According to a July 2000 Booz Allen Hamilton survey of manufacturers of consumer products, 70 percent now have menu-pricing programs in place or in development, as opposed to only 30 percent in 1996. A leader in the development of menu pricing, Procter & Gamble Company introduced its first program in 1994, under its Streamlined Logistics (SLOG) initiative. By reducing inventory, transportation, and administration costs, the program generated $50 million in supply chain cost savings. Other consumer products companies, such as Kraft Foods Inc. and S.C. Johnson & Son Inc., developed similar programs in the ensuing years and even extended their scope beyond the original concept developed at P&G.
Early adopters have continued to expand and evolve their menu-pricing practices by identifying new trade-offs in cost and value. For example, P&G’s program has undergone at least three major evolutions and currently addresses everything from compensation for returned products to funding for retail promotions. The wider array of service dimensions leads to better Differentiated Service Policies.
From Theory to Practice
The examples above demonstrate the potential of Differentiated Service Policies. But converting ideas to action demands rigor and forethought. Our experience shows us that companies seeking to develop Differentiated Service Policies should consider five principles:
- Optimize the trade-off between buyer value and seller cost.
- Build on detailed economic modeling.
- Use simple and straightforward policies.
- Bundle choices into a predefined set of options when possible.
- Anticipate changes and evolve policies to accommodate them.
The best service policies optimize the value to both customer and manufacturer by balancing the service cost incurred by the manufacturer with the value received by the retailer. Retail buyers must understand the relative value of the multitude of desirable service offerings, because choices regarding which services to purchase can drive costs (or even revenue loss) within the retailer’s operations. Manufacturers, too, incur specific costs related to each option provided, and the service policies must accurately reflect these costs to ensure the appropriate trade-offs. Menu pricing — a technique designed to remove joint supply chain waste — offers the most sophisticated and best example of this principle.
Detailed economic understanding is an essential part of developing effective service policies. Consider, again, Amazon. Holding a book to meet a 24-hour shipping policy can impose significant costs when the sales volumes are low. For high-volume titles, like a new Harry Potter release, Amazon can order full pallets of the book and move them in only a few days. For a low-volume book, a single carton of 24 books could represent multiple years of sales, which would tie up capital and warehouse space but produce very little return. Of course, Amazon also applies roughly the same effort in placing an order for one book as it does for one carton of books. Furthermore, the wholesaler often charges a premium for a “split case order” (an example of Differentiated Service Policies at the wholesaler). Amazon must conduct a careful analysis of these cost trade-offs based on the forecasted demand for each title, coupled with an understanding of the consumer’s valuation of faster shipment, to define the best service policy for each of the 4.5 million titles it sells.
Though the economics of Differentiated Service Policies can be complex, simple and straightforward policies do work best. Too much complexity confuses the customer, making value trade-offs difficult to comprehend. Lipton, a division of Unilever PLC, made its initial foray into menu pricing in 1996 with the introduction of an innovative menu-pricing program. Known as the “Lipton Cube,” the program offered retailers the flexibility of a long list of choices. However, the program also had extensive participant requirements and such a complicated structure that many customers were confused and ultimately chose not to participate. Worse still, some customers began “cherry picking” certain offerings that generated profits for themselves but losses for Lipton. Fortunately, Lipton quickly learned from its mistakes and discontinued the first program, introducing a new menu-pricing program in 1999. The new offering, though simpler, was built on a detailed understanding of supply chain economics. To date, it has proven popular with customers and profitable for Lipton.