Price Optimization Software Helps Bolster Gross Margins

For a retailer, the primary operating goal is to bolster gross margins. It's the quickest and easiest way to increase operating profit, the industry's gold standard.

Retailers post higher gross margins by selling more items at the same-store locations year-over-year at higher average prices, hence so-called higher comp or comparable sales. In tactical terms, it translates into increasing "gross margins across the [selling] season," says Ed Thompson, vice president for consumer goods and retail business optimization of i2 Technologies Inc.

i2's Demand Planner provides the historic pricing data used by its Revenue Price Optimization solution to determine the product's price elasticity or sensitivity to price changes, Thompson says.

i2's software can go far beyond simple yield optimization. It takes into account other factors, including such long-term objectives by asking whether it is best to maximize price with a limited number of customers at the expense of growing the customer base. It also considers cross-elasticity of demand, or if price and demand of one product is tied to another.

Likewise, Manguistics offers Networks Profitability Demand. It calculates willingness to purchase goods at various prices. The software generates a pricing curve that predicts the chances of a sale at particular prices over a range.

DemandTec of San Carlos, Calif., provides enterprise-wide price optimization software for manufacturers and retailers, most selling consumer packaged goods. It consists of three modules.

The first analyzes POS data to determine price elasticity and cross-elasticity for every item in every store. The optimization module determines the optimal balance of pricing and promotion to maximize sales and profit, according to DemandTec. Finally, the financial engine helps retailers match strategies to business rules and financial goals.

Stated another way, DemandTec software combines demand forecasting and optimization science with robust financial modeling so retailers can boost margins while continuing to meet customers' needs quickly and not substantially increase costs or slowing growth.

Not surprisingly DemandTec claims that price optimization is the next area where retailers will generate big gains. That comes hard on the heels of operational efficiencies (expense reduction) and some modest incremental revenue by implementing ERP, CRM and SCM systems.

Price optimization software is a hot category. Sales will total about $133m in 2007, up from $86m last year, according to International Data Corp., a market research firm based in Framingham, Mass.

Among the factors airlines consider are the fight date, arrival and departure time, airplane capacity and historic demand and booking lead time.

Increasing gross margin, whether it be by an airline or retailer, is easy to say but hard to do because price optimization is more art than exact science. However, that doesn't diminish the need.

Because of heightened retail competition and ever-savvier consumer behavior, "gross margin dollars are not what they used to be," says Stephen Granovsky, president of Karabus Management, a consulting firm, based in Toronto. Karabus specializes in installing merchandise optimization software produced by ProfitLogic of Cambridge, Mass., another leading vendor.

Invariably the exercise translates into the seasonal game of chicken between price-conscious shoppers and aggressive retailers. It's a question of who blinks first, and when.

However, retailers armed with the latest software can play the game more assuredly and less intuitively to better negotiate and maximize "the minefield of opportunity out there," Granovsky say.

ProfitLogic's newest offering helps retailers establish a merchandising plan for select products throughout their complete lifecycle. A successful plan allows retailers to capture the highest prices for sought after goods, minimizing the need for them to take costly markdowns.

And by more optimally scheduling those inevitable markdowns, ProfitLogic software (like its competitors using a proprietary forecasting engine based on deep-think mathematical algorithms) again helps the retailer maximize gross margin, albeit smaller than originally envisioned.

Right from the Start
The retailer's core merchandising plan addresses the entire sales continuum: from purchasing through in-season clearance. ProfitLogic software crunches and analyzes historical data to establish demand patterns that a retailer's merchandisers should consider when doing seasonal buying. Getting it right at the beginning pays big dividends throughout the selling season.

The software plots projected demand patterns against actual demand curves, using downloaded POS data, to find disparities. When they appear, the software calculates the size and speed of price cuts required in order to optimally (in terms of the retailer) push the demand curve to the right or stimulate demand.

The timing and level of discounts reflect the customer's product-specific price elasticity or sensitivity that ProfitLogic software recalculates each week using POS data.

That's a significant "statistical challenge," i2's Thompson says.

Typically, retailers use the software to maximize returns on seasonal or fashion products that generally haven't met sales retailers' expectations. Moreover, retailers typically apply the recommendations of the revenue optimization software to similar products in similar geographic clusters or locations, Thompson adds.

Ideally the "sell through is (slightly) less than what you need at the end of the season," he says. Essentially the retailer wants to get down to minimum stock levels by the end of the season, and not by resorting to fire sale prices to do so.

For a ProfitLogic customer, it normally takes about 16 weeks to install the company's price optimization software. Cost of the software license is tied to the size of the operation being studied.

Retailers most successful at increasing gross margins do so by following a strategic plan that weights several merchandising variables early on. The goal is to improve assortment and inventory to better match actual demand - in terms of color, size and style - at specific locations, or at least clusters of similar ones.

"It's not about an average store. It's about each individual store," Granovsky says.
To gain such flexibility, stores typically must adjust their "average product mix" by 20 percent to 30 percent. This, in turn, "frequently requires significant changes in the way merchants buy," Granovsky says.

Initially, then, the merchandising plan tests purchasing decisions (correctly anticipating customer demand and placing orders to meet it). That requires that logistics get the required merchandise to the appropriate location in a timely manner to meet projected demand.

Logistical challenges are significant. Ideally, the merchandise plan groups or clusters stores that share proximity and like demand so that pre-packaged, similarly priced merchandise can be delivered in a timely, cost-effective manner. Pre-packaged merchandise generally gets on store shelves more quickly than loose items because minimal handling is required at the often space-constrained retail outlet.

Action at the DC
Rather, packing is done at the distribution center and loading delivery trucks ideally takes route delivery sequence and store configuration into account. Such capabilities usually are addressed in transportation or warehouse management systems.

American Eagle Outfitters, for example, recently began using ProfitLogic's Store Cluster Optimization module to determine price zones for each of its 742 stores.

A well-conceived merchandising plan not only maximizes margin, but also minimizes the need for retailers to make subsequent, inevitable price markdowns because a retailer either misread demand or it has changed.

That's why retailers must be prepared to quickly adjust their merchandising plan. The most common, quick-fix strategy: slash prices. However, doing this sharply reduces important project sales and gross margins.

Instead, retailers ideally should optimize sales at each stage: full price, promotion and clearance. This requires that they plan for the entire lifecycle of the item, reducing prices at specific inventory breakpoints or times. This, in turn, requires that the assortment plan and markdown strategy be considered together.

ProfitLogic software, for example, helps increase in-season sell-through and gross margin sales by suggesting when and where retailers should cut prices and by how much. It overlays a store's historic sales data and consumers' price elasticity (sensitivity) behavior to make that recommendation.

The general rule of thumb: take markdowns earlier to maximize return.

Gross Margin Impact of Software is POS-itive

Northern Group Retail Ltd. of Toronto already has exceeded ambitious original gross margins goals that it set 18 months ago when it began integrating ProfitLogic's Markdown Optimization software.

The software has helped Northern boost gross margin by 4.5 percentage points (a 2 percentage point gain the first year and an additional 2.5 points at the start of the second). That exceeds the 4-point increase the company originally sought within two years of implementation, says Lara Smith, general merchandise manager for the company's Northern Reflection division.

In addition, Northern has reduced its inventory and increased turns of that remaining stock.

Essentially, the implementation has paid for itself in a year, Smith says. "The gross margin impact is so positive, the decision to go with the technology is almost idiot-proof," she said at a meeting of the National Retail Federation in New York in January.

Northern achieved gains by having the software analyze merchandise in the almost 300 shopping-mall-based stores it operates across Canada, most selling moderately priced women's casual apparel. The automated markdown effort replaced a manual system that combined a tedious review of weekly business reports and gut instincts.

The software "takes the emotion out of it," Smith said.

Northern feeds all merchandise information, in terms of stock keeping units, into the ProfitLogic engine, stored at company headquarters in Cambridge, Mass. Each week the software recommends systematic markdown spread over the selling season that Northern's planning team reviews each Monday.

In making its recommendation, the software evaluates current sell-through rates, using POS data, against current inventory and compares that with historical data, as measured by store clusters. It considers style and color.

In addition to maximizing gross margin, Northern's merchandising goal is to sell 90 percent of its inventory by the ultimate sold-out date.

ProfitLogic's gross recommendations are cluster-specific, addressing the six major regions in Northern's market. District managers can further tweak or adjust the markdowns, taking into account local market conditions.

Those major regions are: the region east of Ottawa, including the Maritime provinces and Newfoundland; Quebec; southern Ontario, including Toronto; northern Ontario and Manitoba; the far west, including Alberta and Saskatchewan and Victoria, B.C.; and finally the remainder of British Columbia.

Making the exercise tougher for Northern was deciding to begin installing ProfitLogic software in November 2002, prior to the start of the important holiday period, and completing the difficult mission 14 weeks later.

Northern is one of ProfitLogic's dozen or so Markdown Optimization customers.

In retrospect doing the exercise during a slower sales period would have made more sense, Smith says. And her only other regret: hesitating to take the deeper initial discounts as originally recommended by the ProfitLogic tool.