09/07/2019
5 QUESTIONS TO CONSIDER WHEN PRICING.
Imagine you are the CEO of an oral care company and you have been selling a product called the Power Brush 2000, a good electric toothbrush. Your revenue model was likely focused on profiting from selling the toothbrush with some creative pricing coming from the replacement heads (a typical “razor-razorblade” model perhaps with a subscription plan à la Dollar Shave Club). Now, your R&D group has a new product ready for launch, a toothbrush for the 21st century. The toothbrush is smart (it has built-in sensors and AI to detect plaques and cavities) and is connected via Bluetooth to the Internet. So, let’s call it the Smart Connect XL3000. Your job now is to price the Smart Connect XL3000, or, more broadly speaking, to articulate a revenue model.
The revenue model is one of the most important elements of a firm’s strategy. It defines the ways in which a firm gets compensated for the value that its products or services generate. In the old days, revenue models primarily consisted of picking a “good” price. Connected, smart devices are changing this paradigm.
Companies that pursue what we call a connected strategy (ie., those that transform their connection to customers from episodic interactions to a more frequent and data-driven relationship) have a bigger set of revenue models to choose from. In other words, the price can now depend on factors that previously could not be used to influence the pricing decision. To think systematically about revenue models and to spot opportunities for improvement, we find it helpful to ask the following five questions:
What is paid for?
When is the payment made?
Who is paying?
Why does the customer pay?
What currency is the customer using?
Let’s look at each of the five questions in detail.
Change what is paid for: pay-for-performance
Customers face uncertainty about how good a product or service is. A customer might be willing to pay $500 for a toothbrush that prevents cavities, but how can the customer be sure that the toothbrush will really work? Pay-for-performance solves this problem. Customers don’t buy the product or service, but pay for the value created. In the case of the Smart Connect XL 3000, we might charge customers $10/month as long as their teeth are healthy. This revenue model is now feasible, since with a connected device it’s possible to monitor whether the product has been used (correctly).
Change when the payment is made: pay as you go.
Customers usually derive benefit over time. You buy running shoes and run 500 miles in them. You use your toothbrush every day. Traditionally, in episodic relationships, payment happens upfront. Of course, your customer could mail you 50 cents every time she is using her toothbrush, but that’s not feasible and you probably wouldn’t trust your customer to do it consistently.
In a connected relationship, these problems disappear. Your toothbrush, connected to the customer’s phone, could charge 10 cents per minute of use. This is the pay-as-you-go model. We start seeing this revenue model in many B2B relationships. For instance, Rolls-Royce is not selling jet engines anymore, but selling “power by the hour” to airlines, charging for every hour its jet engines are in use.
Further Reading
A related model is “freemium,” where firms like Dropbox, LinkedIn, and many video game developers provide a free version and charge for access to premium features. What makes many freemium models feasible is the ability to manage micropayments. Few consumers would be willing to pay $300 upfront for a video game they play on their phone. But, many are willing to spend 99 cents every day to upgrade their characters, buy special weapons, access hidden levels, and speed progress in the game. After a year, they have easily spent $300. But since payments are small and at exactly the time the value is created (“Wow, I was able to win this battle and level up!”), customers are quite happy to pay. These small sums can add up. It has been estimated that the free mobile game Clash of Clans has earned more than $3.5 billion through in-app purchases (of products that practically have zero cost of production).
Change who is paying: think eco-system, not supply chain.
Research in strategic management has moved the focus from the supply chain to the ecosystem. The ecosystem is much broader and includes all firms related to your product. To identify your ecosystem members, ask yourself, “Who else would derive value from our product?” If you are selling a connected toothbrush that avoids cavities and can make automatic bookings for bi-annual check-ups, dental insurers and dentists might be willing to contribute some money.
Change why the customers pay: address more fundamental needs.
The more you understand your customer’s true needs, the broader the set of services that your customer is willing to pay for. For instance, one of Nike’s customers might not just want to run, but to finish her first marathon. If Nike can help her achieve that goal by allowing her to track her performance and connecting her to a virtual running club, her willingness to pay might be much higher than just paying for a shoe. Consumers don’t buy a toothbrush because they like the brushing — it is the healthy teeth, or the wonderful smile, they want.
Change what currency the customer is using: paying with data.
One further revenue model could be to give the toothbrush away (or sell it way below cost) and make money based on oral health data you are collecting. Indeed, several of the most successful connected strategy companies give away their product. Google, Facebook and LinkedIn offer services for free. But nothing is free. Users pay in data.
“Free” services have created a gold rush of firms collecting as much data as possible by any means available. We caution those reselling data. A truly sustainable revenue model requires firms to show clearly how the data they are collecting creates some benefit for its customers. Unless there is a quid pro quo, customers eventually will become disenchanted and will disconnect.
To maximize value, a connected strategy revenue model identifies the ecosystem’s players, understands their conflicting objectives, and leverages technology. Value is maximized when the corrosive forces of limited information, limited trust, and transactional friction are overcome, fostering a connected relationship. In this vast universe of considerations, those focusing primarily on pricing forfeit the competitive advantage that a continuous relationship with customers can deliver.
Credit: Nicolaj Siggelkow - a professor of Management and strategy at Wharton University and a co-author of Connected Strategy(Harvard Business Review Press, 2019)
