Programmed for profit

ECONOMICS 101

i2's foray into profit optimization touches on economic principles

Malcolm Wheatley, Contributing Editor

In any software space that Rockville, Md.-based Manugistics is in, you can expect to find Dallas-based i2 Technologies in as well. Sure enough, i2 provides an intriguing profit optimization solution, although it's one that may require some managers to pull out their old economic textbooks to fully appreciate its underpinnings.

One strength, explains Andy De, i2 director of product marketing, is that it does a lot more than simple yield optimization-it also takes into account longer-term objectives and legal constraints that a company might have. "Simple profit maximization would take all of your output, and give it to the customer who pays the highest price," he says.

Additionally, supply and demand characteristics within an industry change over time, he says, and the simpler "rules-based" approaches don't always reflect that. For example, he says, two years ago, many electronic components were in short supply, thanks to soaring high tech and telecommunication industry demand. As a result, suppliers concentrated on their top customers and rationed to the rest. With a number of these former top customers imploding, that policy now appears short-sighted.

Another interesting characteristic, is that i2's solution takes into account not just simple demand and supply issues, but the complex interplays between them, such as cross-elasticity of demand. For those whose economics textbooks are long-forgotten, this is a fancy way of saying the demand for one product is linked to the demand for another.

In other words, the profit optimization picture can become two-dimensional, as manufacturers fine-tune prices on a product to stimulate demand for others. Still puzzled? Think beer and pretzels. Or beer, pretzels, and chips. Supermarket chains have long been able to see the linkages between promotions in one aisle and demand in another-and now it's the turn of manufacturers to get a piece of the action.

The i2 solution adopts calculation-intensive linear programming algorithms to perform its optimization calculations. This, claims De, makes it unique among the profit optimization applications on the market. This approach is said to provide the solution with the capability to not only optimize on a number of variables at once, but also perform in supply-constrained industries, or in industries that may fluctuate between being capacity- or demand-constrained, such as electronics. Linear programming, which revolves around satisfying constraints, takes such flip-flops in stride.

The $64,000 question is: does it work? Live applications are limited at present, concedes De, but early indications are promising. It's rare for i2 to make serious missteps, though, so watch this space.

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Profit optimization emerges, revealing varied vendor approaches and lessons from early adopters

Malcolm Wheatley, Contributing Editor

Fairchild Semiconductor not only spends a fair amount of time thinking about its pricing, it also has implemented a software solution to help it fine-tune that pricing. In so doing, the South Portland, Maine-based manufacturer of high-tech electronic components is part of a trend toward profit optimization solutions, even if the system it has deployed is but a stepping stone to the full profit optimization vision.

Pricing is no simple matter for any industry. Price a product too high, and you lose business. Price too low, and you're awash in red ink. To address this dilemma, Fairchild Semiconductor selected a dynamic pricing solution from Rockville, Md.-based Manugistics to allow it to model and pinpoint the ideal middle ground for pricing.

The technology Fairchild Semiconductor uses has its roots in a clutch of acquisitions that Manugistics began making about two years ago. That's about the time that Manugistics, a vendor of supply chain management software, identified the pricing and profit optimization space as an arena in which it could gain an edge on upstart vendors, as well as its more traditional competitors. Most notably, Manugistics' acquisition of Talus brought with it a number of patented optimization algorithms that had taken Talus seven years to develop.

Manugistics had developed its own price optimization algorithms, but the ones from Talus were compellingly better, says Greg Cudahay, a Manugistics executive vice president. Additionally, acquisition was the best way to get hold of them quickly.

"You just can't put a bunch of Ph.Ds in a room and come up with this stuff to order," says Cudahay. "With these solutions, users can look at buying behaviors in the market, and how customers respond to a variety of factors that influence their purchase decisions." Fairchild Semiconductor evidently agreed. "We selected Manugistics' software because [the company] offers the most thorough and advanced modeling systems available," explains Herb Rau, engineering project manager at Fairchild. Implementation was quick and straightforward, he reports, thanks to a very detailed preparation phase. "We knew what we wanted to do, and had spent time determining the issues, our needs, and the desired solution set," says Rau. "The software's ability to incorporate external market conditions is unique, and we expect this to bring an added dimension to our business."

That "added dimension" potentially can translate into "more money" for end-user organizations. Manugistics indicates that companies using the software generate bottom-line increases of between 2 percent and 8 percent of revenues annually. Boston-based analyst firm AMR Research offers comparable figures of between 3 percent and 5 percent. Numbers like that may not sound like much, but can equate to an increase of between 25 percent and 100 percent on existing profitability levels for many companies in traditionally tight-margin industries, such as automotive and food & beverage. No wonder then, that an application area that a year or so back was termed "dynamic pricing" is now being re-branded as the altogether more exciting-sounding "profit optimization" market.

The race is on

Vendors in this new space are drawing attention, and much of it is directed toward Manugistics, widely considered the field's prime mover. "Manugistics is the company to beat," says Julie Fraser, a principal with Industry Directions, a Cummaquid, Mass.-based analyst firm. "Talus was the other company in the market that everyone was watching, and now that it is part of Manugistics, that puts Manugistics in an even stronger position."

Maybe so, but the rest of the field shows no sign of giving up the race. Quite the contrary; up to half a dozen smaller companies are making a strong showing, says analyst John Hagerty of AMR. The challenge to understanding the space, he explains, is that there's little homogeneity in vendor approaches. "People are coming at the issue from widely different angles," he says. "Some from the pure price point of view, some from the demand management perspective, and some-bizarrely-from the cost point of view."

Such distinctions matter because they have a bearing on the relevance that a particular solution might have for a particular manufacturer. A build-to-order manufacturer, for instance, has different needs than a build-to-stock manufacturer that routinely bids on dozens of requests for quotations (RFQs) each week.

Some manufacturers will want to know little more than which customers are the most profitable to do business with, and subsequently might be attracted to simpler solutions largely built around activity-based costing software. Others will want to offer potential customers prices that have been finely gauged to reflect a number of variables. These may include the track record for winning business from a particular customer, which competitors the customer routinely buys from, and how strong competitive pressures are in that customer's local market. Still others will want to factor in even more complexity by incorporating supply chain-related variables such as capacity constraints, opportunity costs, and cash contribution per product.

One thing is clear: vendors that offer products with all this and more are out there today, competing for business. And consequently, enormous schisms of definition and meaning are forming, despite the fact that the market has only recently emerged. The reason? Sensing an opportunity on the same scale as the now-massive supply chain management software market, vendors are scrabbling to grab mindshare, hoping to convert that into market share.

In the process, some are throwing their original strategies out the window. "Although we originally built a suite of products that are designed for both retailers and consumer products manufacturers," says Dan Fishback, president and CEO of San Carlos, Calif.-based DemandTec, "our sales and marketing efforts have in fact almost entirely been directed to the retail market."

The harsh logic: in a fast-growing industry, it's better for DemandTec to focus its efforts on being the market leader in one sector of the market-and succeeding-rather than aiming for dominance over all of it and failing. The moral for manufacturers also is harsh: make sure your vendor is committed to manufacturing before doing a deal, or face the risk of being the only company in your industry with an app that's largely used for pricing grocery specials.

While vendors with an SCM heritage such as Manugistics are muscling in on the profit optimization act, customer relationship management (CRM) software vendors such as Siebel Systems, San Mateo, Calif., are adding pricing modules to their offerings. Likewise, large enterprise resources planning (ERP) suite vendors are leaping on the bandwagon.

For example, Pleasanton, Calif.-based PeopleSoft "has been offering a profit optimization capability for some time, although we are still undecided about branding it as such," says Robert Shecterle, a PeopleSoft vice president. A host of startups, too, are either entering the market for the first time, or re-positioning their models to take advantage of the buzz, hoping to be the next Talus. Even a former failed public trade exchange, Palo Alto, Calif.-based Vendavo, is in on the action.

Costs matter

It is, bluntly, a confusing picture that calls for close examination of vendor approaches. At one end of the spectrum are offerings from vendors such as Wayne, Pa.-based Acorn Systems, and Beaverton, Ore.-based ABC Technologies. Although both companies offer what they describe as profit optimization software, neither of their offerings operates directly on prices. "Our Enterprise Profit System enables customers to actually see exactly where they are making and losing money-and why-to arm their employees with data that enables them to increase their profit dollars," says Acorn Systems CEO Leland Putterman.

Kurt Anderson, chief information officer at J&B Wholesale, St. Michael, Minn., says Putterman's view is a fair characterization of his company's experience with the Acorn solution. Despite the "wholesale" in the company's name, J&B has a manufacturing operation, preparing portion-controlled beef and pork products for the retail and food-service industries in 11 states.

Anderson says it was hard to tell how profitable it was to actually serve each customer. "The gross margins looked good, but on a customer-by-customer basis, we never really knew if we were making money or not," says Anderson. The Acorn solution, he says, now provides the company with the data it needs to focus much more on net profitability-which is, after all, the bottom line figure that really counts.

Alan Stratton, director of customer advocacy at ABC Technologies, cites the implementation of his company's product at the Navistar Truck division of Navistar International Corp., Warrenville, Ill., to highlight a similar capability. Navistar, too, he says, was at one point struggling to understand how profitable each of two of its truck ranges were. Sure enough, the ABC system showed that one truck range, which was primarily sold to two large customers, was produced at a loss. Having gone to these customers and attempted but failed to get a price increase, Navistar saw the business go to competitors instead, which promptly dragged down their profitability, while Navistar prospered by devoting previously unprofitable capacity to producing other trucks. Ultimately, says Stratton, the two customers returned to Navistar, effectively saying, "What can you profitably make for us?"

While such stories underscore that solutions from Acorn Systems, ABC Technologies, and similar suppliers do indeed operate on profitably, it's important to remember that they do so primarily by manipulating the cost part of the profit equation, not the revenue side. In theory, there's the option to use the insights gained on costs to lever prices upward, but with no exact guidance generated as to how, or by how much. Indeed, at J&B Wholesale, Anderson says the company explicitly avoided this route, preferring to use the insight into its true costs to fine-tune its operations.

Toward EPO

Some solutions more directly address external pricing factors. Palo Alto, Calif.-based Metreo is one vendor in this space that bears watching, says Industry Direction's Fraser. Uniquely, it claims capability in both price planning-analysis, in other words-and price execution, via links to CRM and ERP systems.

The product's prime focus is on quickly delivering better prices, taking into account a number of competitive and market-based factors, even on a city-by-city basis, says John Dionisio, a company vice president. The pricing achieved is better, he explains, in the sense that they consider market conditions and competitive strengths; and faster, in the sense that RFQs aren't hanging around waiting to go though lengthy approval processes.

The Metreo system also "closes-the-loop" and offers what Dionisio describes as "quote-order revalidation." This means the software checks that approved orders contain the same prices as the quotation that went out. "You'd be surprised at how often that isn't the case," says Dionisio. "On a multi-item RFQ, it's hard to spot manually."

While dynamic pricing solutions promise significant benefits, they still primarily operate on one aspect of the equation-prices. That still leaves room for a somewhat more complex form of profit optimization: software that directly operates on the revenue part.

Manugistics is headed toward a broad-based solution set, says Cudahay. "The Fairchild Semiconductor implementation is an example of pricing optimization," he says. "Work we're doing with other customers-still under non-disclosure agreement-is closer to our ultimate objective, which is Enterprise Profit Optimization." Under this approach, user companies would deploy applications for supplier relationship management, supply chain management, and pricing and revenue optimization to coordinate everything from initial procurement of materials, order fulfillment and planning, to fine-tuning prices.

But Manugistics isn't the only show in town. San Rafael, Calif.-based Maxager harnesses the well-known Theory of Constraints to the profit question by visualizing and then measuring the flow of cash running through a plant as it turns purchased materials into finished goods to fulfill orders. "Maxager converts workflows into cash flow, showing how fast you are producing-and consuming-cash," says Mark Oppenheimer, a Maxager executive vice president. "As we do this in real time, dynamically, it's very easy for manufacturing people to focus on the results of their actions-including pricing decisions."

Implementation of the Maxager system was quick, according to Vas Shapkaroff, financial analysis manager at the Gary, Ind.-based steelworks of U.S. Steel. "Installation started in January 2001, and was running in production in May 2001, which was close to the schedule we had planned," he says.

Finally, while sorting through vendor approaches is a big part of understanding this emerging software category, solid transactional systems also are a concern. As Fairchild's Rau advises, "The issue focuses heavily upon the strength of the data infrastructure of the company attempting to implement a project like this. If the data is not available, or is not 'pristine,' then the company trying to implement this type of project will have a very difficult time.

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