Real-Time Profit Optimization: Coordinating Demand and Supply Chain Management*

by David F. Pyke

and M. Eric Johnson

Advances in information technology have generated remarkable opportunities for both marketing and supply chain management. In the marketing area, firms are increasingly able to understand individual customer preferences and therefore to dynamically adjust prices. This greatly improves their ability to optimize revenue generation. In the supply chain area, firms can use technology to improve their visibility to costs and lead times - internally and throughout the supply chain. We believe that the next major opportunity for competitive advantage is for firms to link the innovations in marketing with those in supply chain management, allowing them to refine pricing, capacity, production and inventory decisions. This coordination will give marketing managers visibility to true costs and responsiveness as they make pricing and promotion decisions, and it will provide supply chain managers with a better understanding of pricing structures as they decide when to expand capacity and where to strategically locate inventories. The result: not just optimized revenues or costs, but optimized profits across the entire supply chain.

At a recent working summit hosted by the Center for Digital Strategies at the Tuck School and Cisco Systems, executives from many industries debated the opportunities and barriers for wide-scale profit optimization.! The group concluded that linking the innovations in supply-chain management with the technology-enabled capability to serve customers in a more targeted manner is key to driving profit optimization. Through our ongoing research on this topic coupled with the experiences shared by many different companies at the summit, we have concluded that:

  • Given globalization and the increased speed at which the economy functions, the costs to the system of sharing bad information or hoarding useful information have gone up dramatically;
  • Digital technology has greatly increased the ability to share information in a timely manner - but organizational cultures are not always keeping pace with the changes technology is enabling;
  • Real-time, tailored product differentiation is increasingly possible and important, but it requires a more integrated and visible way of thinking about manufacturing, component standardization, and product design collaboration;
  • Tailored or dynamic pricing is viable, but unlike in the experiment, it must be accompanied by clear product differentiation or executed through plausible channel segmentation;
  • The value of coordinating marketing and supply chain information has been traditionally focused on making the supply chain more responsive to customer demand, but there are just as many gains to be made from understanding the costs borne by the supply chain of pricing, promotion or product configuration decisions.

In this article, we highlight some of these learnings and explore how digital technologies can be used to better share critical information, enabling profit optimization. We first examine the issues from the vantage point of both marketing and supply chain management. Then we show how the driving forces in both areas lead to exciting new opportunities. Finally, we address key questions executives should ask themselves about the potential of information-sharing breakthroughs.

Marketing Innovations

The Internet has enabled firms to experiment with many new pricing strategies for both goods and services sold over the web. Products that were previously sold in the bricks and mortar channels with weekly or monthly changes in prices can now be sold over the Internet with posted prices changing much more dynamically (daily or even hourly). In fact, the technology has also become available to change prices on the shelves of bricks-and-mortar retailers just as frequently. The term "dynamic pricing," which includes markdowns and price promotions such as discounts, rebates, and coupons, encompasses the strategy where prices change over time, and across consumers.

Not surprisingly, the airlines have been leaders in dynamic pricing. For example, American Airlines (and its spin-off Sabre), learned that one key to dynamic pricing is the ability to switch whole distribution channels on and off. That way, the average ticket price for a given flight can be changed without changing the price of the tickets within a given channel. Lowering the average price can be accomplished by making more seats available through the lower priced channels, and raising the price can be accomplished by switching off availability through those channels. Customers with a higher willingness-to-pay have powerful incentives to use the higher priced channels, because the tickets sold through those channels are given particular characteristics that those customers need, such as ability to book only a few days ahead, to get instant confirmation of the reservation, to reschedule without advance notice or fees, and so on. The overall mix of tickets being sold can literally be adjusted from minute to minute.

Other companies have introduced creative pricing systems that enable them to reap considerable rewards. For instance, each selling season, retailers face the perplexing problem of when and how much to mark down leftover inventory. New techniques and software for the markdown problem have been successfully applied at a number of progressive retailers. Likewise, many firms run regular promotions that are designed to increase sales to certain customer segments. Recent research and software advances have provided deeper understanding of the effects of promotions on demand - effects that occur before, during, and after the promotion. Other firms have taken advantage of a careful analysis of customer segments. Dell Computer, for instance, often lists different prices for exactly the same computer depending on whether the customer is ordering for home, government or business.

As firms adjust prices over time, they can gain an understanding of customer segments and their reactions to these changes. In fact, there appears to be growing evidence, at least in consumer packaged goods, that the change in demand for a unit price decrease (relative to some reference price) is different from that of a unit price increase (relative to the same reference price). In addition, there is an increasing body of research and practical experience that helps firms understand frequency of store visits (both on-line and bricks & mortar) and probability of purchase once the customer is in the store.§

To charge different prices over an extended period, however, it's usually necessary do more than clearly delineate customer segments: firms often must also provide different products. Many problems with dynamic pricing and personalized pricing can be solved if companies can differentiate their products at a level that corresponds to the breaks between price points. Airlines can charge different ticket prices because they are differentiating their products through different lead times, different degrees of certainty regarding availability, and different rescheduling and ticket return policies. Dell can customize computer prices because it is also customizing its computers. Cemex, a large Mexican Cement company, can even customize cement prices because it customizes its cement - preventing its products from becoming a simple commodity. Using its website, customers can specify the tensile strength, brittleness, elasticity, texture, color, resistance to molds and fungus, delivery location, delivery time, delivery rate, and a host of other qualities vitally important in using ready-mix cement. Each of these specifications is then taken into account when it comes to pricing.

When companies face problems trying to introduce different prices, it is often because the products in question weren't sufficiently differentiated. Amazon discovered the importance of this principle when its one-day experiment with personalized pricing ended amid a storm of Internet protest and an almost instantaneous customer boycott. The chief reason Amazon wasn't able to charge different prices to different customers was that the products it was trying to supply at different prices books and CDs-were the same. Amazon was actually providing another service that was customized its customized recommendations but it was providing that service for free.

Effects of Marketing Innovations on the Supply Chain

Dynamic pricing and product differentiation unfortunately can create supply chain problems. The well-known bullwhip effect is a direct result of, among other things, varying prices. A simple promotion, for instance, can send a shock wave through the supply chain. Revenue may be maximized, but it is not at all clear that profits are also maximized. Likewise, every time a company adds another unique product, it is gaining in its ability to segment the market and to set more favorable prices. But it is simultaneously increasing the complexity of its operations and adding to its unit costs. Whirlpool, like many companies, experienced the long-term result as a "binge and diet cycle" in which the company first fattened its product lists, to serve more market segments more effectively, then later trimmed its product lists, to get unit costs down-then started the cycle all over again.

Supply Chain Innovations

While impressive marketing innovations have been advancing, supply chain management has undergone a similarly impressive transformation. Managers in many industries now realize that actions taken by one member of the chain can influence the profitability of all others in the chain. Competition has moved beyond firm-to-firm rivalry to supply chain against supply chain. In addition, during the 1970's and 1980's global competition forced many manufacturing companies to improve the quality of their products and reduce their manufacturing costs. With 20 years of progress, many of these manufacturers found that the biggest challenges they faced, and the next opportunity for improvement, were outside of their immediate control, and that solutions required better coordination with their upstream and downstream partners.

Such inter-firm integration, long the dream of management theorists, finally began gaining momentum in the late 1990s. Some would argue that managers have always been interested in integration, but the lack of information technology made it impossible to implement a more "systems-oriented" approach. With the recent explosion of inexpensive information technology, it seems predictable that businesses would become more supply chain focused. However, while information technology is clearly an enabler of integration, it alone cannot explain the radical organizational changes in both individual firms and whole industries. A sea change in management theory was needed as well.**

Two fundamental catalysts have conspired over the past decade to initiate the required change in management theory. First, power has shifted from manufacturers to retailers. Wal-Mart, for instance, has forced many manufacturers to improve their inventory management, and even to manage inventories of their products in Wal-Mart stores and distribution centers. Following Wal-Mart's lead, most major retailers have been asking suppliers to tighten up their inventory management and improve their order fulfillment capabilities. Second, many eBusiness initiatives over the past five years have led managers to rethink their supply chain strategies. With the rise of outsourcing and virtual supply chains, the importance of integration has grown. Likewise the proliferation of software tools that support eProcurement, vendor managed inventory (VMI), collaborative planning, forecasting and replenishment (CPFR), and product content management (PCM) has put more information into the hands of supply chain managers. In fact, the technology for tracking an entire supply chain often outstrips firms' ability to use it. For example, Deere & Company offers technology that makes it possible to monitor the supply chain all the way back to the component raw materials. These raw materials might include the individual trees from which wood products are made, or in the case of agriculture, the seeds from which the crop is grown. It is possible to track which tree went into which piece of furniture, or which grain went into which loaf of bread. Such awesome supply tracking is possible because Deere has installed sophisticated sensors, wireless communication, and geo-positioning devices in the tractors and other equipment that handle the raw materials.

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