How Does Price Optimization Software Work?
November 14th, 2022 (Updated 03/09/2023) | 10 min. read
As a large-scale enterprise business, you are of course fully aware what a considerable lever pricing is for your company’s success. And it’s great that your pricing team are wizards at what they do manipulating all the pricing ingredients (such as your products, your industry, your customers, and the market) they have at their disposal to unearth more profit for your business. But is your pricing team doing it all with one metaphorical hand tied behind their backs (i.e., stuck using manually produced, labor-intensive and error-prone Excel spreadsheets)? Cut them some slack and consider automating the best possible pricing insights for your products. If that is where your business is at, ask yourself the same question that will we answer in this article; ‘How Does Price Optimization Software Work?’
At Pricefx, having spent more than a decade in the price optimization space, we are perfectly placed to look at the technology and how it has condemned Excel to the pricing history books, and how price optimization software combines with an award-winning suite of 360-degree pricing solutions.
So, let’s get our hands dirty and dig into it, first defining exactly what price optimization software does before examining how it works and the significant business outcomes that the innovative technology presents for most companies.
What Price Optimization Software Does
Price optimization is about finding the price point that is most likely to help you execute your company’s unique set of business objectives (regardless of what that is – from increasing revenue or sales volume through to maximizing profit).
In other words, price optimization software will give your organization the capability and visibility to calculate the right price for the right value provided to the right customer in the right market segment.
But remember, price optimization will not set your business strategy.
Instead, price optimization software will augment your business strategy and help you find your data-driven way to get to your desired business outcomes faster and more efficiently – regardless of what it is – increased margins, volume, revenue, or market share, driving customer behavior, or even simultaneously finding the right balance between all those outcomes if that is what you would like to do.
However, not all price optimization software is created equal. Before we dive into how price optimization software works, let’s look at defining what price optimization is, and how the two main streams of price optimization offer different levels of pricing insights.
What is Price Optimization Software?
Price optimization software considers a wide range of internal and external data to determine where the perceived value of your product offering lies and then works to recommend you with price points (or ranges) for your products based on your customers’ willingness to pay.
The technology assists you to establish the best pricing strategies to implement with certain product or customer groups, to develop regional or seasonal strategies, to organize discount and promotion strategies and cadences, in addition to calculating how best to combine products to maximum effect and profitability.
However, depending on which of the two following models of price optimization software that your organization chooses to implement may affect your potential business outcomes.
Price Optimization Software Powered by Machine Learning (ML)
Long story short, price optimization software powered exclusively by Machine Learning performs in two major ways; by segmentation and by demand modeling.
Simply put, segmentation is a price optimization process whereby prices are differentiated based on your customer’s willingness to pay. Segmentation is based on the fact that price sensitivity can vary widely from customer to customer, from product to product, and again, in all the locations in which your products are sold. Your ML-driven price optimization can, for example, help you decide on a different price for different markets as perhaps your costs of production vary across geographies, or perhaps your organization has different business strategies for each individual country you operate in.
Demand modeling, as we see from the image above, is related to the price elasticity of your products. What that means is that the price will influence the number of units sold of one of your products. You can segment customers into small groups that have similar price responses and measure the price elasticity on an ongoing basis for each segment, taking a surgical approach to pricing.
If you set the price too low or too high, you won’t have much revenue, but if you price it just right, you will do fine. Optimization is a method to identify that ‘just right’ price to maximize your profit and other required business outcomes.
Price Optimization Software Powered by Artificial Intelligence (AI)
Taking things up a few notches, price optimization software powered by Multi-Element waterfall Optimization is valuable to both B2C and B2B companies.
AI-enhanced optimization software mimics the way a complex society of individuals behaves. There is no actual AI learning in this approach, rather you’re creating an AI paradigm that imitates your customer, your processes, and the marketplace.
This autonomy of each agent is what makes Ai-informed price optimization so powerful. A swarm of small interacting agents, each with their own job to do (for example, to protect your margins), can choose how they go about their tasks with free will, constrained only by rules around behavior and interaction.
When you send in a new and additional overarching objective (for example, increase sales), each agent will work as part of the greater army of agents to achieve this objective within the context of your entire portfolio and waterfall while also working on the first objective you set to begin with (remember – protecting margins). And it will do so within the parameters you have set, like: “Must give specific discounts to certain customer groups,” or “No price increases of more than 5% per annum.”
That means that you can simultaneously optimize various elements of your pricing waterfall.
A Practical Use Case for AI-informed Price Optimization
Imagine you own a shoe company, and you sell three types of shoes: summer shoes, waterproof winter shoes and non-slip clay-court tennis shoes for the European and North American market.
Having determined your pricing strategy for each of your three products, you have decided that you want to:
- Increase Sales volume on your non-slip clay court tennis shoes to lower production costs (as these are your products with the least sales numbers)
- Have a standard 20% profit margin on your summer shoes
- Have a standard 30% profit margin on your winter shoes and;
- You want to simultaneously apply all these rules in every market you sell in except for Canada, the state of Michigan, Estonia, Latvia, and Lithuania where a standard 50% profit margin applies across all your shoe models where demand is strongest across your entire product range.
Utilizing AI-informed price optimization software, the above 4 required business outcomes can be built into a single rule for your pricing software system to calculate your optimized prices worldwide automatically.
3 Starting Points to Make Price Optimization Work
So, we have seen that price optimization software simultaneously accounts for all the factors that drive price, and rationally aligns price/customer/order/product relationships simultaneously while calculating what drives price responses in the marketplace.
1. Get Your Hands Dirty with Clean Data (and lots of it)
Price optimization is not a guessing game — you need clean and hard data (customer, product, and sales/transaction data) to do it right – to calculate how much customers will pay for your product or service.
Data points may include information on demographics, inventory, supply and demand, historical market specifics, sales metrics, churn rates, product features, promotions, rebates, discounts, perceived value, and price sensitivity, among others.
Price optimization software is going to be best for teams that have already worked with data in the past.
If you have created a model in Excel and have already been doing some level of optimization yourselves, then you know what the work entails, and the challenges involved.
Do not allow less-than-perfect data to deter you on your journey.
If you understand the limitations of your data—that is a sign of pricing maturity.
If you are asking yourself questions like;
- ‘Do I really understand my data – and the value of my products in the market?’
- ‘Is there a better way to segment my customers? And create differentiation of price across different customer segments?’
… then you are ready to take the journey to using price optimization software into your business.
2. Define Your Scope & What You Want to Optimize
You need to establish whether you are going to optimize prices for your entire product portfolio or just a subset, or for all customers and markets or just a select few.
If your scope is optimizing only a subset of your entire product line, you need to ensure that it is representative of your business.
By choosing a subset that is too specific, your optimization model you develop will not be scalable for the rest of your business and pretty soon, you’ll have regressed back to working inside an Excel spreadsheet.
Define what you want to optimize
As we have discussed, your company’s optimization goal could be anything from maximizing margins, volume, or revenue, to minimizing cost to serve, so you need to know what it is you are trying to do.
Think about this step with care and consideration. The goal is not simply to pin down the price that will drive the most volume out the door, it should reflect what you are trying to achieve as an organization.
In reality, “price optimization” is the lever or tool used to achieve the goal of optimizing the real business objective, and that the objective can take many and multiple forms at once.
3. Realize Your Price Optimization into Repeatable Price Lists or Price Settings
Moving forward, you will want to stay on top of your pricing and continue adjusting it. The automation of Price Optimization makes it a painless and easily repeatable process and updating your price lists/chosen product lines on an ongoing basis is key.
Using a price optimization software tool that is part of a 360-degree pricing software solution (including a price setting capability) can assist greatly.
Whether it is optimizing your entire product line or just a few carefully selected products that will drive you towards the business goals that your organization is seeking, the most important thing is to get started.
Once you have started instituting price optimization is part of your processes, it is crucial to make it a continual and ongoing process.
There is no rule of thumb on how often you should change prices based on price optimization, as it depends on the growth stage of your company, market conditions and competition, customer behaviors, your goals, and other factors.
However, if the optimization processes can be duplicated on a regular and ongoing basis, you are on the right track.
That’s Great – But is Price Optimization Software Right for Me?
Now you know how price optimization software works and the pricing insights and pathways to profits and other business goals that it can provide for companies just like yours.
You may already have an idea if the innovative technology of price optimization software like the award-winning Pricefx or similar is something that can help your organization achieve its business objectives, but you would like to make sure.
To dive a little deeper into price optimization software, check out the handy article below for further benefits of the technology and to drill down to who it is right for and who may not need it at all.