Developing a scalable demand-side company: Strategic resources and positioning
by Olga Egorov
M.S. Psychology and Social Pedagogics in Zaporizhzhya National University, 1999
M.B.A. Strategic Management and Entrepreneurship in Moscow International Higher School of Business MIRBIS, 2006
M.S. Organizational Management in Moscow International Higher School of Business MIRBIS, 2007
Submitted to MIT Sloan School of Management in Partial fulfillment of the requirements for the Degrees of Master of Business Administration
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Developing a scalable demand-side company: Strategic resources and positioning
by Olga Egorov
Submitted to MIT Sloan School of Management on May 6, 2018 in Partial fulfill-ment of the requirefulfill-ments for the Degrees of Master of Business Administration ABSTRACT
This thesis develops a strategic positioning for a consulting company operating in the demand-side of the business, that will utilize a strategic framework "create-capture-deliver" and help its customers to generate value using massive small-scale experimentations. The thesis addresses questions like best target indus-tries, using human capital as a strategic resource of the company, and managing strategic partnerships.
Efficient price optimization has become a competitive edge for many industries. Constant review of prices by pricing consultants may be an essential tool for some industries and companies but totally unacceptable for others. This study helps to clarify who would appreciate the service of price optimization.
The study further provides insights on the types of firms that would need pricing services and how they can both integrate such services into their daily operations and turn such services into strategic advantage.
Thesis Supervisor: Duncan Simester Title: NTU Professor of Marketing
TABLE OF CONTENTS
1. INTRODUCTION... 4
2. PROBLEM DEFINITION... 7
3. POTENTIAL CLIENTS...8
3.1. Top Managers with Limited Business Knowledge...9
3.2. High brand value and highly differentiated products...13
3.3. Foreign Enterprise operating on the US Market...14
4. STRATEGIC RESOURCES AND SCA...17
4.1. Relationships with customers...17
4.3. Industry knowledge... 18
4 .4 . S ecret sauce... . 19
4.5. Human capital...22
4.6. Partnership with Academia... 23
1. INTRODUCTION
Price optimization requires a combination of modeling and massive experimenta-tion that are typically impractical for small-scale businesses to conduct. Business analytics are often more applicable to supply-side, not demand-side, problems, and modeling demand and experimentation require skills that most industries lack. This status-quo opens broad possibilities for consulting companies that have expertise in pricing and can help clients understand their customers' needs by using small-scale experimentation. Such possibilities are valuable for the con-sulting company for three reasons.
First, providing qualitative pricing optimization is highly valuable to client businesses. The deeper a consulting company dips into the client's business, the more value qualitative pricing optimization can be added. Specialists in marketing recognized the importance of understanding customers' needs more than twenty years ago, and such findings are still relevant.
Second, increasing expertise in a client's business helps to increase en-trance barriers and to protect a consulting firm's niche. The niche consultants has the advantages of expertise in the client's area and time that the competing con-sultant lack; thus, competitors are not able to compete efficiently with the niche consultant.
Third, the cost of switching to another consultant becomes high for the cli-ent because the currcli-ent consultant understands the clicli-ent's market. In some cases, once you know more, the client will be not able recreate the same qualita-tive pricing optimization expertise, which will differentiate the current consultant from other consulting companies and create switching costs.
Each benefit is a good reason for the consulting company to pursue this strategy. However, all advantages that a consulting company may garner from such collaboration are also motivations for the client to develop in-house exper-tise. Building strong long-term relationships with the client's business will be a good investment only as long is it is not efficient for the client to do so. A consult-ant's close relationship with a client may deter the client from developing in-house expertise, even if developing such in-house expertise would be more desirable for the client. Thus, close relationships with the client is good for the consultants, but
not necessarily good for the client.
For example, I had a detailed interview with a founding member of an Inter-net infrastructure firm who started the business from a
7rn-hase
sup ported by private equity investment. The company was in its ninth year of operation and had a stellar success story. In the interview, the founding member attributed the com-pany's success to many factors, including smart pricing. He was proud of being able to not only have a disproportionate CAGR on revenue and the bottom line, but also gaining market share. Even with the company's success, my intervieweesaid that pricing decision were not necessarily optimal. When asked to narrate the decision-making path on pricing, he confessed pricing was decided using ele-mentary excel sheet tools, best and worst scenario estimates and guidance on competition moves. He said that the entire effort was rigorous but could not be termed scientific or holistic. He also said that different scenarios led to common
solutions hinged on biases from previous experience. The decision could not sub-sume the complex juxtaposition of so many internal and external variables. Sub-optimal decisions on pricing were not exposed because there was tailwind of many positive enablers. The company's management team experienced extra stress because of the non-standardized process to determine pricing. A scientific approach to optimal pricing that encompassed all the variables, starting with the consumer buying decision journey and including other independent variables mentioned above, would be invaluable to this founding member and his company.
2. Problem Definition
Each product has a price, but not every company can freely determine the price at which it wants to sell its goods. Companies should have a good methodology for determining the price of their goods, which price in turn determines each
into account internal and external constraints. Depending on the product's prop-erties, the size and financial strength of the seller, and the company goals, the optimal pricing method can be determined via several paths. The choice of which method to use takes into account the novelty of the product, the differentiation of the product in quality, and the life cycle of the product. Often, the cost of produc-tion or prices for competitive products and substitutes are also considered to be
large factors in determining product pricing.
Pricing is a never-ending process that requires deep understanding of cus-tomers and their willingness to pay. Not many companies own such expertise in-house. This opens a niche for consulting firms by providing pricing optimization. However, while efficient price optimization is essential for many industries, it is completely unacceptable for others because of the proprietary nature of their businesses. Identifying which companies would benefit from pricing consulting is a first step as a consulting company in building price optimization as an offered service. After finding companies that would appreciate this service, they may not necessarily be ready to invite consultants to determine their optimal pricing. This hesitancy may stem from various causes. Many firms set considerably higher than average prices and do not want their customers to find out. Some companies hide their price structure in order to manipulate benchmarks and justify price in-creases. Others are afraid that the value of product will diminish if the price is transparent, and that as a result, the usage of the product will be affected. In
summary, companies feel concerned that as a result of opening their pricing tech-niques to a consultant firm, the companies may lose substantial revenue.
Any of these reasons may explain why pricing is a very secretive side of business, and working on such an intimate topic requires trust. What can help consultants to build that trust with clients? Which strategic resources should be employed in order to get win-win, long-term collaboration with the client?
3. Potential clients
For the first step of identifying companies interested in pricing optimization, segmenting companies can be useful and insightful. One effective and orthodox way of segmenting is by industry, as the firms within a specific industry compete with each other. The importance of industry level expertise cannot be over em-phasized. An unconventional but equally useful way of segmenting potential cli-ents could be by stage of evolution, both within an industry and regardless of industry. The needs of a specific company varies with its level of ambition, risk appetite, and primacy of goals, which can range from gaining market share (even with cash burn) increasing the bottom-line gains. An additional external compo-nent for consideration is the industry or environmental volatility. This can com-pletely change the rules of "where to play" and "how to win" choices when it comes to decisions pertaining to pricing.
3.1. Top Managers with Limited Business Knowledge
Whenever top company managers have strong business backgrounds, they tend to develop in-house pricing expertise in order to understanding the
im-portance and complexity of this topic. Having a deep understanding of custom-ers' needs and preferences allows these top managers to easily build a consulting practice themselves. External pricing experts would have difficulty competing with the in-house pricing expertise. One way to overcome this shortcoming is to partner with industry insiders. Such insiders may become members of the con-sulting company's advisory board, which monitor and navigate companies' in-dustry penetration. A consulting company needs to build expertise before entry in order to show the client that a partnership would add value to the company.
Second, perhaps a more obvious solution would be to work with companies with top managers that have professional, not business, backgrounds. Consider, for example, companies specializing in IT, fashion, restaurants, or fitness-centers markets. These companies are usually founded and led by industry enthusiasts that lack formal business training, and who thus may not realize the importance of qualitative pricing optimization. Due to deep understanding of their industry, professional top managers are used to operating their businesses based on their experience and are usually not open to new ideas or techniques.
I interviewed the owners of a very dynamic IT startup in New Jersey that operates in the software development field. Both founders have a technical back-ground with strong practical expertise in this field, and both feel confident that they know how to manage their business. Both agreed that the best way to cal-culate the pricing of their services would be to calcal-culate their costs and to look at competitors' prices. When I suggested their profit may increase if they operated on the demand-side of the business, they were surprised. At the end of the inter-view, they were ready to discuss pricing consulting seriously.
A similar scenario unfolded when talking with various people from a Den-mark company in a completely different industry-fashion. The founder and all top managers in the company had decades of experience working with apparel but no business education. The pricing decisions they made were simply cost driven. One person from the marketing department was responsible for suggest-ing prices, which were then approved by the CEO. The results of those interviews revealed the insight that many such companies use someone from either market-ing, finance, or procurement departments to determine pricing instead of a spe-cialist.
To test this insight further, I reached out to the two companies in two dif-ferent industries-fashion and fitness-that are typically led by industry but not business experts. The US-based fashion company operates in three states and has production lines and retail stores in twenty cities; I spoke with the CEO. The
small fitness chain in France has ten fitness clubs in different cities, and I inter-viewed the COO. I asked them both about the top-management background in their companies and about the ways they manage pricing in their businesses. The answers I received validated my insight. Despite differences in industries and ge-ography, both companies used a purely cost-driven pricing model. The same was true for the managerial backgrounds-both companies were founded by people with no basic business education and were operated based on the top-managers intuition. To price their goods, both companies first considered cost of produc-tion, including ordering apparel, logistic expenses, taxes, custom fees, cost of store maintenance, and operation costs. After calculating all costs, companies then added the desirable markup and, in some cases, forecasted the maximum discount they would offer customers during seasonal sales. Both companies had several different categories of services/goods and priced them slightly different based on previous sales and forecast for the demand; however, the pricing of each category still reflected cost structure.
Thus, we may claim that when the target companies have management with more functional background without business education and with little under-standing of sophisticated pricing strategies, the services of pricing consulting or-ganization become critical.
If a company has no resources to create pricing expertise in-house, collaboration with pricing consultants might be a viable solution. With collaboration, such a
company will be able to analyze real demand data and draw inferences from such analysis. With such inferences, they would be able to effectively and efficiently predict customers' behavior and their willingness to pay. Collaboration has sev-eral advantages for the company. These advantages include low maintenance cost, high quality results as more data can be analyzed, and certainty that their pricing models and tools are current and sophisticated. Despite these clear ben-efits, there are two main concerns for companies that collaborate with pricing consultants. First, such collaboration may require some form of an exclusive con-tract to further protect the client's competitive advantage. A second concern is that of control and security. With collaboration, the company has little control over the specialist firm that provides the services and may worry about security of data.
3.2. Enterprises with high brand value and highly differentiated products
Thinking further on the types of companies that may require qualitative pricing service, I analyzed the types of product portfolios held by the potential target companies. This analysis showed that companies with a narrow product line or those who operate on a commodity markets and do not have enough differentia-tion from consumers will not be interested in pricing help due to the specificity of their business. Companies that work on a short range of product may require a
one-time contract with pricing consultants but will not generate work-flow for fur-ther collaboration. On the ofur-ther hand, operators from the commodity markets also are unlikely to request the services of price optimization consultants. Usually pric-ing for commodities depends on the competition and does not vary too much within a sector.
Only those companies that have highly differentiated products and do not know how to effectively price this differentiation will understand and value a pric-ing service. This hypothesis is also strengthened by fact that with the further de-velopment of trading platforms, more and more sellers with highly differentiated products become vulnerable in their pricing policies. In-house pricing capabilities would not be a good decision for these companies because, with high probability, in-house pricing could not help compete in a pricing game with the competing players, like Amazon, etc. High quality optimization with deep understanding of market specifics may help such customers to increase their sales while maintain desire profit.
I conclude that an important criteria for finding target companies is that optimal pricing services are most valuable for companies that have a strong brand and a broad variety or regular rotation of their products. Such customers will be able to recognize the value of pricing services because the most common pricing model used by these companies is cost-driven and does not consider customers' willingness to pay.
Thus, companies with high brand value and highly differentiated products need to use pricing service in order to differentiate from their competitors. By offering efficient pricing optimization, consultants may help their clients change their pric-ing behavior in order to address problems of disruption, increase their profit, and maintain brand sustainability.
3.3. Foreign Enterprise Operating on the US Market
Many foreign companies want to take advantage of the United States' continued economic growth. However, a successful foreign company is not guaranteed suc-cess in the United States. The United States is well known as the world's most competitive economy in terms of economic performance, business efficiency, governance, and infrastructure. Whether a company is small, a billion-dollar cor-poration, or a foreign market star, competition will be a huge part of its business in US. Successful business tactics in Europe, Asia, and Latin America may not work in the United States. The highly competitive US market may kill any overseas company that lacks understanding of relevant culture, specifics, and efficient pric-ing techniques.
Two UK-based companies are examples of successful foreign companies attempting to enter the US market. Hailo, a ride searching app brand, got into price war with the dominant players in the United States (i.e., Uber and Lyft). In
October 2014, Hailo shut down its operations in Washington, Chicago, Boston, Toronto, and Montreal. In 2007 Tesco, a grocery chain, failed in its expansion into the US retail market. After five years of trying to convince American consumers to shop at its Fresh and Easy outlets, it shut down its shops, losing nearly $1.8B in the process. These are just two examples on a very long list of successful foreign
brands that failed at the US market.
A key feature of these failed attempts was the failure of these firms to properly price their products. When an overseas company plans to open in the United States, market pricing is a secondary concern to finding a good go-to-market strategy; companies may think they already know how to price their prod-ucts due to their success in their home countries. This undermines the value of pricing consultants for the potential client and brings to the stage full-service con-sulting companies. However, pricing in the US market is often very different than pricing in foreign markets, and a foreign business starting to operate in the Amer-ican market will soon recognize the need for a pricing process to meet customers' needs and to produce profit. Thus, pricing consultants may be interesting for overseas companies that have already opened in the American market but have problems with efficient pricing for their products. By applying market expertise and providing consulting on efficient pricing, consultants may help such custom-ers succeed in gaining and maintaining market share. However, this hypothesis would not work for a foreign company with strong strategic partnership or experts
in the United States. Such partners or experts may help in making pricing deci-sions; hence, pricing services from a consulting firm would not be needed. Thus, overseas companies operating in the American market without strategic US part-ners may have problems with efficient pricing for their products and be interested in strategic partnership with pricing consultants.
4. STRATEGIC RESOURCES AND SCA
A pricing consulting company should follow the strategy of long-term trusted re-lationships with the clients. In order to attract, build, and maintain such relation-ships, the company needs strategic resources that will become a base for the
SCA (strategic competitive advantage) of the business. Strategic competitive advantage is an ability to satisfy our customers better than our competitors and to continue doing so in the long term. In order to find such strategic competitive
advantage, we need to think about strategic resources that may help us acquire customers and involve them in long-term collaboration with our company.
4.1. Relationships with customers
The results of my industry interviews indicate that potential clients may not be happy to outsource the process of making pricing decisions. Some of the
firms I talked to were not ready to replace their current process of doing their own pricing because they did not know how much value hiring a pricing consult-ant would add. Even after recognizing the value of using pricing consultconsult-ants,
many companies may ask why they cannot continue to do pricing themselves using our methodology. What is the secret sauce the consulting company uses that their clients could cannot replicate in their own businesses? To answer these questions, pricing consulting firms have to build a hypothesis of how cli-ents missed effective pricing optimization in the past and what may prevent them of doing so in the future.
4.2. Industry knowledge
By dint of internal conditions, stage of growth, nature of strategy, competitive environment, and change in external conditions (PESTEL framework), the need to be able to price right is more of a continual element than a one-off approach. These variables set the ground for a very sophisticated pricing consulting require-ment that can be better done by a niche team who constantly monitors the varia-bles and singularly focuses on this aspect. To get such industry specifics, a con-sulting team should gain deep knowledge and understanding of the clients' in-dustry. Acquiring industry proficiency may involve the consulting firm hiring
ex-perts from the required industry. However, such a solution is not scalable-a con-sulting company cannot hire every expert it may potentially need. Moreover, in-dustry rules and specifics vary broadly from country to country and sometimes even from region to region. As already mentioned, another, more sustainable way of getting such expertise is to work closely with the industry insiders. Not only does this allow consultants to accumulate and maintain the necessary knowledge base inside the company, but it will also assure that the knowledge base is up-to-date and reflects all modern trends and technological changes. Such experts may become trusted advisors for the consulting company or, even better, board members that will be loyal and interested in bringing new expertise to the con-sulting business.
4.3. Secret sauce
Because of the time and energy and resources spent on acquiring exper-tise in a certain industry to give optimal pricing recommendations to clients, it is
important for consulting firms to have a strategy of maintaining these clients in the long term. Consulting firms want clients to make good pricing decisions but
not have the capability to make such decisions himself using the consultant's methodology and tools. Thus, the insight from this reasoning is the following: the consultant price optimization process should have some secret ingredients
(customization) to avoid customers considering potential development of in-house pricing capability. By creating standard business processes for different industries, consulting firms may make their business model scalable and sus-tainable.
The secret ingredient could be a mix of wealth of knowledge management database that goes far beyond the confines of industry, such as geography and evolution stages that no single industry expert, notwithstanding her/his experi-ence, can fathom easily when it comes to pricing decisions. It would include a templated approach of factoring in changing consumer behavior by way of exper-iments that need to be structured differently to best capture all variables. These complexities and their constantly changing nature is best done by a dedicated organization versus internal managers who are juggling many roles.
It is also possible that no secret source is actually needed to satisfy the customer. In some situations, even the simple perception of the existence of such a secret ingredient may be enough. This idea came from the business model of the US-based consulting company ZS Associates. ZS Associates, Inc. was founded in 1983 at Kellogg School of Management University of Northwestern University. Today it is a global management consulting firm specialized in sales and marketing, marketing strategies, operations, and executions. ZS is recog-nized as an expert on go-to-market and business strategy sales and implemen-tation capabilities.
One of ZS Associates specializations-sales force design- is based on the business model similar to the model I describe in my study. During the project, the consultant is actually implemented into the client's business body and helps the client's company to optimize and structure its day-to-day sales force opera-tions. I tried to reach ZS Associates for a personal interview but did not receive a response-even when the request came from a first-level connection. I found this lack of communication confusing but later learned that ZS is one of ten companies that almost never give interviews. I realized that probably this behavior is a part of the corporate policy to protect the company's know-how in this area-or, if you will, their secret sauce.
However, in order to test my hypothesis, I still needed to talk to a company that utilized a secret source as part of their business model. My search brought me to a Russian-based consulting company that specializes in the sales force optimization. I interviewed the founder and the managing partner of that company in order to test my insights. The founder told me that their relationships with the client are usually long-term and last at minimum two years. For this amount of time, the company integrates its expert into the client's structure. That expert be-comes part of client's business processes and digs deep into the customer's in-dustry and organizational specifics.
I asked about the types of clients that usually require such services and the reasons behind their decision to hire consultants for such projects. The answer
confirmed one of my insights. The main category of clients were companies led by top managers without proper business background that lacked understanding of how to optimize the sales force of their company. The Russian consulting com-pany claimed it has a secret sauce that is really attractive to their current and potential clients. The company guarantees full reimbursement if client sales have not increased by at least 10% after the first three months of the project. The founder explained that this policy creates a customer perception that a
miracu-lous and mysterious metamorphose happens to the sales force under the super-vision of consultants. In reality, when a company does not know how to optimize its own sales forces, any attention to this area that optimize sales departments performance lead to ten-to-fifteen percent increases. The consulting company has data for seven years of collaboration with clients in different industries that proves this rule. However, thanks to the customers' perception of the secret in-gredient existence and their readiness to let consultants be a part of day-to-day business operations, the consulting company now has deep expertise in more than twenty industries. Thus, perception of the secret sauce existence may work just as well as real know-how.
Maintaining strong, long-term relationships with clients may still be problematic if the consulting firm does not differentiate services sufficiently. Consultants them-selves are usually not satisfied or even demotivated with their results due to un-certainty about further project perspectives and successes. How can consulting firms stand up in the competitive consulting market and overcome that dissatis-faction in consultants' professional achievements, add more value to the client, and improve firm sustainability at the same time?
In order to make long-term relationships with clients or develop strategic resources, consulting firms may use incumbents. The term incumbent here de-scribes a professional consultant who plays the role of an implant in the body of the client's business and may continue working on a client's day-to-day needs in between the active phases of the project. The incumbent plays the role of the personal account manager or expert that, when implemented into company's or-ganizational structure, works with the client's cross-department team on a regular base in order to get more information about the client's current situation and in-dustry specifics. This tool of incumbents may help to build and maintain strong connection with client, client loyalty, and trust in the consulting company. Thus, the following insight: adding incumbents to the business model lets consulting firms build stronger relationships with clients and improves understanding of cli-ent's business. By using incumbents, consulting firms increase our differentiation, add more value to client's business, and create switching costs.
4.6. Partnership with Academia
To build a scalable business model, consulting firms' main strategy should be to increase client industry expertise and achieve a sustainable proportion of stand-ardization, where at least 70% of a firm's methodology is standardized and only 30% or less is customized. However, consulting firms cannot model in advance all potential business situations. This means that sometimes puzzle problems will arise that require deeper analysis. Solving puzzle problems may be challenging for a consulting company and may led to high time investments with uncertain results. Leveraging relationships with academia to add more expertise to projects with puzzle problems may overcome such shortcomings.
Recognizing academia as a valuable resource for consulting firms makes sense for three reasons. First, the vast majority of customers do not have access to academia and top scientific expertise. It is not so easy for customers to under-stand which academic would be interested in and benefit their project. Second, two traits of academics make them attractive collaborators with consultants: one, academics are usually bad in customer service, and two, academics are attracted to solving puzzle problems over routine problems. Consulting firms' strategic partnership and loyal relationships with academia may let them involve academics in complex clients' projects and may help firms to get loyalty from both sides.
Finally, work with academics increases the level of expertise of the consulting team, including incumbent consultants, and thus will provide consulting firms with the ongoing educational growth.
When consulting firms provide more than simple methodology and surveys to clients and actually dip into a client's business and work with specific require-ments of brand and marketing strategy, puzzle problems arise. Involving academ-ics in projects that have puzzle problems increases client loyalty, incumbent suc-cess, and academic satisfaction. This brings us to the insight that creating a con-sulting company that brings academic experience to create and maintain internal consulting proficiency may give the company a sustainable, long-term strategic advantage.
5. SUMMARY
This thesis describes three strategic insights for a pricing consulting company, and describes strategic resources to achieve a sustainable strategic differentia-tion. We propose that the company targets companies led by executives with limited business knowledge, companies with high brand value and highly differ-entiated products, and foreign ventures that operate in the US market and do not have local strategic partners with in-house pricing expertise.
Strategic competitive advantage of the described consulting company will be based on several strategic resources. Such strategic resources will help to acquire and maintain customers in long-term collaboration. Long-term and trusted relationships with customers should be one of the most important strate-gic resources of the company. The second valuable stratestrate-gic resource should be knowledge of client's industry. The third strategic resource for the company should be customer's perception of the existence of the secret source. Human capital should be among the company's strategic resources as well. And last but not the least, a strategic resource for the described consulting company should be a loyal and deep relationship with academia.
