Originally developed by American Airlines Inc., this price differentiation program is based on ticket booking rules and travel policies, and represents another example of Differentiated Service Policies designed to optimize the trade-offs in cost and value between the provider and the consumer.
Of course, Amazon’s shipping lead time and the airline industry’s pricing program represent just two examples among many elements of service with the potential for differentiation. Service policies can also include factors such as fill rates, delivery methods, quantity, and price. A variation on “Pareto’s Law” or the “80/20 rule” — derived from the observation of Italian economist and sociologist Vilfredo Pareto (1848–1923) that 80 percent of the wealth tended to be concentrated in 20 percent of the families — offers the key to one of the most common but least publicized techniques for Differentiated Service Policies.
Employing this concept, inventory managers apply an “ABC segmentation” to the items on hand: “A items” encompass the 5 to 10 percent of items accounting for the majority of sales, “B items” capture the next 10 to 15 percent of the items, and “C items” cover the 80 percent of items that typically generate only 10 to 20 percent of sales. The classification allows the inventory manager to set “safety stock levels” based on different expected fill rates that balance inventory-carrying cost against the potential lost margin from missed shipments.
For example, distributors typically set safety stock levels to fill orders immediately 99 percent of the time for A items, 95 percent of the time for B items, and 90 percent of the time for C items. Though seldom explicitly communicated to the customer, such a policy provides another example of differentiation in service policies that offers a cost-effective compromise between marketing and operations.
But unit sales volume represents merely one option for segmentation. World Kitchen Inc., which manufactures and markets kitchenware, including such brands as Corningware, Chicago Cutlery, Oxo, Pyrex, and Revere, recently implemented a policy differentiating between regular replenishment orders and special promotional orders. World Kitchen offers a five-day replenishment lead time for normal orders shipped from finished goods inventory, but requires a firm order 90 days in advance for the special requirements of a promotional order. The extra lead time allows the company to place the necessary special orders directly with suppliers and avoid any unnecessary inventory-holding cost, while simultaneously increasing the service assurance to the customer, effectively to 100 percent.
Menu pricing takes the same concept to a more sophisticated level by identifying customers by how they buy as opposed to differentiating them by what they buy. Increasingly common among manufacturers of consumer products, menu pricing explicitly addresses the cost/value trade-offs in the retail industry value chain. Through menu pricing, manufacturers offer better service or significant price discounts, sometimes both, to encourage their retail trade customers to change buying behavior and improve the economics of the overall value chain.
With menu pricing, customers choose their preferred buying practices but incur additional costs when selecting less efficient options. A wide array of retailer ordering practices significantly affect the manufacturer’s and the overall supply chain costs:
- Full truckloads minimize transportation costs compared to partial truckloads.
- Full pallets eliminate case-pick costs for creating mixed pallets.
- Factory-direct shipments bypass warehouses and the associated costs.
- More predictable and level orders reduce inventory costs.
- Vendor-managed inventory improves planning and supply efficiency.
The manufacturer sets prices to reflect the underlying economics and thereby encourages the customer to choose the more economical options, but still allows the customer to decide based on the perceived (or quantified) value of the various options. Using price to drive customer behavior ranks among the most successful techniques — but one that’s underutilized by most companies.