AMR Research's Price Management Model

Wednesday, May 12, 2004

Laura Preslan

The Bottom Line: Price management is the most effective lever to impact profit and
revenue, though less than 3% of companies use it to manage price effectively
today

Costs have been cut out of the supply chain. Sales processes have been streamlined. That leaves price management
as one of the few levers left to have a dramatic effect on profit and revenue. Unfortunately, few companies know
how to apply that lever and where to start on the path toward effective price management.

To help companies with this journey, AMR Research has created a price management model. This model guides
companies through price management investment decisions and best practices to regain the margin high ground and
turn price management into a repeatable discipline.

Price management model

Price management is the end-to-end process of optimization, execution, and enforcement of prices:

Price Optimization—The process through which prices are determined

Price Execution—The process through which prices are delivered and communicated to salespeople and
buyers

Price Enforcement—The processes and tools that support deal negotiation and contract compliance

AMR Research’s price management model provides a common framework that defines price management and
demonstrates its value across industries. The model will also be used as a vendor and professional services firm
evaluation and comparison tool.
Each axis in Figure 1 represents one of the three pieces of price management and considers two dimensions: the
functional scope and depth of each price management component.

For buyers (by industry), the model is used to specify the investment strategy and priorities needed to capture
maximum value from price management investments. Companies should use this model to prioritize investments
and determine areas where investment in a spreadsheet and improved business process is enough.

For sellers, the model is used to specify their capabilities in each of these areas. Vendors are very skilled at having
just enough functionality to game Requests for Proposal (RFPs). This model shows what is actually in these
products.

While a seller may offer a wide array of functions, this could only be skin deep. Conversely, a buyer could need in-
depth functions in one area of pricing and light functionality in another. (These nuances and industry-specific needs
will be explored further in future Reports.)

It is important to note that these investments are not mutually exclusive—investment is required in all three
categories, regardless of industry. The difference is in the level of effort and level of investment required to
maximize the value while balancing other price management investments.

Price management definitions

The three legs of price management—optimization, execution, and enforcement—each have their own sets of data,
processes, and technology.

Price optimization: the process through which prices are determined

Many companies use stagnant price models, such as last year’s price plus 5%, or outdated price targets. Others
simply do not understand the impact that price changes have on revenue and profitability. Price optimization
provides the analytic tools necessary to answer these important questions and set the best prices.

Price optimization is the starting point for all industries. However, most companies do not need to invest in price
optimization engines. The combination of a simple reporting tool and a streamlined pricing process delivers 80% of
the price optimization benefit for commoditized industries. Price-sensitive industries (e.g., Software and Retail) can
obtain the highest benefit from price optimization because of elastic markets and seasonality and require advanced
price optimization engines.
The data used to optimize prices includes win/loss data, cost, market position, geography, brand equity, price
elasticity, product lifecycle stage, customer segment, and competitive information.

The key processes of optimization are price/demand modeling, price/supply modeling, and price determination:

Price/demand modeling—This is the process used to predict what customers will buy and what should be
charged for those products and services. Detailed analytics are used to model current and future demand for
products and services as well as the price that the market will bear.

Price/supply modeling—This is the process used to understand production capacity and plan what should be
manufactured or available in inventory, based on predictions about what customers want to purchase. The supply
side of the equation must be considered, as revenue and price modeling without the cost side is out of context of
what can actually be delivered.

Price determination—This is the process used to set prices for each product and service. The information is
compiled into the best prices for products, services, and bundles. All rebates, discounts, and terms are defined by
product and service.

The result of optimization is the best price for every product, Stock-Keeping Unit (SKU), service, and product
bundle. In a negotiated environment, this also includes the target profitability range for each product and service to
support the deal negotiation process.

Companies that optimize prices start by taking a small subset of SKUs (e.g., the three best-selling), and manually
optimize the price using Excel or a Business Intelligence (BI) tool. Then they apply this data to a subset of deals and
measure profitability. Only then do these companies implement optimization algorithms through an optimization
tool. This allows them to develop the right business processes as well as trust the data that the pricing engine
delivers.

The technology of optimization includes analytics and algorithms and ranges from spreadsheets and BI tools to
elaborate algorithm-intensive engines. At the low end, the technology is easy to use, but cannot solve difficult
problems. On the high end, tools tend to be difficult to use and are intended for a limited set of highly trained users.

A significant level of processing power and memory is necessary, as there is a great deal of data required to power
the analysis. Five terabytes of data is not uncommon, and as analysis becomes more mature and detailed, this
number will continue to grow.

The Airline industry led the charge in optimization technology. Many of today’s optimization algorithms were first
created for yield management. However, the airline model is not applicable to the negotiated Business-to-Business
(B2B) environment, as demand is not perishable (e.g., the plane takes off whether or not it’s full) and asset
interconnectedness is not an issue (e.g., switching a 757 for a 737 when excess capacity is present).

The vendors in this space include BI tool vendors, such as Cognos, Business Objects, and MicroStrategy, and
advanced pricing engine vendors, like Manugistics, Metreo, PROS Revenue Management, Rapt, Trilogy, and
Zilliant. pVelocity provides a different approach by bringing manufacturability, or the level of effort and cost
required to manufacture a product, directly into the pricing discussion.

The vendors’ products for the Retail industry are much more mature, as retail revenue management has been a focus
for several years. These Retail-specific vendors include KhiMetrics, DemandTec, IRI, i2, ProfitLogic, SAS,
Manugistics, Retek, JDA, and KSS.

Price execution: the process through which prices are delivered and communicated to
salespeople and buyers

Most companies report difficulty with determining the right price to apply to deals. Price execution solves this
problem by delivering the price for each deal or contract based on defined rules.

Industries with a high volume of products and product bundles (e.g., Commoditized Semiconductor) require flexible
rules-based price execution applications to ensure that the right prices are communicated for all of the components
that make up the final product. The price execution application for nonconfigured products does not need to be as
robust.

The data for price execution includes SKUs/products, tiered volume pricing, rebate information, product bundles,
and promotion data. When price optimization is not part of the business process, this data typically comes from a
spreadsheet maintained by pricing analysts, marketing, or sales leadership.

The key processes are price configuration, price communication, and order capture/entry:

Price configuration—This is the process through which the price for all attributes and options is entered. This
information rolls up to the final product bundle price when pricing rules are exercised during order capture.

Price communication—This is the process used to send price information to salespeople and channels for use
during the quoting process. When done properly, accurate rate cards, price books, and other price communication
vehicles are easily accessible.

Order capture/entry—This is the process used to apply the price to each quote according to the price strategy,
profit/revenue goals, customer segmentation, quantities, discounts, and other terms and conditions.

The result of execution is the communication of prices. Execution systems communicate price well, but have no
functionality to help companies determine the right prices or enforce their usage. Many companies confuse price
execution with price optimization and enforcement.

Execution tools are typically part of a cobbled-together architecture of spreadsheets and stand-alone, custom-built
databases. Most companies have already invested in quote management / order entry systems and must integrate
them with price optimization and price enforcement tools. Today, many companies that are trying to solve their
price management problems have not integrated optimization and enforcement tools with the order entry process,
thereby limiting the value derived from the investment.

The technology of execution is most often provided by a quote management, order capture, or product configuration
tool. While the technology of optimization is highly analytical, execution is about rules and workflow. As products
are configured and/or selected, the price rules engine calculates the bundled price by applying all of the applicable
rules (discounts, rebates, coupons, etc.). Since most companies already have order entry tools in place, the
opportunity for improvement in price execution comes from streamlining processes for how prices are
communicated and updated.

The price execution vendors include Click Commerce, Comergent, PeopleSoft, SAP, Selectica, Siebel, Oracle,
and Trilogy.
Price enforcement: the processes and tools that support deal negotiation and contract compliance

Price enforcement is the leading price management issue today. Even when prices are set and communicated well,
the lack of a closed-loop enforcement process allows customers to game the system and salespeople (either
intentionally or unintentionally) to negotiate away margin or to be out of compliance with contracts.

Every company with a negotiated selling environment should implement enforcement policies and possibly
software. Commoditized industries (e.g., Bulk Chemicals and Biomedical Devices) require robust price enforcement
applications based on complicated contracts and rampant maverick selling. While these industries should still start
with the basic analysis of prices (simplistic optimization), the real benefits are only realized once price decisions are
enforced.

The data used in price enforcement includes contract terms, price ceilings, price floors, target prices, and profitability
range.

The key processes are contract compliance/settlement, negotiation workflow, and sales Standard Operating
Procedure (SOP):

Contract compliance/settlement—This is the process that matches current deal terms with terms and prices on
contracts to ensure compliance. When contracts are used, all price decisions must be in compliance with those
contracts.

Negotiation workflow—This is the process used to support decision-making on spot deals and contracts. Target
price/profitability ranges must be enforced to reduce special pricing requests while empowering salespeople to make
informed decisions based on profit and revenue.

Sales SOP—This is the process used to encourage the proper sales behavior, including incentive structures,
approval processes, and opportunity management. The most important business process change to drive
enforcement is to add a margin component to sales incentives instead of relying on volume-driven commissions.
Technology plays a role, but business process leads the way, as salespeople fundamentally act as they are
encouraged to act through incentives.

The result of enforcement is a reduction in special pricing requests and an increase in revenue/margin from
accurately reflecting contract terms on every order. On average, 70% of revenue moves through special pricing
requests, gouging margin from potentially profitable deals. Companies that have changed sales and manufacturing
incentives to balance volume and profitability goals are starting to see major improvements in margin and significant
reductions in special pricing requests.

The technology used to support enforcement includes tools that manage contract terms, customer segmentation, and
target price ranges. Most companies would like to integrate deal negotiation and contract compliance tools with
order management tools, but that is not the norm today. Rather, roughly 80% of enforcement tools are stand-alone
tools used to approve special pricing requests and analyze contract compliance, but they are not integrated with order
management tools. The current technology maturity for price enforcement tools is low.

Price enforcement vendors include Revenue Technologies, Metreo, Vendavo, and Zilliant. PROS Revenue
Management, I-many, and Model N provide contract price compliance.

Priorities differ by industry

The value that companies can expect to achieve from the three legs of price management varies according to industry
and market position:

Example 1—Retailers are heavy users of price optimization, as their very livelihood depends upon the ability to
maximize the revenue and profitability of promotions and pricing to move goods with high seasonality and short
product lifecycles. However, bulk chemical companies must accept global price floors, so there is very little room to
negotiate purely on price. Instead, they optimize the service bundle offered to customers based on segmentation
rules.

Example 2—Semiconductor component resellers derive maximum benefit from price execution, as their prices
are typically the cost from Original Equipment Manufacturers (OEMs) plus a percentage. On the other hand,
semiconductor companies selling specialty products must focus on optimization and enforcement to protect their
price premiums.

Example 3—Price enforcement is key for biomedical device companies because of contract compliance needs; in
process manufacturing, enforcement is used to control maverick selling. Companies that do not have a negotiated
selling environment (e.g., retail and personal computers) obtain marginal value from price enforcement investments.

Recommendations

The AMR Research price management model illustrates how companies should prioritize their price management
investments to maximize value.

Business process change is at the heart of price management; technology is a small part of the equation.
Organizations must adopt several business process changes before price management technology delivers value:

Define an overall price strategy for revenue and profitability goals.

Develop a customer segmentation strategy.

Identify service-level bundles to support service-level differentiation.

Think about future sales incentive changes that involve a margin component.
AMR Research will use this model to describe industry-specific price management value and investment priorities in
the coming months.

Companies Referenced in This Report

Business Objects

Click Commerce

Cognos

Comergent

DemandTec

i2

I-many

IRI

JDA

KhiMetrics

KSS

Manugistics

Metreo

MicroStrategy

Model N

Oracle

PeopleSoft

ProfitLogic

PROS Revenue Management

pVelocity

Rapt

Retek

Revenue Technologies

SAP

SAS

Selectica

Siebel
Trilogy

Vendavo

Zilliant

Acronym List

B2B—Business-to-Business

BI—Business Intelligence

OEM—Original Equipment Manufacturer

RFP—Request for Proposal

SKU—Stock-Keeping Unit

SOP—Standard Operating Procedure

Copyright © 2004 AMR Research, Inc.