Balancing Act 2009

MICHAEL GARRY

In an economic downturn, consumers are naturally predisposed to purchasing the lowest-priced items at the supermarket. Food retailers, in turn, try to satisfy shoppers' craving for value by keeping prices low.

But lower prices mean slimmer profit margins in an industry already famous for its razor-thin profits. So how do retailers help shoppers weather the recession without endangering their own survival?

A growing number of retailers are finding that they can maintain a reasonable overall profit margin by using price optimization systems to strike a balance between low-priced products and items that are still able to fetch higher price points.

“Because of the economy, everybody touts value,” said Ward Dunn, vice president of sales and marketing for Scolari's Food & Drug, Sparks, Nev.

“At the same time, we have brand equity, particularly at our high-demographic stores, where I don't want to destroy the margin base.”

Dunn used service deli meats as an example. “We sell Boar's Head, and there's no reason for a discount there,” he said. “But I am discounting in other segments of deli, and I have to understand that margin mix.”

To gain that understanding, Scolari's has subscribed to a price optimization service offered by Revionics, Granite Bay, Calif., for about a year. The chain, which operates 16 conventional Scolari's stores and three price-impact stores, provides Revionics with weekly movement data, on top of 18 months of historical sales data.

Revionics, in turn, returns weekly price recommendations to Scolari's. The process is based on a software-as-a-service (SaaS) model whereby Scolari's pays a recurring fee for hosted software available over the Internet, rather than making a large up-front investment for software installed at its organization.

Scolari's started by optimizing its base prices and is now turning to temporary price reductions; promotional prices are next. Its category managers generally review the system's price recommendations before implementing them. “But we're getting to a confidence level where we're just accepting the system's recommended moves,” Dunn said. “That really automates the process.”

Despite the sluggish economy, Scolari's overall profit margin during the past year is up one percentage point, 60% of which Dunn attributes to the price optimization service.

DETERMINING ELASTICITY

How does the system distinguish between items that should be priced low and those that can bear a higher price? Therein resides the “science” of price optimization, which uses an item's historical movement data in combination with competitive prices and other factors to determine a product's price “elasticity.”

Since consumers generally know the prices of products they buy frequently, such as milk and bread, pricing of those “image” items is elastic; lowering the price will drive demand, and raising the price will shrink it. But demand for price-inelastic products like shoe polish and baking soda will generally not change much if their prices are raised, giving retailers an opportunity to improve their margins.

By determining a product's price elasticity, price optimization systems can project the effect that a price change will have on sales and margins, including any cannibalizing or positive effects on other items. Retailers can thereby change prices with some assurance as to what's going to happen. They can also compare the actual sales and margin results to the projection; if the projection winds up being wrong, the system learns from the error.

“The beauty of the weekly price optimization process is that any changes can be reversed next week if the results are not as expected,” said Christie Frazier-Coleman, vice president of price strategy consulting for Revionics, who works with retailers on implementing price optimization.

If supermarkets sold only a handful of products, it might be possible for retailers to make elasticity assessments without resorting to technology. But given that food retailers sell tens of thousands of stockkeeping units, the task has become too daunting to be done manually, Dunn said. “The complexities of pricing are too vast.”

In addition to the sheer number of SKUs, Dunn added, is the demographic segmentation of Scolari's customer base, divided between its price-impact and conventional stores. “Even in our conventional format, we have high-end, middle-end and low-end stores. One pricing approach doesn't meet our requirements for maximizing margins.”

THE BEST PRICE

Another user of the Revionics system is Rouses, Thibodaux, La., an EDLP operator that has subscribed to the service for 10 months for Center Store products. “We use it to keep our prices as low as possible but still maximize our profits,” said Joe Livorsi, general manager of sales and marketing for the 35-store chain. “It tells you the best price based on your cost and [historical] movement.”

Livorsi acknowledged that the system allows Rouses to be much more competitive and aggressive in pricing “without the fear of not knowing what will happen.” That fear is abated by the weekly results of pricing changes that “show us how we're doing,” he said.

The weekly reports also let Rouses know when shoppers are switching products because of the economy. When that happens, “we can switch our offering with it,” Livorsi said. “We're able to see it quickly, because we have the data to back it up.”

As Livorsi explained the pricing balancing act, an item for which consumers can easily find a substitute is one whose price has to be set aggressively. “You have to be sure you have the best value on that item,” he said. On the other hand, if any item is unique, “you're able to get a little more.”

This balancing, conducted via the price optimization technology, has impacted Rouses' overall sales and margins “favorably,” he said, adding, “Our first-year investment [in the system] has been recouped.”

Price optimization helps Rouses react to changing consumer purchasing behavior.

Cumberland Farms, Canton, Ohio, is piloting a price optimization system from KSS Retail, Florham Park, N.J., at 50 of its 600 convenience stores. This retailer also saw a need “to quantify the trade-off between price, volume and profits,” said Ari Haseotes, president and chief operating officer of Cumberland Farms, who spoke about price optimization at the National Retail Federation show last month in New York.

The system is helping Cumberland Farms validate which of its SKUs are “known value items” (KVIs) that should be priced aggressively. “These are items that send a signal to the consumer on what our price position is,” said Haseotes.

In deciding to test price optimization, Haseotes said he believes that traditional methods of pricing — looking at the competition, using set markups or just relying on intuition — are no longer up to the task. “I felt it was slightly irresponsible to price on intuition alone and not try to rely on technology to analyze the dynamics of pricing and volume,” he said.

PRIVATE-LABEL BENEFITS

Private label is another area that can benefit from price optimization, which helps retailers to price private label against national brands. “If the national-brand price goes down, the private-label price will go down automatically in tandem,” said Livorsi.

In one case, the system advised Scolari's that a private-label item was priced too low compared to the national brand. “The perception was that the product was not good, so we raised the price closer to the national brand and sales increased,” said Dunn, who was incredulous at the results. “We kept checking the numbers.”

As part of the pricing equation, retailers will use optimization to set an overall price image “that is consistent with what consumers are looking for,” said Richard Murray, vice president of solution marketing and strategy for SAP Labs, Irving, Texas. SAP markets a price optimization system based on its acquisition of KhiMetrics in 2006.

Aggressive pricing during the recession may attract new customers who will remain customers after the economy improves, observed Derek Smith, vice president, solution consulting for DemandTec, a price optimization vendor based in San Carlos, Calif. “You want to leave the down market better than you entered it,” he said.

The technology can also help retailers in their dealings with manufacturers. For example, by presenting manufacturer cost information in an organized fashion, it can reveal cost trends to retailers. If the system indicates a category's costs are up 6.5% even though market data says its costs have risen 5%, “we can negotiate promotional activity to offset the difference,” said Dunn.

Price optimization is not without its challenges. The biggest challenge Scolari's faced was gathering competitive pricing information, said Dunn, adding that Revionics directed him to companies that perform that function.

Haseotes pointed out the system's need for clean data, as well as accurate cost data, without which it could make “illogical decisions.” Retailers also need to apply the right strategy and business rules to the technology. “These systems will flawlessly execute a terrible strategy,” he cautioned.

The price optimization vendor supplying Cumberland Farms — KSS Retail — sells software to be installed within the retailer's headquarters, rather than via SaaS. As a result, said Haseotes, “we had to get our POS system to seamlessly communicate with our price optimization system.”

Rouses' challenge was getting category managers to simply trust the system. “We were asking them to take a leap of faith and do something differently,” said Livorsi. “Fortunately, our group responded well.”

Mike Griswold, a Boise, Idaho-based consultant with AMR Research, Boston, echoed that concern, noting that “the biggest challenge to adoption is working through the change management.” Many merchandising/category management executives still “see pricing as an art and not a science.”