Which Price is Right?

PRICE CHECK (III): HOW MUCH FOR A COKE?

One of the great moments in the history of price foolishness involved Coca-Cola. On October 28, 1999, the New York Times reported that Coke was testing a vending machine that could sense the outside temperature and "automatically raise prices for its drinks in hot weather."

The story came from Coke's then-chairman, Douglas Ivester. He was describing the technology to a Brazilian magazine, bragging that it could increase price during a sports championship in summer heat "when it is fair that it should be more expensive." Coke confirmed the testing; Pepsi said that it would never "exploit" customers in hot weather.

The story ran around the world and was met with outrage. On the day that the story broke, Coke backpedaled furiously, a spokesman saying of temperature-controlled pricing, "We don't see [that] happening anytime soon, if ever."

Of course, Ivester was right according to economic theory and market experience. His customers already paid a wild variety of prices for Coke, depending on the setting. What Ivester got wrong was the human part, the perception of price. Consider what the reaction might have been to this headline: "Coke testing machine that automatically discounts prices in cool weather." The tale of the temperature-controlled Coke machine is now taught in business schools across the country.

THE NEW SCIENCE OF PRICING: TEST AND TEST AGAIN

Larry Warnock has only been a new-wave scientific pricer for a few months, but he talks with the zeal of a convert -- a zeal that comes from having discovered after 20 years in business something that's been sitting there all along. "How do companies set their prices?" asks Warnock. "Three ways. There's cost-plus. There's 'because my competitor did it.' And then there's what we call OTA pricing. Politely, that's 'out of the air.' Companies say, 'We price what the market will bear.' But they do nothing to measure what the market will bear."

Warnock is an executive vice president at Zilliant, an Austin, Texas - based company at the forefront of measuring what the market will bear. Zilliant's offices hardly seem to sit at the epicenter of a strategic revolution. The workspace is pedestrian. The software, however, is not. Zilliant pulls together a growing body of math that can analyze huge amounts of data and then use even more math to predict human behavior in the face of price changes. This isn't the kind of problem solving that even most math-team alumni have any experience with. Zilliant's chief scientist, Ahmet Kuyumcu, sent along a couple of algorithms of the sort that Zilliant uses. Here's one: Pwin(R)=< sum> NfN x P(R)N.

The leap isn't just the computing power, though, or the math. The real leap of Zilliant, and its competitors, is a shrug of modesty. Zilliant says, We're not actually going to get the price right. What we're going to do is look for the right price.

Zilliant's software runs experiments. You pick a goal -- maximizing total profits, for instance -- and then you start selling stuff, the same stuff, in fact, just at slightly different prices. You don't just take a flier and raise your prices 5% and see if anyone flees to a competitor; you don't just drop your prices 15% and hope that the price brings in 20% more business. You test, you sell, you gather data -- you see what works. Then you change your prices -- maybe 4% up, maybe 6% down -- when you know what's going to happen.

Small changes can make all the difference: Jim Compton and his colleagues at Continental Airlines boarded 44 million passengers in 2001, at an average ticket price of $193. Charging two bucks more per ticket would have swung the firm to profit. That's a price change of 1.04%.

Scientific pricing is really pricing using the scientific method. Let's not guess what's going to happen; let's change prices in a controlled way, watch what happens, then change prices for real after that. And by the way, we'll begin the next set of experiments the next day.

These experiments can reshape how and what companies charge for their services. One of Zilliant's first customers was DHL, the $6 billion-a-year shipping firm. DHL hadn't changed its list prices in five years, and its walk-up (or call-up) business was shrinking in the face of competition from FedEx and UPS.

The typical way that DHL might adjust prices would be to do a market-research study -- to ask consumers whether they'd ship a five-pound package from Houston to Lyons, France for, say, $81. How about $71? The problem is instantly clear. A "study" like that is marginally better than a guess. As Aman Adinew, director of pricing and yield management for DHL North America, was considering his options, he stumbled onto Zilliant.