Dynamic Pricing – Is It Just Bad Business?

Since time immemorial, the success of a merchant was largely determined on how skillfully he sized up the naïf or the swell entering his shop. Fixed retail pricing was an innovation of the 20th century, perfect for the mass market era when merchants no longer could know each customer well. So when we talk about Dynamic Pricing – Is It Just Bad Business?

“Through most of history, pricing has been personalized and dynamic,” says Erik Brynjolfsson, co-director of the Center for eBusiness at the Massachusetts Institute of Technology, who studied historical bazaars and flea markets for a better understanding of fine-tuning pricing. “In the 20th century, there was no easy way to personalize. Everything was standardized. One price fits all. Now with the Internet, we can go back to it.”

That’s the tantalizing theory, at least. The Internet allows a merchant to once again know the customer, know what merchandise he has bought before, what other sites he has visited (and how much they charge), and how eager he is to get the lowest price. Several software companies are using microeconomic theory, mathematics, a little psychology, and computer powers to analyze customer demand and set the best price.

The software can tell a merchant when a customer doesn’t care how much something costs, allowing him to raise the price, or when an adjustment downward will bring in far more revenue, offsetting the lower margin. The software can also help merchants reflect their situation and determine the best price to charge different classes of customers in the shared economy. The art of refining prices is “the fastest and cheapest way for a retailer to improve their business,” says Michael Porges, a partner in the retail practice of Accenture.

So why, if the Web is so well suited for this kind of pricing, isn’t it used more frequently? As anyone who has paid $1,500 for an airline ticket only to sit next to someone who paid $250 can attest, airlines have been doing this for a while. And with considerable success. The airline and hospitality industries have realized revenue increases of as much as 7 percent and net profit increases of as much as 100 percent by using “dynamic” or adjustable pricing, say makers of pricing software.

Travelers have come to accept adjustable pricing. That might not be the case with other products on the Web. Since the Internet is an information and determination tool for buyers as well as sellers, customers can find out about others getting preferential discounts, and get pretty steamed up about it. Self-employed small business people can’t keep up with these practices and I doubt if they would.

Amazon.com found out the hard way when it tested discount prices on thousands of randomly selected DVD shoppers for five days a few years ago. When a customer backlash arose, Amazon ended up apologizing for the practice. “If we started to do it [dynamic pricing] we would alienate our hundreds of millions of customers that we’ve worked so hard to build. It’s not something that the company would consider. It’s just bad business,” admits Patty Smith, a spokeswoman for Amazon.

But don’t expect a little bad publicity to deter companies from using the software. The possibility of improving pinched profit margins is just too appealing. ProfitLogic, which has helped customers such as JCPenney, Gymboree, Ann Taylor Retail, and Gap some years ago determine the best markdown price to clear out inventory, said one customer used its software to determine pricing for its consumer electronics, updating the pricing model with weekly sales data. The biggest value is in value investing. “It’s not uncommon to increase profitability by 5 to18 percent,” said Julie Driscoll, director of marketing for the Cambridge, Mass., company back then.

Optivo in Palo Alto, Calif., was one of several upstarts hoping to help online merchants automate their pricing process a few years way back (Enduse.com of San Francisco and Zilliant of Austin, Texas, were customers). Its software conducted live, ongoing price tests for individual products and then used the data to predict how many units were likely to be sold at each possible price point. During a test, the software presented consumers with a new price and records the results: Did consumers buy more or less? The software then analyzed the data to estimate the price elasticity of the product. It’s not about Native Advertising, it’s about how far pricing can stretch.

Typically price changes range from plus or minus 10 percent. However, the impact on sales and profitability can be substantial. Optivo began evaluation trials some years ago and claimed back then that its customers would see gross margins increase as much as 20 percent. Business leaders should really have listened to the Pope. If they haven’t, they really should!

KhiMetrics, which licensed its suite of tools to Internet superstore Buy.com, eschewed price testing. Instead, the Scottsdale, Ariz., company’s software analyzed dozens of factors such as a product’s life cycle, competitors’ prices, and past sales data before churning out a list of possible prices and calculating the best ones. New sales data were fed back into the formulas daily to refine the process.

The packages aren’t cheap, running anywhere from $200,000 to $500,000. Some vendors also ask for a percentage of revenue increases resulting from the dynamic pricing. The retailer has to assemble sufficient data to make the computations. “If you don’t have a data warehouse, can’t readily integrate it into your system, or don’t have the necessary sales history data, it’s a major barrier,” said Greg Beutler, vice president of merchandising for delivery company Webvan Group, which was evaluating the various software offerings.

Some retailers are reluctant to hand over control to automated systems, according to Ed Wong, formerly Gymboree’s senior vice president of supply chain technology. Gymboree used ProfitLogic’s service to clear inventory and boosted the 600-store chain’s gross margins 4 percent. At that time, Wong considered implementing ProfitLogic’s service online. “It helps the bottom line. It delivers value,” Wong says. But Wong expects large retailers such as Wal-Mart, Target, and Kmart to lead the way in adopting the pricing software online. Kmart’s online subsidiary BlueLight.com is evaluating a dynamic pricing system, a spokesperson says, but declined to reveal any details.

Carrie Johnson, an analyst for online retail at Forrester Research, predicts that online robotic shoppers, or “shopbots,” will change the dynamics. “Retailers will partner with the bots to determine which shoppers are price shoppers and which value other aspects of the purchase-like store brand or shipping price.” If mySimon.com knows that every time a particular shopper searches for a product, he chooses the lowest price, a retailer has the opportunity to set rules that always produce the lowest price over competitors to win that shopper. Though that assumes customers won’t catch on and, much to the chagrin of the Web retailer, throw aside brand loyalty and habitually use bots just to get discounts.

“We’re moving toward a very sophisticated economy. It’s kind of an arms race between merchant technology and consumer technology [in the form of shopbots],” says Brynjolfsson. “If consumers are not sophisticated they can be soaked. If managed intelligently, the tools are there to create a revolution.”