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Analytics Magazine

QED: Six Sigma Operations: From Manufacturing to Pricing

Summer 2008

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By ManMohan S. Sodhi

The other day someone said that operations refer essentially to manufacturing. In today’s economy, it is worthwhile to discuss how operations underlie everything a company does – manufacturing, finance, human resources, IT, marketing and even pricing. Not only do all these functions have “operations,” but also ideas from manufacturing operations apply to operations in other functions. Likewise, quality control from manufacturing applies to operations in other functions as well.

I will focus on pricing. People in operations research are generally familiar with yield management or revenue management (see the excellent book by Robert Phillips in this regard [1]) but less with the idea of pricing operations of which revenue management is a part. People are also not aware that ideas of quality control such as Six Sigma apply to pricing operations. This is what I discuss here.A recently released book by coauthor Navdeep Sodhi and me [2] discusses pricing operations and application of Six Sigma to pricing operations in detail.

Pricing Operations

Pricing operations entail two types of business processes to ensure operationalizing and adhering to pricing strategy. These are:

1. Modification processes involving list modifications in response to changes in the market environment (but not changes to strategy). For instance, increased petroleum prices in 2005 caused airlines to tag special fees as a way to increase list prices; such decisions are operational because they have a decision horizon of a few months at the most. Modifying price guidelines is also an operational process. Similarly, pricing of products in the same family at a company that produces more than a few of these every year is also operational. Communicating the list price changes as regards customers and internal operations (such as ensuring the update of ERP or other systems) is also part of such operations.

2. Control processes to ensure and track adherence to price guidelines. The purpose of these processes is to ensure high levels of realized prices relative to list prices, the latter being the embodiment of pricing strategy. (Realized prices are what a company actually gets after yielding various discounts.) Control processes also track whether a price promotion was effective in getting the hoped-for incremental sales and additional profits.

List-price changes are not as frequent as individual transactions. Still, tighter operational processes make this process of modifying list prices easier. Tighter processes also ensure that once list prices are changed, these changes can be implemented in the tens of thousands of transactions that follow.

Unlike pricing strategy, operations work closely with internal processes that deal with the execution of transactions. For example, pricing operations entail observing changes in the market — say, the entry of Chinese companies like Haier in household appliance market or sharp increases in supply costs like that of oil in 2005-06. Pricing operations also translate these external changes to more restrictive or more lenient discounting guidelines, and ensure adherence to these updated guidelines.

Six Sigma Pricing

Six Sigma methodology aims for (almost) no defects using a disciplined, data-driven approach for eliminating existing defects in any repeated process – manufacturing or not. To achieve Six Sigma level of quality, a process must not produce more than 3.4 defects per million opportunities, hence the term “Six Sigma” referring to the six standard deviations around the mean of a normal distribution.

However, we can use Six Sigma as a metaphor to reduce standard deviations, i.e., the variations in repeatable processes, so that (almost) all occurrences are within acceptable limits. The variations can apply to the diameter of a pipe, the discount in different transactions or waiting time for customers in a bank (see Snee and Hoerl’s book [3] for application of Six Sigma to service operations).

The application of Six Sigma to pricing, keeping in mind the particular organizational challenges of pricing in a company, is applicable to pricing operations because these entail repeated processes. In a given company, these processes may run in an ad hoc manner despite their being repeated, thus making them even more amenable to Six Sigma Pricing. One complication of applying Six Sigma to pricing operations relative to manufacturing is the pricing processes entail several functions — these processes require all levels of people in marketing, sales, finance, customer service, IT, inventory management and legal to work together while having different incentives. On the other hand, most of the steps for processes at this level are internal to the company and therefore under the company’s control.

The physicist Richard Feynman, who once served on California’s Curriculum Commission (1964), observed that textbooks tend to copy existing textbooks. Likewise, researchers usually extend existing literature to get published. Therefore, it is easy to understand why some academics associate operations with manufacturing, harking back to a time when most of the economy depended on manufacturing. However, most of the economy is not manufacturing-based – in the United Kingdom, less than 15 percent is. Therefore, we need to consider teaching and research in the application of ideas such as Six Sigma,well honed in manufacturing, to services and pricing.

ManMohan S. Sodhi (M.Sodhi@city.ac.uk) heads the Operations Research group at Cass Business School in London.

References

1. Phillips, R., 2005, “Pricing and Revenue Optimization,” Stanford Business Books, Stanford, Calif.
2. Sodhi, M. and Sodhi, N., 2008, “Six Sigma Pricing: Improving Pricing Operations to Improve Profits,” FT/Press Prentice-Hall, N.J.
3. Snee, R.D. and Hoerl, R. W., 2005, “Six Sigma beyond the Factory Floor,” Prentice Hall, N.J.

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