Dynamic pricing allows large and small companies improve their margins quickly. Any corporate leader needs to know about dynamic pricing and we answer all dynamic pricing questions here:
Basics of pricing:
- What is Dynamic Pricing?
- What are the Benefits of Dynamic Pricing?
- Why is Dynamic Pricing relevant today?
Implementing dynamic pricing at your company:
- How Does Dynamic Pricing Work?
- Different Modules of Dynamic Pricing
- Which industries use dynamic pricing?
- Pitfalls and how to avoid them
- How to choose the best pricing solution
- Leading dynamic pricing vendors
What are traditional approaches to pricing?
Sellers used to set the price for a product or service based on a manual analysis of the cost, demand, supply or competition. Without sophisticated algorithms, two pricing strategies were common:
- Premium Pricing: Premium pricing is where companies set the price higher than average competitive price. The key factor for the success of this strategy is differentiation. Premium pricing effectively works when the product has a unique feature that differentiates it from similar products in the market and has a competitive advantage.
- Penetration Pricing: Penetration pricing is basically setting the price relatively lower than the market competition. Companies use this pricing strategy to raise brand awareness and increase customer loyalty. Initially, penetration pricing may cause revenue loss but the main goal of this strategy is market penetration.
Profit maximization is not always possible with both strategies. At premium price level, demand would be low. Even if you have a high demand for penetration pricing, the price will remain low. What if you can cover all the price segments and respond faster to demand fluctuations in the market? This is possible with price discrimination.
What is price discrimination?
According to Wikipedia:
Price discrimination is a microeconomic pricing strategy where identical or largely similar goods or services are transacted at different prices by the same provider in different markets.
In the pre-internet days, companies’ capabilities for setting different prices for different customers were limited. Student fares are a common mechanism to set cheaper prices to customers who have less willingness to pay. Time-specific products such as transportation or hospitality products also have the advantage of changing prices based on time of purchase.
However, e-commerce enabled companies like Amazon to develop digital personalized stores for each customer. Each customer gets personalized product suggestions and personalized prices. This started a golden age for price discrimination where companies can offer customers prices based on their exact willingness to pay. Price discrimination in the digital world is commonly called dynamic pricing.
What is Dynamic Pricing?
Dynamic pricing, also called surge pricing, demand pricing, real-time pricing or algorithmic pricing is where the price is flexible based on demand, supply, competition price, subsidiary product prices. Price may even change from customer to customer based on their purchase habits. Dynamic pricing enables suppliers to be more flexible and adjusts prices to be more personalized.
What are the Benefits of Dynamic Pricing?
Dynamic pricing is the strongest profitability lever. 1% increase in prices will result in 10% improvement in profit for a business with 10% profit margin. Machine learning based dynamic pricing systems have clear advantages when compared to manual pricing
- More precise, SKU level prices
- Faster response to demand fluctuations
- Price changes take into account more factors including customer’s price perception, leading to long terms increases in sales or profits
- More positive impact on revenue. Image below shows how much more value dynamic pricing generates compared to other pricing strategies
Why is Dynamic Pricing relevant today?
It is difficult to achieve significant financial improvement in a large company. Most large organizations
- move slowly because of multiple levels of hierarchy
- are reluctant to make radical changes as they need to be conscious about the sensitivities of a broad customer base
- need hundreds of millions of additional sales to achieve a significant percentage improvement in profits
- need hundreds of millions of OPEX improvements to achieve a significant percentage improvement in profits. However, OPEX improvements are painful and slow. For example, headcount reductions are demoralizing and severance packages negatively impact financials in the short term.
However, dynamic pricing is one of the few approaches that can lead to quick results in large companies and make the responsible team heroes. We explained why dynamic pricing is so important for large companies in detail.
How Does Dynamic Pricing Work?
Dynamic prices are determined by rules based or self-improving algorithms which take into account numerous variables to set the best price for that specific product for that customer at that time. These are some of the variables used to make pricing decisions:
- Stock levels
- Current cost
- Future cost predictions
- Product page views in e-commerce platforms
- Seasonality of products
- Data about specific customer
- Demographic data like age, gender, current location and permanent residence, income
- Device-specific data like device brand and model. For example, iPhone users tend to spend more than Android users
- Behavioral data including
- Customer’s spending habits: How much did customers spend in the past for similar products
- Customer’s willingness to search for good prices
- Competition’s prices
- Substitute products’ prices including products sold by both company and its competitors
After knowing all of this, extensive machine training is required to build a successful dynamic pricing model.
Different Modules of Dynamic Pricing
Because of the complexity of dynamic pricing, different modules are sometimes used for different product categories and market responses to manage complexity.
Long tail module
This module is for new products or long-tail products with little or no historical data. Main challenge for this module is to use product attributes to match products with little purchase data with products that have rich purchase data so prices can be informed by rich data.
A US retailer with more than two million range of products customized its long tail module algorithm. To build the long-tail module, company gathered a rich set of data for its 100,000 top-selling SKUs including competitor prices, data on customer behavior, product attributes and descriptions, and online metrics. Developers then worked with category managers to create attribute similarity scores and leveraged rich data of popular products to price products in the long-tail. Pilot resulted in 3% increase in both revenue and margin .
Elasticity module calculates the impact of price on demand considering seasonality and cannibalization.
A leading Asian e-commerce player built an elasticity module based on a multi-factor algorithm that drew on ten terabytes of company’s transaction records. Data included product price, substitute price, promotions, inventory levels, seasonality, and competitors’ estimated sales volumes. Though price recommendations were generated real-time, category managers made the final pricing decisions. Pilot led to an increase of 10% in gross margin and 3% in GMV.
Key Value Items (KVI )module
Key value items are popular items whose prices consumers tend to remember more than other items. KVI module aims to manage consumer price perception by ensuring that items that strongly impact customer’s price perception are appropriately priced.
This is important for resellers like grocery companies. Because they are not selling their own products, they need to make sure that customers see them as the lowest cost option. A leading European nonfood retailer built a sophisticated KVI module statistically scoring each item’s importance to consumer price perception on a scale of 0 to 100. This scale guided pricing decisions and company was willing to lose more on KVIs to retain and improve the customer price perception about their company.
This module leverages granular pricing data from competitors and impact of those prices on company’s customers to react to competitors’ prices in real-time.
Though this is a relatively simple mechanism, two competitive-response modules competing with one another can create quite unexpected results like asking $23.6M for a book! Two 3rd party Amazon merchants had dynamic pricing models. While first merchant’s system aimed to sell its book at a price 27% more than the second merchant, that merchant dynamically sets its price to 1% less than the first merchant. Predictably, the price of the book skyrocketed at every iteration of the algorithms. This is why including price data in your dashboards make sense.
Companies manage prices between channels both for price discrimination and also to encourage customers to visit less costly channels. Omnichannel modules ensure that prices in different channels are coordinated.
Time-based pricing module
Online retailers may charge customers more or less at the specific time of the day due to the following reasons:
- seasonality of products
- retailers charge more between 9 AM-5 PM since most online retail customers shop more during weekly office hours
- if customers want a same-day delivery or shopped right before end of the working hour, retailers are eager to charge more
- if the product has an expiration date, as time goes by, the price of the product decreases.
Conversion rate pricing module
Which industries use dynamic pricing?
Airlines are the earliest adopters of dynamic pricing. A ticket for the exact same flight with the same destination and at the same date can have a number of different prices for different customers. Because airline sales moved online earlier than other categories and because airlines are expected to charge different prices for the same ticket bought on different days, it was easy and acceptable for airlines to move to dynamic pricing.
Retailers, especially e-commerce companies like Amazon and eBay use dynamic pricing for personalized pricing. If you consistently buy from Amazon or another e-commerce website, prices will be higher. Algorithms calculate the loyalty level of each customer and set the price lower if a person is a newcomer.
Dynamic pricing is now used for almost every product and service. From the price of a concert ticket to the price of a hotel booking is calculated by algorithms. Even Uber is using surge pricing.
For hotel management and tour companies, seasonality is an important factor. Using time-based pricing that means increasing prices during peak season and lowering when the season ends increases profitability. During the peak season, hotels’ supply needs also increases that’s why charging guests higher is not an immoral idea but the goal of the management should be finding the highest price that consumers are willing to pay.
Prices of rental cars fluctuate depending on season and day-of-the-week effect. According to a study made by Thinknum, weekend prices are more expensive than weekdays and summer prices are higher than winter prices. Here are the datasets about seasonal average car prices and discount percentages from the same study.
Physical retail is one of the first industries to use dynamic pricing. Primarily relying on seasonality, stock levels and Key Value Item pricing, retailers managed prices in physical stores to optimize their financial outcomes.
What are the potential disadvantages of Dynamic Pricing?
Though leveraging dynamic pricing has quite a few advantages that boost your organization’s sales performance, businesses should understand that there are risks to implementing a dynamic pricing strategy. It makes sense to have human supervision on the pricing policies.
#DeleteUber. Need I say more? Uber normally uses surge pricing to increase ride prices if the number of available drivers is not enough to satisfy demand. This increases drivers’ incentives to stay on the road and allows Uber to offer a better service to its customers in terms of vehicle availability compared to traditional taxis. However, Uber riders were not happy when Uber continued its surge pricing at a time when protesters were flocking to JFK airport to protest Trump’s immigration ban.
#DeleteUber started trending in Jan 2017, Uber still have not recovered its market share in numerous markets. Machines are currently blind to socio-political developments and therefore their actions can seem tone-deaf to many.
Other potential pitfalls include:
- As mentioned in the “competitive response module section”, competitors acting dynamically on dynamic prices can lead to anomalies and price wars that quickly get out of hand. Companies need to monitor their and competitors’ price levels to ensure that automated price changes follow business logic
- Personalized pricing can be perceived as unfair. For example, a customer using an iPhone could be seeing a different price for a plane ticket compared to her friend using an android phone checking out the same flight at the same time. Companies need to trade-off additional revenues from personalized pricing with its potential negative perception to find the right balance.
How to choose the best pricing optimization solution?
As online retailing grows, dynamic pricing became more important. Major players in the market acquired companies that specialize in algorithmic pricing or outsourced the technology to have a competitive advantage. Working with a vendor that has experience in your industry, you can set up a competitive dynamic pricing solution within weeks.
Absolute must features for pricing optimization software
- Analyzing profitability
- Automated price management
- Forecasting upcoming price trends
- Customer analysis for personalized pricing
- Market analysis for price competition
- Sufficiency to adapt different situations and changes
Be aware of your needs and constraints
- Software-as-a-Service vs in-house systems: Cloud-based solutions may reduce the risk of data loss but increase the cost.
- Compatible with existing systems: To get the best results, software should be able to integrate with existing company systems like CRM or ERP to get the most accurate data.
- Price: Some have freemium options where you have access to a few features and have to pay for complete service. If you are looking for a long-term solution, a subscription method would fit best.
Leading dynamic pricing vendors
We have data on 4000+ vendors and here are a few dynamic pricing vendors. For the up-to-date, sortable, filterable prioritized list of vendors, please visit our pricing category.
Some example vendors include:
5Analytics: Analyze each customer’s historical purchase data by applying machine learning to provide personalized prices.
Antuit: Antuit brings a level of price optimization analytics, insights and predictability to the rest of the retailing world.
Some vendors, though they do not directly have a solution for pricing, can help identify price changes. For example, import.io provides daily or monthly reports showing what products your competition has added or removed, pricing information including changes, and stock levels.
If you are short on time and want to work with experts who can suggest you the most suitable vendors for free: