The second factor to consider is order size: Is it small or large relative to total capacity? A commitment of large chunks of capacity can significantly affect the financials of any business and must be handled strategically. Smaller increments of capacity pose fewer risks and strategic considerations.
The most commonly encountered combinations of the two factors suggest two utterly dissimilar pricing strategies. One extreme reflects the Japanese keiretsu system, with a small number of suppliers focusing on a small number of customers in long-term relationships. At the other extreme are companies that, thanks to the Internet, can handle transactions from thousands, even millions, of customers, yet still not use up a significant proportion of available capacity. (See “Are You Modular or Integral?” by Charles H. Fine, s+b, Summer 2005.)
In the keiretsu model, open-book, full-cost pricing has become increasingly common. This approach encourages customers and suppliers to jointly examine the full costs of producing goods or services, and to price them at an appropriate margin. The margin should be large enough to encourage the supplier to reinvest in serving the customer for their long-term mutual benefit.
Honda of America excels in applying this model with its suppliers. Honda’s buyers first analyze a supplier’s cost structure in depth. Then, by tracking supplier capabilities around the globe, they benchmark these costs against best-in-class performance. If a supplier’s productivity or quality standards fall short, Honda works closely with the company to develop plans for closing the performance gap. Ultimately, underperforming suppliers are dropped. Competitive suppliers, however, earn adequate margins that can be reinvested for continued growth with Honda.
At the opposite end of the spectrum is the mega-transactional company, trafficking in multiples of intense short-term deals. Yield management is an optimal pricing philosophy for small increments of capacity in transactional relationships. Here, prices do not depend on underlying costs. Instead, prices are dynamically adjusted, on the basis of forecasted demand, to maximize overall revenue for every increment of capacity.
When it was introduced 25 years ago by American Airlines, yield management aimed to sell the right seat to the right passenger at the right time. Proponents of yield management often limit its application to “perishable capacity,” like airline seats and hotel vacancies. But it actually has wider applicability. Consider Amazon.com. At first blush, Amazon’s inventory — books and other products — doesn’t look perishable, and so wouldn’t seem suitable for yield management, except under unusual circumstances (say, a period of high demand for a bestseller with variable availability). But Amazon’s fulfillment center operation, which can receive upward of 1 million orders in a single day, prices “fulfillment capacity” variably, maximizing profits exactly as an airline does. It offers different delivery lead times at different price points: Customers willing to wait can receive free shipping; those wanting immediate gratification must pay a premium.
Although yield management is more common in consumer-facing businesses than in industrial ones, untapped opportunities for applying its principles can be found in both. Simply look for chances to allocate capacity — or, alternatively, inventory — to different customer segments at different price levels. Think about businesses with variable lead times, to which customers would willingly pay a premium for faster service. Most repair businesses — from the local auto dealer to an aircraft engine overhaul operation — are first-come, first-served. This pushes out lead times when demand exceeds capacity. By applying yield management techniques, a business can offer fast-turnaround service at a premium price — if it can accurately predict demand and dynamically allocate capacity.
Although open-book pricing and yield management apply to the most common combinations of customer relationship and capacity increment, our framework suggests two other pricing approaches, which might be viewed as variants of the open book and yield management methods.