Still Skeptical After All These Years: Deposit Price Optimization

This article, the second in the series on Deposit Price Optimization, focuses on the larger segment of the financial services industry that views price optimization with a certain degree of skepticism. I sometimes sense from my conversations with individuals that this “new technology” can best be described as “mysticism,” or as I read in a recent article that “it sound[s] like ‘Star Wars.’” Therefore, this article on deposit price optimization will embody a brief history of price optimization, an industry definition, illuminate through anecdotes non-financial services industries which use the technology and the benefits these industries have experienced, and lastly, the current status of price optimization in the financial services industry.

Brief History. Known by the terms “price management,” “pricing science,” “price differentiation,” “profit-based pricing,” “yield management,” or “revenue management,” price optimization is a widely accepted discipline that is providing increased revenue and profitability in the airline, hospitality, car rental, cruise line, railroad and television broadcast industries. The Wall Street Journal has described price optimization as the number one emerging business strategy, “a practice poised to explode.” The first reference to “revenue management” was by C.J. Taylor in 1962, credited for his work that recognized the value of selling more airline seats than capacity in anticipation of “no-shows.” What today is referred to as “over-booking.” Developed in the airline industry in the wake of deregulation in the late 1970’s, revenue management controlled the price of seats. Although the focus was on opening and closing fare classes, the net effect was price changes. The first major users of revenue management were American Airlines and Delta Airlines starting about 1985.

Definition. Price optimization is the art and science of enhancing firm revenues while selling essentially the same amount of product/service. Price and revenue optimization is the method of finding the right price to offer the consumer by segment, by market, by channel, and by product at all times. The essential element that price optimization adds to pricing is consumer price elasticity.

Price optimization is a combination of statistical and algorithmic methods that synthesize recommendations from historical pricing and marketing data. The scientific foundation of price optimization is the segmenting of customers and deals by price sensitivity, and using each price segment’s unique sensitivity to set prices on future deals.

INFORMS, a private group devoted to promoting the development and application of revenue management and pricing in new industries, describes the pricing technique as “an ardent focus on the use of data, mathematics, and computers to better understand purchasing behavior and to recommend better prices These pricing techniques tend to be operational – what price do I offer when the next customer walks in the door – thus distinguishing them from the activities typically associated with marketing departments – determining static price lists and running promotions, for example.”

Industry Anecdotes

Airlines Industry. Price optimization used by the competition in the airline industry has bankrupted several corporations…the clearest example being Peoples Express Airlines. Donald Blurr, founder and CEO of Peoples Express was quoted as saying that he “believes that major carriers use of sophisticated computer programs to immediately match and undercut his prices ultimately killed Peoples Express.” R.L. Crandall, Chairman and CEO of American Airlines said in 1992 “we estimated that yield management has generated $1.4 billion in incremental revenue in the last three years” by “creating a pricing structure that responds to demand on a flight-by-flight basis.”

Automobile Industry. According to CFO Magazine in the August, 2000 issue, “Ford Motor Company has quietly been enjoying a huge surge in profitability….1995 and 1999, US vehicle sales rose just 6 percent, from 3.9 million units to 4.1 million units. But revenue was up 25%, and pretax profits soared 250% from about $3 billion to $7.5 billion. Of that $4.5 billion growth, Ford’s Lloyd Hansen, controller for global marketing and sales, estimates that about $3 billion came from a series of revenue management initiatives.”

Car Rental Industry. Kevin Geraghty of Aeronomics, Inc. states that “[revenue management] basically saved National Car Rental. And you can go from the CEO of National on down, and they will say: ‘just applying these operational research models made the life and death difference for this company.’”

Clothing Industry. The following excerpt was taken from an article in Forbes, Pricing Software Could Reshape Retail, Brian Bergstein, April 24, 2007. Referring to markdown optimization software, often used by clothing retailers to determine what to put on sale and at what discount “Bob Buchanan, an analyst at AG Edwards & Sons, says the software tends to recommend putting things on sale sooner, in hopes of moving product faster. Great – who doesn’t love a sale? But earlier markdowns tend to mean shallower discounts – 20% off instead of 40%, for example….Sometimes it means no discount at all. Recently, ALDO Group Inc., a Canadian shoe company with stores worldwide, began selling two kinds of sneakers it wanted off shelves by the end of June. One pair was $29, the other $49. According to Bob Raven, ALDO’s vice president of finance, the $29 version was a smash and figures to sell out by May. The $49 pair seemed to be doing so-so. So a merchandise manager, following his instinct, prepared to cut the price, perhaps all the way to $29. Until the company cranked up its new markdown-optimization system from Oracle. The verdict: Keep the shoes at $49. The software showed that based on current and historic sales figures, the shoes would still sell out by June. ‘You start to see a lot of stuff you didn’t see before,’ Raven says.”

Other Corporate Users of Price Optimization include:

Hotels (Hyatt, Marriott, Hilton, Sheraton, Disney)

Leisure Travel (Club Med, Princess Cruises, Norwegian)

Ford Motor Co

Car Rental (National, Hertz, Avis, Europcar)

Washington Opera

Freight (Sea-Land, Yellow Freight)

Television Ads (CBS, NBC, ABC)

UPS

Texas Children’s Hospital

Retail (Wal-Mart Stores, 7-Eleven Inc.)

Grocers (Albertsons)

The Benefits. The ultimate benefit of computerized revenue management according to Revenue Management Systems, Inc., a major vendor of price optimization software to the airline industry, “is increased revenue. Each flight departure is managed to insure that it generates the maximum revenue from the ideal mix of both high and low yield passengers. You can expect this system to generate anywhere from 3% to 8% additional revenue for your airline, resulting in potential profit increases of 50%-100%.”

According to P.J. Jakovljevic from the Technology Evaluation Centers, in his article Advancing the Art of Pricing and Science, “advanced analytics and sophisticated systems have long been used to manage inventory, control the cost of goods sold, and manage the supply chain in terms of costs and delivery. But the irony is that none of these factors is as powerful a lever for profitability as pricing. Indeed, recent research and surveys show that when companies make pricing a priority and implement solutions from a specialized pricing formula, these vendors can see a profit improvement, sometimes as high as 20 percent.”

As applied to the banking industry, Nomis Solutions, a major vendor to the high-end market of financial services providers states on its’ website “innovative banks are adopting a profit-based pricing approach to increase profits, obtain valuable customer insight, and gain competitive advantage. They have implemented profit-based pricing solutions in 12 weeks, realized 10-20% profit improvements within three months, and have achieved a 10X return on investment (ROI) within a year of use.”

And now to Financial Services. According to Tower Group analyst Bobbie Britting, in the August 2006 Tower Group piece called “Profit-based Pricing: Time to Stop Leaving Money on the Table,” the analyst states that “Profit-based Pricing…is the next level of pricing sophistication in financial services. Traditional pricing techniques such as one price fits all, market based, index based, and risk based all ignore a fundamental component: consumers’ price sensitivity. Development and use of sophisticated mathematical algorithms allow financial services institutions to implement the profit-based pricing principle: find the right price for each segment, market, channel, and product at all times.” She goes on to state that “early adopters of profit-based pricing will garner the greatest benefits, and financial institutions that do not implement the technique are leaving money on the table.”

According to Ms. Britting, a leader in price optimization providers in the financial services sector has among its customers 5 of the top 20 banks in the world and 4 of the top 10 banks in the United States. And in June of 2006, 98 banking executives attended a conference in Chicago that focused entirely on pricing optimization and profit-based pricing. Institutions with representatives attending or presenting included Bank of America, CitiGroup, Barclay’s, Washington Mutual, Wachovia, JPMorgan Chase, Wells Fargo, HSBC, Royal Bank of Canada, and auto industry captives DaimlerChrysler Finance and Ford Motor Credit.

Tower Group estimates that from 2007 to 2010, 90% of institutions with $70+ billion in assets will be using price optimization software, from 9% currently. The estimated figures for institutions with $10-70 billion in assets and institutions less than $10 billion in assets will grow 60% and 40% respectively, from 7% and 0% in 2007.

The next article in this series will discuss how price optimization replaced pricing practices employed by other industries, while at the same time, draw parallels to those practices with those currently employed in the financial services industry.