Chapter-02

RobertPhillips,PricingandRevenueOptimizationStanfordUniversityPress,Stanford,CaliforniaExpectedpublicationdate2005PermissiongrantedforuseofthismaterialinBUDT-758D,PricingandRevenueManagement,Spring2005(RobertH.SmithSchoolofBusiness,UMD)Thismaterialmaynototherwisebereproducedortransmittedinanyformorbyanymeans,electronicormechanical,includingphotocopying,recording,storageinaninformationretrievalsystem,orotherwise,withoutpriorpermissionoftheauthor.Chapter2IntroductiontoPricingandRevenueOptimizationInthischapter,weintroducethebasicconceptsbeingpricingandrevenueoptimization.Wefirstlookatsomeofthecommonpricingchallengesfacedbyorganizations.Thesetypicallyincludealackofconsistentmanagement,discipline,andanalysisacrosspricingdecisions.Wedescribethreetraditionalapproachestopricing:cost-plus,market-based,andvalue-basedanddiscusssomeoftheirshortcomings.Wethenintroducepricingandrevenueoptimization.Atthehighestlevel,pricingandrevenueoptimizationisaprocessformanagingandupdatingpricingdecisionsinaconsistentandeffectivefashion.Atthecoreofthisprocessistypicallyanapproachtofindingthesetofpricesthatwillmaximizetotalexpectedcontributionsubjecttoasetofconstraints.Theconstraintsreflecteitherbusinessgoalssetbytheorganizationorphysicallimitationssuchaslimitedcapacityorinventory.Whiletheuseofconstrainedoptimizationiscommontoallpricingandrevenueoptimizationapplications,thetypeofproblemtobesolveddependuponthespecificcharacteristicsofthemarket.Marketsvarybothintermsoftimingorcadenceofpricingdecisions,thenatureofthegoodsandservicesbeingsold,andthetypeofcustomercommitmentthatisbeingpriced.2.1TheChallengesofPricingFormanyorganizations,“pricing”includesaremarkablycomplexsetofdecisions.Whilemostcompanieshaveagoodideaofthelistpricesthattheyhaveestablishedfortheirprod-ucts,theyareoftenunclearonthepricesthatcustomersareactuallypaying.Amultitudeofdifferentdiscounts,adjustments,andrebatesareoftenappliedtoeachsale.Forthisreasonitiscriticaltodistinguishbetweenthe“listprice”ofaproductandits“pocketprice”–thatis,whataparticularcustomerendsupactuallypaying.The“listprice”isgenericwhilethe“pocketprice”maybedifferentforeachcustomer.Thepricewaterfallwasintroducedby2122Copyright2004RobertPhillips.Allrightsreserved.Figure2.1:PricewaterfallforaCPGcompany.McKinseyandCompanyasagraphicalwayofillustratingthediscountsthatoccurbetweenthelistpriceofaproductanditspocketprice.Aconsumerpackagegood(CPG)exampleisshowninFigure2.1.Inthiscase,therearetwelvepricereductionsordiscountsappliedbetweenthelistpriceandthepocketprice.Theseincludean8%competitivediscount,3%salesspecial,1%exceptiondealandsoondowntoa1%freightallowance.Thenetresultisthatthepocketpriceforthiscustomeris29%lessthanthelistprice.Thepricewaterfallillustratesquiteneatlythatthepocketpricepaidbyanindividualcustomerisoftennottheresultofasingledecision,butthecumulativeresultofaseriesofdecisions.Infact,forthemajorityofcompanies,manydiscountsaretheresultsofindepen-dentdecisionsmadebydifferentpartsoftheorganizationwithoutconsistentmeasurementortracking.Thecompetitivediscountmighthavebeenauthorizedbytheregionalsalesmanagerwhiletheproductbonuswasdeterminedaspartofageneralmarketingprogramandthefreightallowancewasgivenbythelocalsalespersoninresponsetoalast-minutecallbythepurchaser.Asaresult,nooneisincharge.Nooneintheorganizationisre-sponsibleforthefactthatthediscountofferedtothiscustomerwas29%whilethatofferedtoanotherwas18%.Infact,notonlyisnooneincharge,itisoftenremarkablydifficulttodeterminewhatthepocketpricepaidbyaparticularcustomerevenis.AsMichaelMarnandRobertRosiello,whointroducedthewaterfallconceptputit:ThecomplexityandvolumeoftransactionstendtocreateasmokescreenthatmakesitnearlyimpossibleforeventherareseniormanagerswhoshowCopyright2004RobertPhillips.Allrightsreserved.23aninteresttounderstandwhatisactuallyhappeningatthetransactionlevel.Managementinformationsystemsmostoftendonotreportontransactionpriceperformance,orreportonlyaveragepricesandthusshednoreallightonpricingopportunitieslosttransactionbytransaction.(MarnandRosiello[1992],page86.)Withoutaconsistentprocessofanalysisandevaluation,theprobabilitythataparticularpocketpricemaximizescustomerprofitabilityisliketheprobabilitythatablindfoldeddartplayerwillhitabulls-eye–notzero,butnotveryhigh.Infact,thesituationcanbeevenworse.Sophisticatedbuyersoftenunderstandaseller’spricingprocessbetterthanthesellerdoeshimself.Asophisticatedbuyingdepartment,facedwithapricewaterfallsuchasthatshowninFigure2.1,wouldquicklylearnhowto“divideandconquer”inordertoobtainthelowestpocketprice.Thebuyer’sprocurementagentwillcallthelocalsalespersontogetadditionalconcessions,theseniorsalespersontogetrelieffromstrictinterpretationofvolumepurchaseagreements,eveninvoicingtogetpaymenttermchanges.Smartbuyerswilldetectadisorganizedordispersedpricingorganizationandplayittotheiradvantage.Managementattentionisoftenheavilyconcentratedoninvoicepricesorlistprices.However,thepricewaterfallillustratesthatthemajorityofimportantpricingadjustmentsoftentakeplaceaftertheinvoiceprice,andcertainlyafterthelistprice.Aty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