The Value Propositions of Dynamic Pricing in Business-to-Business E- Commerce By Kyle Appell and Bob Gressens Moai Christopher Brousseau Accenture

Transcription

1 The Value Propositions of Dynamic Pricing in Business-to-Business E- Commerce By Kyle Appell and Bob Gressens Moai Christopher Brousseau Accenture Introduction Since the advent of e-commerce, businesses have low-cost, global access to a highly focused and greatly expanded network of stakeholders in the enterprise value chain. One of the most promising opportunities to improve this network is the application of dynamic pricing models to an organization's sourcing and selling activities. Innovators in this space are demonstrating that dynamic pricing is a critical component of e-commerce, driving significant bottom-line results through increased revenues, lower costs, and improved processes. Furthermore, analysts project that up to one-third of business-to-business (b2b) e-commerce in the next several years will involve dynamic pricing. Dynamic pricing can be formally defined as the buying and selling of goods and services in markets where prices are free to move in response to supply and demand conditions. One basic, yet highly effective, form of dynamic pricing is an online auction. Early adopters of dynamic pricing are employing this technology in a number of unique ways. Some businesses are using Web-based English auctions" to sell excess inventory, while others are using Reverse auctions" as a means to bid-out procurement contracts, such as with Request for Quotes (RFQs). The success of dynamic pricing is currently helping fuel the growth of entirely new businesses, including broad-based e-commerce portals and marketplace-focused exchanges. The emergence of new interactive networks and the rapid adoption of e- commerce capabilities will eventually give rise to electronic marketplaces where goods and services are exchanged in real-time dynamic pricing environments analogous to the trading of securities on the NASDAQ today. For now, dynamic pricing is a better way to sell excess, obsolete, or slow-moving inventory, as well as time-sensitive, limited, or rare products. It is also an excellent means of procuring goods and services. This paper defines the value proposition of dynamic pricing in b2b e-commerce at two critical touchpoints in the enterprise value chain: sourcing and selling (see Figure 1.0). It provides background on the emergence of online dynamic pricing solutions, further explains the business benefits of these solutions, illustrates these benefits through case studies, and describes specific business applications for dynamic pricing. Figure 1.0 Enterprise Value Chain

2 Business Benefits Overview The Internet is a powerful means to connect buyers and sellers quickly, efficiently, and at a very low cost, regardless of whether there are just a few trading partners or thousands. Sharing product information and enabling online ordering is just the beginning. The next wave to transform online business is the adoption of dynamic pricing as an integral piece in the overall e-commerce solution. The benefits of this transformation are significant and immediate as evidenced by the impact on the way businesses source and sell (see Figure 2.0). Figure 2.0 Where the benefits of dynamic pricing are found According to a 1999 survey by the Center for Advanced Purchasing Studies, leading U.S. businesses generate an average of $11 million each in annual revenues from investment recovery activities 1 (investment recovery is revenue from the sale of assets no longer needed by the enterprise). In other words, these revenues represent net recoveries from selling surplus and/or excess inventory to third-party intermediaries at a significant discount (roughly 20% to 30% of their original market value). In a slightly different context, businesses write off better than two-thirds of the $55 million worth of surplus inventory they carry each year, consuming valuable capital and negatively impacting earnings. Early adopters of dynamic pricing applications have taken advantage of this opportunity to dramatically reduce the gap between surplus inventory and net recoveries (see Figure 3.0). In fact, some companies have more than doubled their investment recovery dollars in the course of just a few months (or in some cases, weeks). Assume that the average company, which carries approximately $55 million in surplus inventory annually, realizes a conservative 25% increase in its recovery price. This recovery would generate incremental revenues of $3 million per year, which along with the additional savings attributable to lower overhead and process improvements, significantly adds to the bottom line.

3 Figure 3.0 Benefits of dynamic pricing for surplus inventory management Dynamic pricing also offers tremendous benefits for procurement, on which large companies spend an average of 36% of sales 2. Given such a sizeable base, a two percent decrease in purchasing costs, for example, quickly improves margins. Dynamic pricing positively impacts procurement costs in two ways. First, competitive bidding reduces contract costs. Second, the RFQ process, despite advances with e- mailing and faxing, remains a labor intensive and slow process ripe for significant cost savings and time reduction. By automating this process and implementing dynamic pricing technologies, companies have managed to cut approximately 15% from the cost of vendor contracts and reduce purchase cycle times by two-thirds 3,4. These savings leave purchasing teams with more time to focus on the most highly valued aspects of their jobs such as vendor evaluations and approval, managing larger and more complex supplier relationships, and other strategic activities. Early adopters of dynamic pricing applications have taken advantage of this opportunity to dramatically reduce the gap between surplus inventory and net recoveries (see Figure 3.0). In fact, some companies have more than doubled their investment recovery dollars in the course of just a few months (or in some cases, weeks). Assume that the average company, which carries approximately $55 million in surplus inventory annually, realizes a conservative 25% increase in its recovery price. This recovery would generate incremental revenues of $3 million per year, which along with the additional savings attributable to lower overhead and process improvements, significantly adds to the bottom line. Dynamic pricing also offers tremendous benefits for procurement, on which large companies spend an average of 36% of sales 2. Given such a sizeable base, a two percent decrease in purchasing costs, for example, quickly improves margins. Dynamic pricing positively impacts procurement costs in two ways. First, competitive bidding reduces contract costs. Second, the RFQ process, despite advances with e- mailing and faxing, remains a labor intensive and slow process ripe for significant cost savings and time reduction. By automating this process and implementing dynamic pricing technologies, companies have managed to cut approximately 15% from the cost of vendor contracts and reduce purchase cycle times by two-thirds3,4. These savings leave purchasing teams with more time to focus on the most highly valued aspects of their jobs such as vendor evaluations and approval, managing larger and more complex supplier relationships, and other strategic activities.

4 An Overview of Dynamic Pricing Over the course of history, changes in the business world have tended to occur in evolutionary patterns sparked by revolutionary ideas. Today, this pattern occurs at a much faster pace. Now, with the Internet achieving critical mass throughout the business community and the general populace, being the First mover" is no longer sufficient to ensure a unique competitive advantage. Forward thinking and critical insight into how technology will impact business, and moving to facilitate those changes, will increasingly become the mark of true strategic advantage. For instance, it took Japanese auto manufacturers several decades to compete on par with, and eventually reshape, the American automotive industry. However, Amazon.com managed to change the balance of power in the retail book industry in a fraction of that time. Market Requirements for Dynamic Pricing Dynamic pricing is best suited to certain types of products, services or markets. There are several unique characteristics that identify when dynamic pricing can occur (see Figure 7.0). Shortcomings of Static Pricing To understand the value proposition that dynamic pricing offers b2b e-commerce, one must comprehend the shortcomings of static pricing models as well as the business trends and changes in technology that are driving this evolution. For centuries, businesses used bartering (a precursor to dynamic pricing) as a matter of routine. The Industrial Age, however, saw the emergence of mass production and extended distribution chains that drove large economies of scale, which made faceto-face contact with each customer impractical. As a result, static (or menu-driven) prices became necessary to manage the sale of the enormous increase in both volume and variety of products over far larger geographic regions. Although businesses realized huge gains, they lost the ability to interact with customers on a one-to-one basis. Today, menu-driven pricing has effectively become the de facto standard for business, and so people tend to overlook its shortcomings. Static prices are often referred to as sticky" because they typically are slow to adjust to market conditions, thereby causing a gap between the price that is charged for a good and its actual market value. Considering the proliferation of different product Stock Keeping Units (SKUs), the use of static pricing is not surprising. A tremendous amount of effort is required to determine how to price each item and how to keep pricing catalogs current. Static prices also provide only a glimpse of the overall market demand, conveying little more information than whether or not there was a buyer at a given price. As a result, businesses spend a substantial amount of money on market research to help them understand and forecast demand. Enabled by the Internet, dynamic pricing solves the dilemma of sticky" prices and provides virtually instantaneous knowledge about market demand by identifying the number of bidders, who they are, how motivated they are, and the prices and quantities they desire 5. E-Commerce Trends The Internet is ushering in a new era of b2b commerce and has proven itself a viable channel for marketing and selling to consumers (see Figure 4.0). Widespread Web access has given consumers greater buying power due to improved market

5 information and increased competition. Additionally, since consumers can now access a broader global marketplace at very low cost, it is no longer necessary to buy from only local vendors. Figure 4.0 Waves of Internet applications The focus of most e-commerce strategies today is two-fold. Customer-facing" e- commerce applications provide better customer service, order processing, and direct access to accurate marketing information. Vendor-facing" e-commerce applications result in backward integration of the enterprise supply chain and create efficiencies within the market. Not surprisingly, initial e-commerce strategies like translating printed catalogs online, automating customer service, and order processing were natural extensions of traditional business practices that were rooted in static pricing models 6. The widespread ease of Internet access and the tremendous power to exchange large amounts of information in real time is changing the traditional model of static or fixed pricing. Figure 5.0 illustrates the different types of interactions between buyers and sellers using dynamic pricing. For example, when one buyer interacts with many sellers the interaction model could be a reverse auction.

6 Figure 5.0 Particpant interaction models of dynamic pricing Since buyers and sellers can each be either a business or a consumer, their interactions can be further divided into three distinct market types: business-tobusiness (b2b), business-to-consumer (b2c), and consumer-to-consumer (c2c). As previously stated, consumers have already validated c2c and b2c Internet commerce (specifically dynamic pricing) through sites like ebay, where they trade with other individuals, and sites like Priceline.com, where they trade directly with businesses. The next logical step is for dynamic pricing to migrate into the b2b market space. Figure 6.0 shows some of the companies that are early adopters of dynamic pricing. Figure 6.0 E-business models and a sampling of companies in each space Market Requirements for Dynamic Pricing Dynamic pricing is best suited to certain types of products, services or markets. There are several unique characteristics that identify when dynamic pricing can occur (see Figure 7.0).

7 Figure 7.0 Suitability of some product categories for dynamic pricing First, the products or services being traded should have one or more of the following qualities: Well-defined (clearly specified or widely understood) Relatively standardized (e.g., commodities or near commodities) Perishable (e.g., foodstuffs) or time-sensitive (e.g., airline seats) Depreciating value (e.g., computer components, automotive parts) Scarce (e.g., limited resources, art auctions) Second, the marketplace will likely have one or more of the following qualities: Uncertainty about the price exists due to imperfect information about the marketplace. This may occur in cases where the product is new, the level of supply and/or demand is unclear, or the market is highly fragmented. Sufficient competition exists among bidders, or can be created via the introduction of new bidders. In some markets, a critical mass can be achieved with as few as five to seven bidders. It is becoming much easier to overcome the hurdle of insufficient competition with the globalization of trade and the widespread use of the Internet. A buyer or seller exists with sufficient market clout to make and stimulate competition. Geographical or physical constraints between buyers and suppliers create a high cost to participate in, or expand, markets through traditional means. Value chains exist in which middlemen create pricing or information inefficiencies. A significant variance exists between supply and demand, perhaps because of long production lead times after an order is made, or large fluctuations in demand. Products that are not well suited for dynamic pricing include those that are very specialized because they require tight relationships between buyers and suppliers in order to successfully bring the product to market. An example might include a complex electronic component that is specifically designed in conjunction with a key supplier to meet strict component performance and quality requirements. Market situations where dynamic pricing may not be well suited include: Small markets without sufficient breadth and volume of market demand. Markets where the price of a commodity is well understood. Monopoly situations where buyers negotiate directly with the supplier.

8 Future Vision According to industry analysts, e-commerce is poised for tremendous growth over the next few years. Forrester Research predicts that by 2003, b2b transactions will grow to $800 billion, roughly two-thirds of all e-commerce 7. They also predict an increase in b2b auction sales from $19.3 billion to $65 billion (see Figure 8.0). Figure 8.0 Market projections for dynamic pricing in b2b e-commerce. Source: Forrester Research The future of e-commerce will bring a proliferation of digital marketplaces (both horizontal and vertical) in conjunction with new technologies that will further leverage dynamic pricing. Electronic agents will first scour the Web for buyers and suppliers, searching for goods on sale, or purchasing demand. Eventually, more sophisticated agents will compete in dynamic pricing markets on behalf of companies or individuals. As prices approach their "true" market value, trade partners will increasingly compete on factors such as reliability, quality, and value added services, not only price. Dynamic pricing engines will grow to support even more complex transaction formats such as: Multi-attribute auction formats that use criteria other than price, quantity, and time (such as "condition of goods," "delivery-time," and "supplier performance history"). Complex multi-line RFQs and bid schedules. Formats that allow a higher level of negotiation between buyers and sellers (online chat, online negotiations, etc). Continuous-matching formats where automated agents, comparable to current computerized stock-trading systems, perform the matching in real time. This trend is driving businesses to seek improved efficiencies. In the future, it is likely that goods will be built to order as opposed to the current dominant model of build/warehouse/sell. For instance, Dell Computers has become a market leader by exercising the build-to-order capability and differentiating itself from other players in the crowded field of PC manufacturing. Businesses that successfully manage to freeup manufacturing capacity will have created a new asset, which in turn can be auctioned. In effect, the available capacity itself could become a tradable commodity. Business Applications for Dynamic Pricing Dynamic pricing is changing the very nature of how goods and services are traded

9 along the enterprise value chain. At each step, businesses have direct and low-cost access to an extended network of trade partners. Figure 9.0 illustrates the market space and how various businesses that use dynamic pricing have positioned themselves along the enterprise value chain. Figure 9.0 Dynamic pricing marketspace This section explores the specific applications of dynamic pricing that enhance selling and sourcing activities, specifically in the context of e-commerce applications. First, it explores the seller-centric capability of dynamic pricing as a new pricing mechanism and channel for liquidating excess or non-strategic inventory. Next, it examines two new buyer-centric applications of dynamic pricing for the selection of long-term contracts and spot-buys. Further, we outline potential benefits and risks to both the buyer and seller with each dynamic pricing application. Seller-Centric Application: Liquidation of Surplus Inventory Major businesses have learned a difficult lesson about the cost of carrying excessive levels of inventory. Aggressive international competition and faster product life cycles have forced companies to rethink manufacturing processes, inventory management, and supply chain activities in an effort to adopt continuously leaner practices. Despite all their success, it still remains impossible, not to mention economically impractical, to reduce surplus inventory levels to zero. Surprisingly, this is not a small issue. On average, businesses in the United States carry approximately $18 billion in surplus inventory annually, an amount equivalent to about one-tenth of all finished goods. While it is easy to think of surplus inventory in the narrow context of unsold, obsolete, or refurbished goods, this categorization actually encompasses a broader range of goods. For discussion purposes, surplus inventory can be divided into two basic product categories. The first category consists of those goods or services that are perishable - items whose usefulness and functionality last for a finite amount of time. In the event they are not used prior to their expiration, their value diminishes to zero. Examples of these types of products include chemicals, pharmaceuticals, airline seats, advertising space, and so forth. The risk in holding these products for too long is that they will expire before being sold, resulting in lost revenues and, potentially, disposal costs. The second class of surplus inventory includes goods whose value depreciates with time yet maintain some salvage value. Computers, electronic devices, and stamped metal parts are prime examples. As more powerful and improved devices are introduced to the market, older models become less desirable and potentially obsolete. The challenge to the selling company then becomes to accurately predict

10 the rate of technological change and forecast the impact this change will have on product demand, an extremely difficult task. The process for selling surplus inventory is also inefficient. Many companies still trade orders back and forth via phone and fax, which is labor intensive and slow. In addition, by yielding control of the product to third-party intermediaries, these companies give up their influence over where and at what price the merchandise is ultimately sold. Although some businesses need inventory to effectively protect against variability in demand, there is a more efficient way to sell excess inventory. Dynamic pricing offers a more effective solution to this problem. Rather than selling off surplus inventory to third-party intermediaries, companies are now beginning to use the Web to auction surplus goods directly to customers. Figure 10.0 illustrates the kinds of participants who are buying through this channel. By leveraging the inherent flexibility of the Web to target a select group of highly motivated buyers or extend the reach of businesses across a maximum number of participants, dynamic pricing has a distinct advantage in generating competition and market liquidity. Beyond realizing significantly improved returns and more efficient processes, companies are retaining greater control over their brand, extending a valuable service to their customers, gaining more valuable market insight, and reducing costs. Figure 10.0 Types of participants in seller-centric auctions Future Vision According to industry analysts, e-commerce is poised for tremendous growth over the next few years. Forrester Research predicts that by 2003, b2b transactions will grow to $800 billion, roughly two-thirds of all e-commerce. They also predict an increase in b2b auction sales from $19.3 billion to $65 billion (see Figure 8.0). Seller-Centric Dynamic Pricing Applications: Benefits & Risks Seller-centric dynamic pricing applications carry risks and benefits to buyer and seller. Benefits To Seller (Company) Enhanced revenues Lowered costs and improved efficiency Access to a larger and more diverse group of buyers

11 Real-time access to market demand information Stronger relationships with trading partners New channel to dispose of aged, unused, or idle assets Benefits To Buyer (Trade Partner) Opportunity to lower price Lowered cost and improved efficiency Access to a larger and more diverse group of suppliers Better information about the market conditions Ability to participate in multiple auctions concurrently Means to smooth out supply and demand shocks Risks To Seller (Company) Yield control over pricing to market mechanisms Exposure to new competition More complex logistics Risks To Buyer (Trade Partner) Pay more than market value Credibility of product and/or supplier Access to customer service Buyer-Centric Application: Use of Dynamic Pricing for E-Sourcing Another, and potentially more significant, application of dynamic pricing is in the field of sourcing and procurement. This applies to sourcing of both long-term contracts with suppliers, as well as unpredictable "spot buys." Several businesses have used dynamic pricing solutions in common procurement activities such as supplier consolidation, annual negotiations and corporate-wide projects to gain savings through purchasing activities. Further, these solutions can be applied to both strategic (or direct) goods and services relating to a buyer's manufacturing operations, as well as indirect purchases (commonly called Maintenance Repair and Operating resources, or "MRO"). It is important to note that the fundamental value proposition is identical for all purchasing methods mentioned above (i.e., long-term, spot-buys, direct and indirect), although there are clear differences in specifics such as financial details and procurement methods. Many companies already use the RFQ process for sourcing of goods and services. Both processes are simple forms of competitive pricing for sourcing or supplying goods. Typically, the process requires sealed bids from prospective suppliers, which are then evaluated by the buyer. The buyer then selects one or more suppliers and negotiates detailed terms for specific contracts. This process can be labor intensive for both parties and may result in contract terms that vary from supplier to supplier based on the market position of the supplier and the negotiating skills of the buyers and suppliers on each side of the table. Varied contract terms are created by incomplete market information. Buyers often rely on suppliers for detailed product information such as capabilities and product qualities. Since many supply industries are fragmented, buyers primarily look to

12 suppliers they have dealt with before or happen to discover via targeted advertising, trade journals, or aggregated catalogs. Since supplier productivity can vary widely and is continually changing it is very difficult for buyers to effectively gather, organize and evaluate vendor performance on an ongoing basis. As a result of this disconnect, buyers come to rely on outsourced strategic sourcing initiatives, where third parties periodically visit an organization, dig through the vast amounts of transactional information, re-check the supplier landscape and re-source long-term contracts with suppliers for key commodities. By using some of the dynamic pricing solutions mentioned earlier, a buyer can automate the RFQ tender and bid processes. The Internet gives buyers the ability to eliminate geographic and cost barriers to potential suppliers, and to include additional suppliers into the bidding process at very low cost. Further, a real-time auction greatly increases competition in the marketplace by giving suppliers instant feedback on where they stand in the marketplace, coupled with the opportunity to submit new bids to win the contract. Historically, the economic leverage provided by competition has been most effective in markets where the products or services in question are commodities or near commodities. Commodities and near commodities can be generalized as goods that are relatively well standardized or consistently specified. Coal and printed circuit boards are good examples in that specifications for both products can be well understood. Between 1995 and 1998, companies that implemented reverse auctions for sourcing realized an average cost reduction of 17% as compared to previous contracts for similar goods 11. Sprint used reverse auction services to source longterm contracts, which cut proposal cycle times by 70% and led to significant cost savings on $75 million telecommunications services contracts. Visteon Automotive Systems achieved "multi-million dollar savings" on contracts for printed circuit boards by hosting the bidding process in a reverse auction format (see Case Study 2). Buyer-Centric Dynamic Pricing Applications: Benefits and Risks Buyer-centric dynamic pricing applications also carry benefit and risk to buyer and seller. Benefits To Buyer Opportunity to create or increase competition for buying dollars Better information about the marketplace Enhance the RFQ process and compress cycle time New supply management capability Benefits To Seller Access to new customers New and timely information on state of the market Automating the RFQ process New demand management capability Risks To Buyer

13 In the event sufficient competition does not materialize, then the price could potentially be higher than the buyer expected Risks of taking on new suppliers Potential effects on decision-making and relationships Risks To Seller In the event sufficient competition exists to ignite a bidding frenzy, the price may get driven below that desired by the vendor Risks of taking on new buyers Potential effects on decision-making and relationships Conclusion As businesses engage in the "e-economy," they face significant challenges and opportunities. The business value created as stakeholders leverage widespread, lowcost access to vendors, trade partners and other businesses that form a vast network along their value chain is tremendous. In this paper, we have discussed a framework of dynamic markets, and examined case studies of early adopters of dynamic pricing who have already realized tangible business benefits. To thrive in the e-economy, businesses must capitalize on the strategic advantages that come from speed and information. Businesses must embrace capabilities that allow them to optimize all aspects of their expanding reach to customers and business partners. Two key elements of this network are the sourcing and selling capabilities of every business. Dynamic pricing clearly creates significant value for both buyers and suppliers in each of these activities. The next wave of e-commerce enablement is dynamic pricing, which delivers advantages of speed and information to innovative businesses. Fast-moving enterprises are proving that dynamic pricing can be a valuable piece of a company's overall e-commerce strategy - a strategy that can result in increased revenues, lower costs and improved processes. Footnotes 1. Center for Advanced Purchasing Studies, "Purchasing Performance Benchmarks for Investment Recovery," 1999, ISSN# Killen and Associates, Potential effects on decision-making and relationships 4. Harvard Business School White Paper # , "FreeMarkets Online," February 26, 1998, page NewsEdge Corporation, "A.T. Kearney Employs Internet Technology in Business-to- Business Competitive Auctions," September 3, The Economist, "The Heyday of the Auction," July 24, Forrester Research, "Anatomy of New Market Models," February Businessweek, "Goodbye to Fixed Pricing?" May 4, NewsEdge Corporation, ibid. 10. Information Week, "Going, Going, Gone!" October 4, CIO Web Business Magazine, "How Bazaar," August These savings are averaged over nine different commodity types including: plastic molded parts, metal stampings, metal castings, metal machinings, chemicals, pole line hardware, commercial valves, corn sweetener, and printed circuit boards. Accenture and Moai engaged in joint research and development of this report. The data on which this report is based were not independently verified. Accordingly, the results may reflect inaccuracies in the underlying data. Other methods or approaches to the study may have yielded different results.

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