WHAT'S THE RIGHT PRICE?

Julie Gallagher

For an increasing number of retailers, price optimization software is viewed as a competitive tool. For Penn Traffic, it may be a matter of survival.

In April, the Syracuse, N.Y.-based company emerged from Chapter 11, one year after it signed a price optimization contract with Demandtec, San Carlos, Calif. Its newfound financial stability is owed, in part, to its price optimization strategy, according to Don Dikeman, director of retail pricing, Penn Traffic.

"In order to become a long-term viable player, there needed to be significant changes to the way we were doing business," Dikeman said. "The reactive pricing strategy that we were following just wasn't a good one. We need to become proactive and find our own identity out there."

Price optimization helps chains find themselves price-wise by suggesting optimal base price levels based on a complex mix of sales history, competitors' prices, supply chain information and sales goals, among other factors. The software can also be used to forecast shopper demand and set promotions.

Penn Traffic is not alone in its focus on price optimization. In SN's 2005 Supermarket Technology report, 31% of respondents regarded price optimization as a high priority application for 2005, compared with 13% who regarded it as such last year.

However, given the sizable investment required, price optimization remains far from mainstream in food retailing. Pilots start at $500,000, while full-fledged rollouts run $1 million and up, said Greg Buzek, president, IHL Consulting Group, Franklin, Tenn.

So far only about 20 supermarket companies have replaced or augmented their often manual pricing systems with price optimization systems, according to Hung LeHong, research director, Gartner, Stamford, Conn.

Still, the return on the investment achieved by the technology's earliest adopters is sparking retailer interest. Some experts report that returns are usually achievable within a year of implementation. "Price Optimization: A Retailer's Guide," released by IHL Consulting in March, cited several successful case studies, including one example of a retailer increasing its revenue 9%, gross profit 6% and net profit 1% to 2% in a pilot.

Boise, Idaho-based Albertsons became one of the highest profile adopters of a price optimization model in November 2003. It uses the Retail Revenue Management solution, from Khimetrics, Scottsdale, Ariz., which optimizes pricing and promotions, in its more than 2,500 stores. Its strategy is designed to boost sales and maximize return on capital investment.

"We can track pricing and who the primary competitor is store-by-store on each one of our products," Larry Johnston, chairman and chief executive officer, Albertsons, said in a statement. "Our competitive pricing moves have been substantial and they are paying big dividends. [Albertsons] has much greater transparency and vision into what customers want, what the right products are and how customers will respond to those."

AVOIDING GARBAGE

One key to the success of these projects is the quality of the historical data used to feed the optimization software. To avoid a garbage-in, garbage-out scenario, Buzek advises retailers to be prepared to dig deeply into their data warehouses for the last 12 to 18 months' worth of sales information.

Penn Traffic has delved even deeper into its data supply for the sake of its optimization strategy. Currently the optimal price suggestions provided by its solution are based in part upon 24 months of historical sales information.

Price optimization is helping the chain regain its footing while fending off competitors. The struggling company was forced to sell or close its Big Bear and Big Bear plus stores after filing for bankruptcy for the second time in May 2003. Currently the 110-store retailer operates stores in four states under the Bi-Lo Foods, P&C Foods, Riverside Markets and Quality Markets banners.

Its challenges were further compounded by Wal-Mart Stores' entrance into its market, as well as its dependence on an antiquated, homegrown pricing system. Now, two-thirds through with its implementation of price optimization, which began last July, Penn Traffic has already exceeded its sales and margin goals, Dikeman said.

"We still somewhat rely on the old system for reporting but as we implement more categories we'll move away from it," he said. "We're over 60% implemented in our center store categories and hope to be totally implemented by the end of our fiscal year." Dikeman could not share information about the specific categories for which prices have been optimized, though he did say that Penn Traffic isn't currently optimizing prices for perishables.

For all of its reliance on the sophisticated mathematics underlying price optimization, Penn Traffic's success is based in part upon its "pricing intuition" -- knowing when to accept, or reject, price suggestions. Although the calculation of these suggestions is automated, "no one is just pressing the button and automatically approving all suggestions," LeHong said. "You want to verify any price. The skill of those who set the price is a factor. It should be someone who is very aware of the environment and the future."

Of course, it is not uncommon for a retailer's pricing processes to be based solely on intuition, with their pricing system existing simply to record price. For such retailers, however, the transition to a computer-assisted pricing model can be difficult.

"One of the biggest price optimization challenges for retailers is believing that a [recommended] price will work," LeHong said.

Generally, retailers follow 90% or more of all pricing recommendations generated by an optimization model, according to the IHL report.

Penn Traffic is pleased enough with the recommendations made by Demandtec's base pricing tool that it is negotiating the licensing of the vendor's promotion optimization module. Penn Traffic's progression from pricing to promotions optimization is typical of retailers who've experienced success with tools that help them to determine the optimal price. Albertsons is also using both the base price and promotion capabilities of Khimetrics' system.

Promotion optimization replaces traditional promotional strategies that are also based on intuition as well as the manual analysis of spreadsheets and vendor contributions.