Price Model Optimization
Author: Frank Frohmann
“This thing called ‘PRICE’ is really, really important. The only difference between companies ones that SUCCEED and the one that fail is that the champions figured out how to MAKE MONEY. They were deep-in thinking through the REVENUE-, PRICE-, and BUSINESS MODEL. That’s under-attended to generally.” (Steve Ballmer, Microsoft, ex CEO)
My vision is to support companies with an integrated consulting approach which tackles the challenges mentioned by Steve Ballmer. The article below gives you a first idea about the definition of business-, revenue and price model. The definition is based on more than 25 years of business experience. For more detailed information please contact us or refer to my book ‘Digitales Pricing (Springer Gabler 2018). The second edition will be published in 2022.
1. Price management processes consist of numerous challenges that have different relevance depending on the sector (B2C, B2B, C2M, C2C), industry and company.
2. Important business decisions are upstream of the pricing process: • The definition of revenue sources (the revenue model). • The definition of the value-to-customer and the operating model as central pillars of the business model. This means: professional price management must go beyond the pure optimization of the pricing process. Pricing has to reflect the higher-level decisions on the business model and the revenue model (cf. Frohmann, 2018).
3. In digital business models (platforms, marketplaces, ecosystems, etc.), price is no longer a reliable metric for competitive pressure. Many companies (like Google, Amazon, Alibaba or Tencent) cross-subsidize parts of their business. Not all business units have to contribute to profit. Services are therefore offered for free (Google, e.g., search engine, cell phone operating system) or below production costs (Amazon, e.g., Kindle Fire).
The Levels of Digital Pricing at a Glance
The starting point for digital pricing is the business model (cf. Figure 1). A business model is a structured representation of the value creation and value extraction of a company (cf. Osterwalder & Pigneur, 2010).
The business model definition results in potential revenue sources (products, services, software, digital content, advertising, digital services, etc.). The revenue model of a company or business unit answers the following questions, among others (cf. Frohmann, 2018, p.55ff):
1. With which business offers do we want to generate revenues?
2. Which revenues come from which sources?
3. Can individual revenue sources be combined? Or do we want to offer our business services separately? Most companies operate with multi-tier revenue models. Particularly in the case of digital business models, these are based on a deliberate decision not to generate revenue from certain offers. Examples of two-part revenue models are:
1. Software for free - make money on advertising. Google offers the Android software free of charge. In this way, it promotes the penetration of its mobile operating system, the number of users and its revenues through context-specific advertising.
2. Service for free - make money on advertising Google offers its search engine for free. Advertisers pay for access to user data. Facebook uses the same revenue model for its social media platform.
3. Software for free - bundled with paid service Red Hat Linux offers its open-source software for free. Services must be paid for by customers.
Similarly, there are revenue models that aim to generate revenue in all components. One of these 2-part revenue models is "Bait and Hook".
"Bait and Hook" is based on the revenue linkage of 2 products that are used jointly. Revenue is generated with both components. Very important for subsequent pricing processes (price level optimization and price model definition) is: The link consists of a durable good and a consumer good that is consumed at regular intervals.
Examples of this are the following product combinations:
• Copier and paper
• Razor and razor blade
• Printer and cartridge
• Water descaler and water filter.
With increasing penetration of digitalization, “Freemium” has become a successful revenue model in numerous industries. 2-tier freemium models are particularly relevant for digital services such as software, content, video games, apps, contact platforms and social networks. The distinction between user perspective and company perspective serves as an explanation: From the user's perspective: "Freemium" is a combination of free and fee-based parts of the offer ("basic for free, premium for fee"). The free version is associated with limited functionalities. Extensions of the basic version (e.g., via premium features) are subject to a charge.
From a provider's perspective: Many freemium models rely on 2 main sources of revenue:
• Digital service.
The world's largest music streaming provider Spotify operates with a "freemium” revenue model. Crucially, there are several potential price models for the premium component. For music streaming, for example, subscriptions (e.g. Spotify) or pay-per-use (e.g. Apple i-Tunes).
Definition Price Model
A price model is based on the revenue model definition. It is created by logically linking six essential pillars.
The six dimensions (see Figure 3) of a price model can be defined based on the following questions:
1. Are business services combined into a bundle or do we charge for a
single offer? → Scope
2. What does the customer pay for? → Reference base
3. How many components does the price model contain? What is the unit of measure? → Price metric
4. How does the customer pay? → Form of payment
5. Who sets the price? → Degree of interaction 6. at what point of time is the price set? → Time of price setting
Price models (how much to charge?) define the qualitative basis to which quantitative price levels (how to charge?) refer. All six dimensions of a price model are logically linked. Linking the answers to each of the six outlined questions defines a model.
1. Scope: As a direct consequence of the higher-level revenue model definition, the number of revenue sources is defined. A current example is the "Apple One" price model. This involves the bundling of 4 revenue sources from the field of digital services (Apple Music, TV+, Arcade and News+).
2. The Reference Base of a price model is based on the question: which offer is the customer paying for? Traditionally, customers pay for a transaction, such as the purchase of a product (ownership) or service.
Other potential reference bases are (cf. Buxmann/Lehmann, 2009, p.519ff.; Stoppel, 2016, p.58ff; Frohmann, 2018, p.227ff):
a. Access: the customer pays for access to an offering.
b. Usage: the user pays to use a revenue source (e.g. products, services, software, digital content, digital services).
c. Outcome: Customers pay based on the results achieved. Fulfilled value propositions are monetized.
d. Success: customers pay for achieving a defined economic outcome (cost reduction, profit increase, profitability improvement).
3. The price metric is defined by 2 elements: The unit of measure and the number of price components. In particular, the unit of measure can take different forms, depending on the revenue source. Examples are: Price per transaction, Price per storage requirement (in GB), Price per usage in hours or minutes, Price per mile, Price per number of users.
As 3 further pillars of the price model, payment form, degree of interaction and time are added (cf. Figure 3). These serve to describe in more detail how the price model is implemented for the customer.
The logical connection of the answers to the questions outlined above defines a price model. Example: A flat subscription model for music streaming (e.g. Apple Music) refers to „a single revenue source“ - is based on “access” - covers „1 component“ and a „monthly rate per user“ - is based on “regular payments” – is “not interactive” and an “ex ante price model".
The following Figure 4 serves to precisely delineate the 2 challenges (revenue model definition and pricing model optimization). The figure shows 4 revenue sources (software, digital services, advertising and digital content) for Google's automotive division as an example. The 4 revenue components result in 4 potential price models for the different services of Google's "autonomous driving" business model (license fee, two-part rate (base fee + cost per minute), auction/pay-per-click and subscription).
The Reference base in particular is of enormous importance in the definition of the price model, as it determines the first milestone with regard to the price level decision.
Price models which are based on ownership or access are usage-independent systems. Across different offers, a common denominator is established to which the respective price level (in the numerator) refers. This promotes the comparability of prices from different competitors. This forces the intensity of price competition. A particularly striking example is the music streaming business, in which all competitors operate with a similar pricing model. Subscription models are interesting for some companies, but they are only one of numerous price model options.
Many B2C and B2B companies have been able to differentiate themselves with usage-based approaches. Examples of sectors that apply "pay-per-use" are:
• Car insurance
• Sharing business models (e.g. bike sharing, car sharing, e-scooters)
• Online advertising (pay per action).
Ultimately, a customer only ever pays for the satisfaction of a need or the solution to a problem. The needs-based perspective generates a much broader basis for price model design. Digitalization triggered the evolution of price models which led to value-driven reference bases:
Innovative price models focus on the customer's benefit (outcome, success) rather than the transaction, access or usage. In creative - outcome-based - approaches the reference base is aligned with the value drivers of a product. Value metric and price metric are fully aligned.
The basic idea of an outcome-based price models can be described using a case study from the B2B sector. In mechanical engineering, pricing is traditionally done on a unit basis: The business customer pays for a machine or the purchase of certain components. But: the actual benefit results from the service provided by the machine and the resulting end product. Therefore, an outcome-based reference base for the price model is appropriate. The basis of assessment is then no longer the machine, but its performance (e.g., the products manufactured or the number of operating hours). Outcome-based approaches exist in various forms:
• Price per “mileage” (Michelin)
• Price per “cubic meter of purified water” (Enviro Falk)
• Price as a “function of transported weight” (Schindler)
• Price per “laugh” (Pay-per-smile; Comedy theater in Barcelona: Teatreneu)
All 4 examples demonstrate the enormous potential of digital technologies (operating model, level 1) for Price Management processes (level 3). Optimizing products, developing new services and designing creative price models go hand in hand. In the case of innovations or significant product improvements, a variation in the pricing model is often the decisive lever for profit optimization.
One of numerous examples is Michelin's "pay per mile" approach in the B2B segment (truck tires). With the traditional pricing approach, Michelin would not have been able to implement a price increase in a double-digit percentage range. Monetization of the technical advantage required a completely new pricing model (from "price per tire" to "price per mile").
In success-based price models, the company's revenue is based on the economic benefit that the customer derives from the offer. Billing is not based on a discrete unit (e.g., time or data volume). The wind turbine manufacturer Enercon offers a successful price model example. Enercon only generates revenue when its turbines generate electricity for the customer. The higher the running performance of the wind turbines (and the electricity generated as a result), the higher the customer's payment to Enercon. The basis for this is digitalized value-generation processes, including automated recording of the necessary process data and sophisticated measurement technology. The price metric is the running performance of each individual wind turbine recorded via sensors. Through its creative pricing model, the manufacturer takes some of the risk off its business customers. If the return is low, Enercon earns correspondingly less.
Conclusion: Price Model Optimization
Digitization offers enormous opportunities for differentiation in pricing. Not via the price level as such (numerator of the price formula). But via the price model (the "denominator"). The object of price model design is to answer the questions for what, when, by whom and on the basis of which parameters the price is designed. Innovative price models do not only lead to a better monetization of the benefit. As an independent value driver for the customer they increase the value-to-customer (and thus enhance the business model)! The consequence of this: price management is not only "value capture" (monetization). Pricing can also contribute to value “generation”. The selection of the optimal price model is a complex process that requires methodical support. A prerequisite for decision support logics for price model optimization is a stringent definition (cf. Digital Pricing, p. 239f).
The introduction of new price models in the market should be carefully planned and prepared. The decisive factor is the benefit argumentation for the customer.