In 2002 Hewlett-Packard Co. unseated long-entrenched Sun Microsystems Inc. as the largest supplier to the server market and has managed to hold onto that spot ever since. How did HP do it? Simply put, it got its prices right.
The year before dethroning Sun, HP’s CFO Robert Wayman made pricing one of his top initiatives for delivering shareholder value. But Wayman’s plan to use price to drive profits was almost thwarted by HP’s internal pricing systems, which he soon discovered were woefully inadequate. Back then, pricers extracted pricing decisions from spreadsheets detailing thousands of computer components that can be combined into as many as 10 billion different configurations. Each possible configuration must be priced correctly. And, given that the products have short lifecycles, right prices–if they are indeed right–quickly become wrong prices. The managers who set HP prices often relied on their gut instinct or were reacting to competitors’ moves. When a so-called “guru” pricer was promoted or moved on, HP would be stuck. With Wayman’s initiative as impetus, managers like Mark Hillstead, then the controller at HP’s Unix server group, went to work to fix the system. The Unix server group, which is part of HP’s North America enterprise systems division, builds computers for companies, universities and governments. Hillstead worked with San Francisco-based Rapt Inc. to phase in the Rapt Price Director, a tool that helps companies calculate profits and market share using elasticity models generated from reams of actual order data. The software helped HP unlock its customers’ true willingness-to-pay on every order. “The benefit to HP was immediate and measurable,” says Hillstead, who is now the corporate director of finance. Although in a recent interview he declined to quantify HP’s gain, at a presentation at Stanford University two years ago, Hillstead had said that better pricing decisions allowed the unit to achieve a 1.4% increase in net revenue.
Hillstead notes that HP has been implementing the tool throughout its worldwide enterprise systems and its workstations, storage and software divisions over the last two years. “If it wasn’t working, we would have abandoned it a long time ago,” he says.
In 2002 HP was, and still remains today, a rarity among companies. Most–and according to Boston-based AMR Research Corp., that means 97%–just don’t tend to manage their prices effectively. Yet, the cost of getting prices wrong can be enormous. Among other things, companies risk losing market share and seeing their profit margins decline.
Getting prices right, on the other hand, pays off exponentially. New York-based McKinsey & Co. claims that companies that can optimize their prices are seeing an average increase of 8% in top-line revenue and an 11% increase in operating income for every 1% improvement in pricing.
With these kinds of returns, it’s not surprising that an increasing number of companies are exploring price optimization software, similar to the tool HP used, to help them get pricing right. “It’s becoming more mainstream,” says Laura Preslan, AMR’s research director. “The number of inquiries that have come in about price management have at least quadrupled in the past year.” She notes that because pricing is so undisciplined and unstructured in most companies, those using PO solutions see up to a 350% return on investment in 12 months and a 2% to 7% margin increase.
According to Preslan, this tool has become a must-have for most companies. “CFOs are going to have to do this because of competitive pressures,” she says. “It’s going to be very difficult to compete against a company that has solved this problem.”
In fact, McKinsey found that “best-in-class” pricing organizations tend to be those where the CFO commits at least 20% of his or her time to the pricing exercise and assigns dedicated responsibilities within the finance group to manage pricing continually. “Especially at the transaction level of pricing, where attention is brought to managing customer-specific profitability, the finance organization can play a critical role,” says McKinsey’s Eric Roegner. “Specifically, finance can provide the company’s field sales organization with customer-specific price and margin information and then drive it to demonstrate improvement against a set of pricing metrics.”
PO solutions, which are algorithm-intensive engines, force companies to reevaluate the way they do business. The review involves everything from sales commissions and incentive structures to order approval, price determination and special pricing requests. The tools also enforce discipline among the sales force and can prevent each unit from making independent and often conflicting pricing decisions that undermine the company as a whole. “You can’t underestimate the group-therapy aspect of price management,” says AMR’s Preslan. “It’s sort of like being an anthropologist in that you need to go through your organization and find out how sales people price products today. The CFO doesn’t have visibility into these pricing strategies. But there’s a lot of information that lives in subsidiaries, in remote divisions and different geographies, and it’s nobody’s responsibility to roll it all up and make proper corporate decisions. That’s why the CFO needs to get involved.”
The airline industry, for instance, pioneered the use of what it called “yield” optimization to ensure that planes flew at maximum capacity. Price-sensitive industries such as retailers and software companies are also big users because of the elasticity of demand in their markets and the complexity and enormity of their raw data. Companies that already use PO solutions, many leaders in their field, include Wal-Mart Stores Inc., Cisco Systems Inc., RadioShack Corp., Washington Mutual Inc. and General Electric Co.
There are three disciplines in the pricing technology space: price optimization–figuring out what the right prices should be; price execution–communicating those prices; and price enforcement–ensuring the sales and marketing force adheres to the prices. But there are literally thousands of variations on the theme.
But simply buying PO software does not guarantee success. AMR’s Preslan says that a June survey of 32 companies that implemented PO solutions found that one of the leading indicators of success was whether the CFO led the PO initiative. If he or she didn’t, the company either chose the wrong vendor, experienced limited benefits or no benefits whatsoever. “The ones who were really seeing off-the-chart results were the ones who had a CFO-driven initiative,” said Preslan. “The CFO knows what the end-goal is: To increase profitability.”
Cause and Effect
PO software either helps people make better decisions or provides an understanding of the risk associated with making a decision, says HP’s Hillstead. “Three or four years ago, with the pricing processes I was familiar with, we’d make a decision, but we were never quite sure what the impact of that decision was. We never really had access to what actually changed at a level of detail that gave us the visibility to say, ‘Yes, that’s a one-to-one relationship’ because we did this,” Hillstead recalls. “That’s why the finance people like it so much. It allows them to place events and dollars in the same sentence.”
Yet, while finance people at HP loved the pricing system, the marketing group’s reaction was mixed, he says. Prices had been set using judgments that were 70% qualitative and 30% quantitative. “Now, we’re asking them to flip that to 70% quantitative and 30% qualitative. It’s hard for some people to make that change,” says Hillstead. “The sophistication of the tool and the complexity of the raw data lead people to a healthy skepticism. Most need a master’s or a doctorate in statistics to understand some aspects of it, but once they get beyond that, I think they find the tool very, very useful.”
And, as Hillstead is quick to point out, “every tool and every process has its weaknesses.” Perhaps, but insofar as HP is concerned, the proof is already in the pudding.