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How Does Price Optimization Work?

Vendavo July 20, 2018

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

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

Yes, it matters. A lack of understanding will limit your success, and that lack of knowledge is likely to kill any potential for continued or added improvements over time.  It’s fundamental to the ongoing and permanent success of pricing programs: they must be understood – and believed in – by everyone who uses them.

All Solutions Aren’t Created Equal

In most cases, pricing solution vendors take one of two possible approaches with price optimization:

  1. Simple rules engine: 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.
  2. ‘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 second 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.

Know Your Audience

The key to knowing price optimisation rests within each potential audience. Users of pricing solutions must have some understanding combined with a relevant level of control. These two things will empower them to get the most out of any system.  For example:

  • For most front-end salespeople, there is little point in trying to explain a 12-level pricing segmentation with 15,000 pricing segments. Words like elasticity, artificial intelligence, regression, and even “willingness to pay” won’t help.  Instead, share a simple context for each price (context, rather than segmentation!) and then show them what has been achieved in similar circumstances. Give them an example and show them how it has worked.
  • Product managers and pricing professionals responsible for the prices that go to market can’t hide behind a lack of understanding of their system if things go wrong. Increasing competition, commoditization, and pricing sophistication within their markets may be pushing them to consider increasingly complex systems just to survive.  These roles need a level of understanding that allows them to fully control the engine. Think about how this plays out in other industries: complex systems are designed to be understood to the level needed to control. Take a car or a smartphone for example. We all feel that we have a basic understanding of how they work and we know exactly how the controls will affect us as users.

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

To learn more about price optimization and different pricing strategies specific to the aftermarket and spare parts industry, join Dominic O’Regan, Business Consultant with Vendavo, and Gianpaolo Callioni, Partner at End-to-End Analytics for the webcast: What Do I Do With All These SKUs: 3 Proven Pricing Models to Conquer Your Profitability Challenges.