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Price Optimization Software Big in Retail Business
prostoalex writes "Even if you spent only a single day in an economics class, you're probably familiar with a concept of supply and demand. The Associated Press is running an article on retailers employing mathematical models for price optimization, where some products are priced higher to generate higher margins, and some are discounted to generate larger volumes even at the expense of per-product margins. DemandTec, Oracle and SAP are some of the companies producing those mathematical models for retailers around the country, with AP listing some of the pricing optimizations employed currently."
Seriously - this is NOT new. Not even in the software field.
and make it up in volume! That's what I always say.
this is more about consumer behavior than straight economics. the optimizations referred to aren't just adjusting pricing to supply and demand, but, as noted in the article, address perceived value as well. I'm no economist, nor do I want to be, but it seems to me that such analysis can uncover otherwise unexpected responses to price adjustments.
Customers vary in their willingness and ability to pay. If a company charges one simple price for each item, it creates a situation in which some people get a great deal (they pay less than they might be willing to) and some people don't buy the product at all (because the price is more than they want to pay). But if a company can find a way to separate the customers that really value the product from the customers that value it less, then more people will be able to buy the product and the company will earn more profit. (You mathematically prove that this increases what is called consumer surplus which is the equivalent to the consumers "profit" on the purchase and the seller's profit). Both side benefit, as does society.
The amusing fact is that this is nothing more than a capitalist version of taking from the rich (those are willing and able to pay more) and giving to the poor (those aren't willing or able to pay more).
Two wrongs don't make a right, but three lefts do.
As other posters will doubtless already have said, price point optimisation by software is neither new nor interesting. What is interesting IMHO is the scale of the whole system. Big box superstores employ an army of psychologists, ergonomics experts and statisticians to try and control your behaviour and squeeze as much cash as possible from your pocket.
:)
There was a quite fascinating article published the other day in a Digg linked blog that I am sure many here read (I don't have the link unfortunately). What is really interesting is that by knowing the system and subverting it you can make HUGE savings in your shopping. The layout of the store is carefully crafted to expose you to the products they want to push. Color schemes and shelf placememt are designed to confuse or lead you to select certain products. Prices and product sizes are carefully designed to make comparative math very difficult to ordinary folks. Bargains are placed outside the normal lines of sight.
In other words, the very existence of a cold and calculated system is what enables you to game it.
Some bits of strategy I remember:
1) Make a list and stick to it. Impulse purchases account for a huge amount of profit and the stores rely on you buying things you do not need.
2) Never look at the products at eye level, they are the most expensive and worst value.
3) Move as fast as you can to the back of the store. Start at the back of the store and work your way forwards.
4) Do not stop unncecessarily. Deliberate impedences are put in isles to slow you down.
5) Don't take a cart or basket unless you really can't carry what is written on your list.
6) Use the bathroom before you go shopping. They place the restrooms to make you walk as far as possible past tempting impulse products.
A couple of my own...
7) Eat before you shop, never go to a grocery supermarket when hungry.
8) Take cash, just as much as you need and no more, and use the cash only fast checkout.
Perhaps someone who knows the systems they use in detail should write a piece of open source software in their spare time to calculate the optimal path through a store
Maybe the author has not yet discovered "Why We Buy".
A cruise thru "The Power of Persuasion" by Robert Levine
might also be enlightning.
I wonder how much this software costs. Does everyone pay the same price for it?
The more you regulate a company, the worse its products become.
you can't afford it.
Lots of companies have been using it for a long time.
s /priceoptimization.mspx
I have used a prize optimization solutions based of MS SQL Server back in 2005
http://www.microsoft.com/industry/retail/solution
I have a better way to game the system: don't participate in "the system". Shop at your friendly local, independent retailers. In our store, we put things where people can find them, and price them competitively.
I don't respond to AC's.
You see. A lot of stores would like to charge each and every customer a different price. Those prices being the set that maximizes revenues from that particular customer. But in practice that is very difficult. Changing differnet prices on the same item for every sale would be cumbersome, and customers who see the person in front of them get a better deal than they do might get pissed. The stores response to this is customer "value" cards.
In an idea scenario, they set all prices on the high end - but then give the customers "value" cards that offer varing discounts and rewards so as to optimize sales and profit. For example, if they know you won't pay more than $2 for a soda, then your soda will always be $2. For example, they might do something like use buying habits track your period. If you buy tampons on the day of your period - you will get reamed hard because they know you need them right now, but if you buy them in the off cycle then you get a good deal. If you buy just milk in the early morning, you will get reamed hard because they know you might need it for breakfast right then, but if you buy it later on you will get a competitive discount. If you buy a phone today, but the last phone you bought was two years ago and had a two year average lifespan, then you get reamed hard because they know you need a replacement right now. Otherwise you get a deal. If you buy condoms on friday night, you get a nailed hard, but if you buy them on wednesday morning you get a great deal.
Yes, you are right that they are separate but related. (Your post is not rude and I hope my response is not rude, either). The lead example concerned pricing of drills. The three models (perhaps from three different makers) define different market segments as far as the retailer is concerned. Optimizing the price on the three models gives the retailer a chance to maximize both revenues and profits even if the retailer doesn't do anything to market the products differently. Similarly, markdown optimization is both a price optimization and a segmentation issue -- segmenting the "I'll pay anything to be the first person to own this" customers from the "I'll buy it later when its discounted" customers.
The classic example, that I was thinking of, is the revenue management strategies of airlines that attempt to optimize prices across presumed underlying segments of price-sensitive leisure travelers versus price-insensitive business travelers. Technically, it's the identical seat that's being sold for radically different prices (up to 10X different) depending on issues such as how the customer buys the ticket, when they buy the ticket, whether they book a saturday-night stay, etc. The result is that the business customers pay for the plane and the vacation travelers only pay for the fuel and variable costs. The ability to differentiate does benefit the business customers because the added volume of travelers means a more frequent schedule of flights, larger planes, and more destinations.
You are right, though, that true market segmentation involves much more than just price optimization.
Two wrongs don't make a right, but three lefts do.
It's not true that everyone always gains from price discrimination, which from the article seems to be one of the ways they optimize prices (by determining when they can price discriminate and when they'll end up cannibalizing their higher margin sales). Depending on the model, it's possible for consumer surplus to fall. Also, as with the $1 paintbrush example in the story, it's possible for the range and quality of products to be distorted. The classic example of this is coach seating on airplanes. Airlines might make more on coach fares by making it more comfortable, but then some of their business customers would downgrade and overall they'd lose money. (Then along came airlines that catered to coach passengers, but that's a different story.)
BEFORE you even make a list, define a meal plan for each meal of the day and only buy enough to cover those meals. This will save you significant amounts of money as you won't be raiding the fridge to come up with dinner. I easily halved my food costs in this manner, but the downside is you eat a lot of the same meals, like spaghetti, so it can get monotonous.
A lot of stores, such as Safeway for example, include the unit price on their shelf tags. This is very convenient when comparing the cost among brands or serving sizes. The unit cost is usually expressed in dollars or cents per gram/mililitres on the bottom right of the shelf tag.
I think it's silly to suggest that people rush to the back of the store or not stop while shopping. Just stick to your list, compare unit pricing, watch for sales and relax. It's not a race. As an adult should be able to walk down the cereal aisle without having to put your hands over your eyes to resist buying the Fruity Pebbles. Just stick to your damn list like a big boy or girl.
"and make it up in volume! That's what I always say."
Printers and ink. Open source and services.
... would it work in practice? Wouldn't tap into good ol' fashioned human greed, and force those penny-pinching rich folk out there to only accept "poor" rates? Wouldn't the egalitarians cry murder as the poor are elevated above the rich? It seems nice, but giving to the poor, taking from the rich, it isn't what capitalism is for.
You know, there is a difference between trolling and pointing out the flaws in your reasoning. Just saying.
you'd learn how to do price optimization yourself. This is nothing new - anyone with the right data and training can do this; the product simply makes it easier. Thank you for the astroturfing.
The role of the writer is not to say what we can all say, but what we are unable to say. -Anais Nin
Why not save the cost of using software to calculate prices, and just ask the stockholders what they'd like to see it priced at? After all, ultimately they are the ones in control of the company. You might as well let them set the pricing so when profits drop, you can tell them "You wanted it, we did it. We're not to blame" and if profits soar then the stockholders can be pleased with their decision.
Still waiting on Serviscope_minor to wake up to fucking reality and realize that Jessica Price isn't going to fuck him.
I was the purchasing agent for a chain of auto parts stores, and we used a method called GROI: Gross Return on Inventory.
The original pricing theory in traditional auto parts stores was based on four "turns" per year: after opening a parts store and filling it up with stuff to sell, you needed to sell each stock number four times, at 35% gross profit, to make an adequate gross profit to cover your expenses -- and pay off your inventory in twelve months.
This resulted in some items being priced much higher than at mass retailers, and caused stores to lose sales on popular items: people would go elsewhere for oil, antifreeze, and the most common spark plugs, brake pads and filters, because they were much less expensive at places like Pep Boys.
The GROI method constantly recalculated sales and adjusted the prices downward on popular items, thus increasing sales and lowering the prices still further. For example, the best-selling oil filters would sell at under 10% gross profit, but we would sell out our inventory of those items twelve to fifteen times per year... thus making a larger profit on the initial purchases we had made to stock a new store. By setting a minimum gross profit percentage, runaway sales on an item would result in higher profits instead of ever-lower margins.
This was all calculated by an incredibly expensive 200 MHz Pentium Pro box, running proprietary software atop SCO Unix.
(I was the only one who could work the thing... which led to me running a newly purchased Netware 4.1 network in the chain's offices... which led me out of that filthy auto parts business altogether, thank Jeebus).
Hah. The parent basically quoted the main points of an article that hit the front page of digg the other day: 15 ways stores trick you into spending.
Wow, you must be the least-frequent posting, low UID, active member.
Wonder if amazon charges a higher price on your first click, then if you don't buy and return several months later, they lower the price based on your contemplation time.
Advice for Wal*Mart shoppers:
Never buy produce or fresh bakery goods at a Wal*Mart. The premium at the true grocery stores often corresponds to the produce & bakery goods actually being better quality.
Also, since you actually have a choice, try to memorize the routine sale prices at your other local stores. Sales tend to be cyclical. Wal*Mart has lower prices on the most popular items; for more obscure stuff they can go higher because those items are harder to find elsewhere, or fewer people are looking for them. I learned this when trying to buy a rare iron syrup (which could've had a proof number).
Wal*Mart is a good place to shop for low prices, but other places have different selection, and it's a good idea to give at least token support to its competition.
There is a fine line between recklessness and courage... -- Paul McCartney
First, a disclaimer. I was employee #4 at KhiMetrics, the company founded by Ken and Tim Ouimet (employees #1 and #2). They're mentioned in TFA. SAP bought KhiMetrics in January of 2006. Ken had been my office-mate in grad school. That said, I haven't seen Ken and Tim in years, and I have no financial stake in KhiMetrics or SAP anymore (SAP bought out the KhiMetrics stockholders with money, not shares of SAP stock).
Yes, it's true that humans doing pricing try to do the same things. But the thing is that software can do things a human mind cannot. Yes, the opposite is also true, but here software has a lot of advantages. In the case of the KhiMetrics (now SAP) software, it works on the category level, optimizing profit for the category as a whole, which can include taking losses on individual items. The software never makes the common mistakes human beings make. For example, different "flavors" of the same size package of the same product should come out at the same price, and the unit price of a given item should go down as the amount bought increases. I can tell you that I have seen examples where humans have screwed this up this week. When there are two sizes of a given product, let's say a certain laundry detergent, then the price per weight of the larger package better be less than the price per weight of the smaller package, or there's never any incentive for the customer to buy the larger package. Still, I see examples where the pricers have gotten this wrong. I've even asked people at the stores if they were trying to move the smaller packages because of having too much of that size in stock or something, and they told me that no, they had no such problem.
The other thing is that the KhiMetrics software uses actual sales data to determine how sensitive the customers are to the price of a given product. This can be done down to the SKU (individual item) level in the product dimension and down to the level of customers of a specific store in the geographic dimension. In other words, the KhiMetrics software is capable of determining the sensitivity of the customers of each individual store to the price of a specific product. No human being could do that at all, much less in the time the KhiMetrics software can do it. Even with a pricing team for each category in each store, which would end up costing a fortune in human resource costs, the result would not be as good as what KhiMetrics can deliver. Additionally, since the Ouimets "grew up in retail," the KhiMetrics software, since the beginning, has been compatible with things like Category Management and Efficient Replenishment, and able to take into account things like having different goals for different products in a category (loss leader, profit generator, traffic generator, etc.). The software takes into account complex factors like seasonality, promotion, and product visibility. Since I have a reasonably good idea of the internal workings of the software, I can tell you with some confidence that I, a Ph.D. in theoretical physics, would not even want to try to tackle the problem of optimizing the prices for a subcategory of 20 products in a single store, much less the dozens of categories and tens of thousands of SKUs in the dozens of stores in a retail chain. KhiMetrics can do all that, basing itself on years of actual sales data, before breakfast.
There are experienced people in retail who are good at such things, but the software was created with people that have the same level of understanding of retail pricing, plus it has all the advantages of being able to do high-speed computerized analysis of huge amounts of price and sales data. I don't work for KhiMetrics anymore, nor for SAP, but I can say that if I were working in a retail company, I would definitely want us to be using software like this for pricing. And experienced retail people agree with me. One thing we saw back when I was with K
"It is nice to know that the computer understands the problem. But I would like to understand it too." --Eugene Wigner
2) Never look at the products at eye level, they are the most expensive and worst value.
If that were the case, shouldn't candy, cookies, ice cream, and action figures be spread out over the entire store on shelves about 2-3 feet from the ground?
I interviewed with a local supermarket mega-chain a couple years ago for a project doing exactly this. Compare prices at each store against what other stores are charging, and model the impact of tweaking the price of a can of Campbell's Tomato Soup by a cent or two (for example).
Airlines have been doing this for years. And hotels, and other industries. Apartment complex management is getting into the game as well.
I have a friend who works for a rental car company, he does this sort of thing in his head at least a dozen times a day - get the customer into a car at the greatest financial benefit to the agency. You may think that you're getting a great deal when he bumps you from a mid-size to a full-size car for only $6/day more, but he comes out the winner, because he'll turn around and rent that mid-size to someone else for $2/day more than you were going to be paying.
Price optimization will happen in a free market, whether by Intelligent Design or the evolutionary optimization referred to by Adam Smith as the "invisible hand."
Of course, if you're a company selling stuff, evolution favors the intelligently designed.
Can you be Even More Awesome?!
Although, WalMart is NOT a good example of profit optimization; there strategy is more likely to take cost decreases and pass them on. Which may not optimize the short term. And certainly only works if you are the more efficient retailer, which scale tends to help. But it is very pre-consumer and relatively dificult to compete against based upon price.
A MUCH better example would be airlines; where what is practically the same product - a coach seat on the same flight might go for 5 to 8 price-points of $100 to $1000 each way. Grocery and department stores might sell comparable products for 10 to 50% more than WalMart but rarely can get the 1000%
I disagree. Wal-Mart has similar and sometimes exactly the same product in slightly different packaging (size) so as not have to compete as aggressively as you might think. I actually worked at a Hypermart (one of the first Wal-Mart + grocery stores) in their bakery department. The local grocery stores had 7" and 9" pies. We had 8" pies. When the competitors advertised their pies as on sale customers would want us to match the prices. Wal-Mart will always match a competitor's advertised price on the exact same product. Ours were not exactly the same as the size was slightly different.
g to create the perception of extreme value (for example charging an odd price of $19.87 instead of $19.99). Who's to know that they don't run their standard margin on a product, come up with a price of $19.49 then "round up" or maximize profits by repricing to $19.87? It still appears as a price decrease when it may or may not be.
It's the same in other departments. I've seen digital cameras nearly identical to the models that Best Buy, etc. have but be a slightly different model with (or without) one of the lesser needed features. This is designed to maximize profits by not having to match competitor's advertised prices.
I'd be surprised if Wal-Mart doesn't use software to help determine what price to charge for a very similar product.
Plus, Wal-Mart uses psychological pricing http://en.wikipedia.org/wiki/Psychological_pricin
"A government is a body of people, usually notably ungoverned." - Shepard Book Quoting Malcolm Reynolds
I remember when Target actually had useful stuff instead of being a big 7-11 with clothing. In recent years, we've been visiting the neighborhood hardware and auto stores again like we didn't for years. Imagine being happy to pay 30 cent/piece for screws because, dammit, I'll know they have them.
I mention Target because they give me the creeps. I leave with the feeling that I'm never really getting a deal and every item of inventory and model of that item has been efficiently spreadsheeted for optimum profit.
The idea of predicting human behavior via software should be obviously ridiculous. Coding behavior patterns based on statistical averages tells you NOTHING about the individual case; we're just plain hard to predict. Too many personal biases that they can't know about or calculate.
And providing different prices to different people - well, the success of this depends on each person being ignorant of what his fellow humans are paying. That doesn't work; people do indeed communicate and discuss the prices / merits of their purchases. Not to mention that the act of charging different buyers different prices is illegal in some states.
While the retailers may see an increase in profit when they implement a system like this, the benefits are transitory and ultimately they lose customers and see their profit decrease.
Here's an example of how "scientific" retail management has unexpected negative results: the idea of managing inventory turns to maximize profit has already been discussed in this thread. Stores that do this well find that they can reduce the number of SKUs they stock and make even more by only stocking the items with the highest markup / fastest turnover. The downside: all those no-longer-carried items still have a market. So when someone wants that 5-bay switch plate or left-handed thread bolt they can't find it at any of these "modern" stores (sound familiar?) They usually end up finding it and buying it online from a specialty vendor. While they're doing that, they also discover that the prices are lower and there's no sales tax. While this is going on, the retailers cry about how the internet businesses are stealing their customers.
So go ahead and use your price optimization software to determine the most effective pricing - but while you do, keep in mind that there's a world of internet vendors out there who use cost-plus pricing and have very low overhead. The only advantage the retail store has is convenience / instant gratification. But if folks find (as they always do) that the retailer is playing games with the prices they'll shop somewhere else. Nobody likes to be manipulated.
And don't complain so much about the internet vendors - you created them with your profit-seeking policies, and drive customers to them with your "customer service".
Great post. I wonder though, how could this software (or similar) be used by a small business with fairly low sales volumes?
As an example - my girlfriend is an optometrist with her own, single practise selling glasses, sunglasses and contact lenses. They don't sell anything in great volume and generally just make up prices as they go along.
She would love to have software like this to give her some pricing guidance, but I personally don't see how it could work effectively without a lot of sales data to crunch over. Is there another option? I'd appreciate your opinion.
One of these days I'm moving to Theory - everything works there
TFA is to an AP news story but displayed on iWon. Is this not the same iWon that keeps spamming me all the time????
Who the hell are these people?
... small volumes, e.g., form a specailty store, and also how does it handle Giffen Goods?
What is the critical mass of sales data required to get good results? Has there been any effort or success in aggregating data from a number of small retailers to give them the results to match the information power of the larger retailers? Obviously, there would have to be secure handling of the data so the risk of letting out your sales data would be outweighed by the rewards of the improved pricing data.
I'm also wondering about Giffen Goods, where a significant part of the value IS the higher price (e.g., due to exclusivity, snob appeal, etc.). Figuring out the price/demand curve for that could be most difficult, at least because these are specialty, low-volume items, almost by definition.
Hmmm... I may want to examine this phenomenon if I can. Admittedly, a lot of the stuff I get at Wal*Mart isn't available at other local stores at all: either it's one of their store brands, or it's the only store in my area to routinely stock whatever item of whatever brand it is. (There's a difference.) But I might want to investigate differences in the items that I can get elsewhere.
I thought their nutella came in a different size jar from everyone else's...
I shop at a lot of stores that do this. Warehouse stores do it as a matter of course--after all, who else sells bulk items in bulk?
Dollar stores use that trick too. Snack cakes that come in ten-packs at normal stores (or even Wal*Marts) come in eight-packs at dollar stores. This was annoying back when ten-packs were priced at $1.09 ($0.99 on sale).
There is a fine line between recklessness and courage... -- Paul McCartney
Come to think of it, bottled water is often $4 a gallon...
There is a fine line between recklessness and courage... -- Paul McCartney
I think he meant the worst value for that class of food.
The candy is in two sections, the checkouts and an in-store shelf; the checkout candy will usually be a "worse value" than the in-store candy, and the candy that's easily visible will be a "worse value" than the candy that's buried in the skinny shelves below eye level.
Cookies have their own section for the most part, but the "worst values" will be at eye level. Below eye-level, there are no cookies--only crackers.
Ice cream will have its own section in the freezer section, but the "worst value" will be at eye level, and the ice cream in the upright freezers will be "worse values" than the ice cream in the chest freezers. Of course, with ice cream, paying more can be good because that sometimes means better quality.
I have almost never seen action figures anywhere but eye-level--either the shopper's or the child's.
There is a fine line between recklessness and courage... -- Paul McCartney