Digital Pricing: The role of price management in the digital transformation

Digital Pricing: The role of price management in the digital transformation

by Frank Frohmann

Key points:

• Digital price management is still limited to topics such as “automated pricing” (AI pricing), “dynamic pricing” or “price management for online channels”. But that is too short-sighted.
• The digital transformation of successful B2B and B2C companies encourages innovation on three contextually related levels: in business models, in revenue models and across the pricing process. All three dimensions are the subject of “Digital Pricing”.
• Innovative pricing models not only lead to better monetization of the usage, but are also an independent value driver for the customer. Creative price models increase the value-to-customer (and thus enhance the business model)! So price management is by no means just monetization. Digital pricing can also contribute to value generation.
• The first part of the article describes the basics of digital pricing. The first two levels (business and revenue models) are briefly outlined. A particular challenge in the context of the pricing process is also highlighted: The “pricing model optimization”.
• The second part of the article describes subscription models in more detail. The final part consists of price-psychological aspects. Psychological tactics and their connection to the pricing process close the circle to the core statement of the article: Digital pricing starts with “Value-to-Customer”!

Digital Pricing: Major earning leverage – in both directions

Pricing decisions are the main earning leverage for companies. This might be known, but is nevertheless still described too undifferentiated. Because this correlation applies in both directions: Pricing involves the greatest opportunity, but also the greatest risk. Price increases can significantly increase revenue and profit if a company has a strong “pricing power”.

Take Netflix the end of 2017 as an example: a price increase of 10% increased the operating profit by 71%. But it can also be the other way round: In the worst case, a price cut can result in a sharp decrease in profits. A particularly telling case at industry level: in 2009, all IATA airlines worldwide suffered losses of over 11 billion dollars. And this despite the fact that airlines – earlier than other industries – had already implemented highly professional pricing processes. Revenue management was already implemented there at the end of the 1960s, whereas today it is sometimes being sold as “new” using the buzzword “dynamic pricing”.  One of many examples at company level: Microsoft lost 4 billion dollars with its X-Box between 2002 (market launch) and 2006. The core error: Too high a starting price in comparison to Sony. All subsequent price reductions (from 479 € to 99 €) were not sufficient to compensate for the incorrect positioning.

“Digital Pricing”: 3 Levels

However, the price optimization for corporate products and services (e.g. products such as game consoles, services such as air travel, digital services such as video streaming) outlined on the basis of the 3 examples is only one facet of price management! Pricing is preceded by important business decisions:

1. the determination of revenue sources (the revenue model)

2. the definition of customer benefit (value-to-customer) as a central pillar of the business model

This means that professional price management must go beyond the pure optimization of the pricing process to reflect the higher-level decisions on the business model and the revenue model. These interactions have reached a new dimension with the increasing digitalization of economic life. Numerous success stories from companies demonstrate how digital technologies can be used to generate and successfully exploit customer benefits.

Practical example B2B:

Hitachi shall be briefly outlined here: A few years ago, the company changed the architecture of value creation (“operating model”) in one of its B2B business areas. The latest sensor technologies were integrated into Hitachi’s train systems. These new measurement methods allowed a significant improvement in the punctuality rate of trains (value-to-customer). The business model was transformed from “selling products” to “offering software-based services”. B2B customers (such as UK Rail networks) were offered “punctuality” as a “train-as-a-service” concept. The consequence of the business model innovation: The revenue model changed from one-off payments (for products) to continuous, time-distributed payment flows for a software-based service. The pricing model is derived from the higher-level revenue model as follows: The better the punctuality rate, the higher the price.

Practical example B2C:

A second practical example – from the B2C business – is based on the same revenue model as Hitachi. The Spanish train operator AVE went one step further in its retail pricing model: AVE offers passengers a punctuality guarantee for the inner-Spanish connection Barcelona – Madrid. If the service promise is not fulfilled, the traveler will be refunded the full purchase amount. Both practical examples relate to the connection of business and revenue modeling and the pricing process.

The necessary basis of the 3-step digital transformation are new technologies (sensor technology, Internet of Things, cloud, artificial intelligence etc.). But it is only the viable customer requirement and its fulfilment through innovative approaches that turns the technological potential into a market opportunity that can be monetized. This applies to the large technology groups (such as Amazon, Alphabet, Apple, Microsoft) as well as to start-ups (e.g. Google Waymo and Flixbus after the liberalization of the long-distance bus market in 2013). Industrial companies that meet future challenges with innovative digital business models (such as Trumpf, Bosch, Siemens etc.) also offer a wealth of successful practical examples.

Business model: Starting point for digital price management (level 1)

 Successful “Digital Pricing” starts with aligning the business model to customer needs! If there is insufficient willingness to pay in the market or the business model is not sustainable, this cannot be offset even by the best algorithm. Tools, methods and automated pricing mechanisms are important, but only a necessary prerequisite.

Consequently, “digital pricing” approaches such as “dynamic pricing” alone are no guarantee for business success. The transport service provider Uber – as one of the protagonists of dynamic pricing – has been making billions in losses for years. The shocking thing about it is that the losses are increasing dramatically (most recently; $3 billion with a turnover of $11 billion). Uber competitor Addison Lee, on the other hand, takes a completely different approach and differentiates itself through a simple pricing policy. The philosophy of “each ride guarantees the same price” is: simplicity and predictability for the customer (“no negative surprise”). Addison Lee’s core value-to-customer is price fairness. Price fairness is also becoming increasingly important in other sectors – especially in B2B.

In digital business models (platforms, marketplaces, ecosystems etc.) price is no longer a reliable indicator of competition. There are numerous reasons for this. Two main reasons should be mentioned here:

1. Many companies (such as Google, Amazon, Alibaba or Tencent) cross-subsidize parts of their business. Not all business areas have to contribute to profits. Services or products are therefore often offered for free (Google) or below cost (Amazon).

2. In digital business models, customers can pay with a different form of value than money. With attention, for example, in the context of freemium models. Here they accept advertising to be able to use the “Free” component for no cost. But they can also pay with their data (as in the case of Facebook and Google).

This observation leads to the second aspect of “Digital Pricing”: the revenue model.

Revenue model (level 2): Hinge between business model and pricing process

The revenue model answers the following questions:

• which services does the company want to earn money with?
• what revenues result from which sources?
• how can we open up new sources of revenue?

Digital business models lead to a radical change in the revenue models of companies. In most sectors, revenue shares are shifting from products (hardware) to services, software and digital content. Advertising (e.g. Google and Facebook) and data have also gained in importance as revenue sources.

Case study 1: Google Waymo

The Google subsidiary defines four revenue sources as part of its “autonomous driving” business model: Sale of software and know-how; transport services (people + freight); advertising and content offers in the vehicle. However, self-driving cars are not sold. In other words: products are not part of the revenue model.

Case study 2: Car manufacturers

OEMs supplement their core business (selling cars) with digital services such as car sharing, ridehailing or more flexible rental models.

Case study 3: Amazon

The tech company defines the value delivery to the customer primarily through content. Hardware only has second priority. Electronic devices like the e-book reader are the key lever for the profitable core business with digital content. Content (such as e-books) is the main revenue driver and tends to be sold at profitable prices. Hardware (e.g. readers for electronic books) is sometimes even offered below the variable costs.

Case study 4: Google

Google’s revenue model for its hardware offering follows the same principles as Amazon’s end device business. Google defines hardware (such as the Smartphone Pixel) primarily as a lever for the profitable follow-up business with software, services and applications. End devices are designed to encourage users to use Google services. Profits mainly result from the use of online services. 95 % of Google’s turnover is generated with advertising revenues.

Online advertising is also becoming more important in the case of Amazon (example 3) and in the mobility business (examples 1 and 2). In the case of Amazon, revenues from online advertising are expected to even exceed revenues from the cloud business (Amazon Web Services) next year.

The consequence of the significant expansion of revenue models is that pricing faces far more challenges than 10 years ago. In more and more cases, the first question that arises is which services should be priced at all. This challenge must be optimized before dealing with the details of the pricing process (price level, pricing model, rebates, discounts and incentives).   

Pricing process (level 3): Specification of decisions on the business and revenue model  

 The pricing process is one of the most important value creation processes of companies. It comprises various phases, the details of which vary depending on the industry. The process approach with the stages

• Analysis
• Strategy
• Structure
• Implementation
• Monitoring

can be made significantly more efficient through new technologies such as IoT, AI, Cloud or Blockchain. The decisive factor here is: without a stringent process, even the most sophisticated technology cannot be sensibly implemented. The process sometimes involves up to a hundred individual stages. It translates the strategy into concrete pricing decisions (price points, differentiation approaches, innovative pricing models, etc.). These form the starting point for the structure of price negotiations and the establishment of prices on the market. The optimization of price levels is a central process phase of particular importance for the monetarization of value. 

What is important is that price management goes far beyond setting prices (and the examples outlined at the beginning). It is also about creating value for the customer, for example by introducing creative structures and pricing models. Successful companies develop a stringent system of value extraction. They adopt a pricing process whose elements are consistent across all levels.

The 3 level model of “Digital Pricing

Creative price models as a starting point for differentiation

Digitization offers enormous opportunities for differentiation in pricing. Not through the amount of the price as such (numerator of the price equation). But through the price model (the “denominator” of the price in the mathematical sense). The price model is not about optimizing the amount the customer pays, but about the reference value: what, how, when and in what form does the customer pay? Innovative price models have been created by Michelin (car tires; “price per kilometer”), Enercon (wind turbines; “price per output/kilowatt hour”), BASF (car paints; “cost per unit”) and Schindler (elevators; “price per transported weight”), among others. In B2C markets, creativity – based on new technologies such as AI – is almost limitless. An example is the “pay per smile” pricing model (Barcelona theatre). “Smile to pay” in turn goes back to the idea of Tencent in China to completely digitalize the customers buying process. Especially important in this context: An innovative pricing model not only leads to a better monetization of the usage, but is an independent value driver: it increases the value-to-customer! Price management is therefore not only “value skimming”, but can also contribute to value generation. Companies can choose from a variety of potential pricing models. “Subscription”, “pay-per-use” and “Freemium” are only 3 options – from a much larger portfolio – of possible pricing models.

The second part of the article describes subscription models in more detail.

About Frank Frohmann:

Frank Frohmann has already been engaged with questions of digitalization in projects for B2C and B2B companies at the end of the 90s. His comprehensive wealth of experience with digitization strategies and price optimization is based on three main fields of activity: External management consulting (Simon-Kucher & Partners; since 1996), operational price management (Lufthansa; cargo and passenger) and in-house consulting (Bosch and Evonik, among others). His book “Digitales Pricing” (only available in German) was published by Springer Verlag in September 2018.

Frohmann has been working as Business Development Manager Pricing at Vistex GmbH since September 2019.

About Vistex:

Vistex Inc. was founded in 1999 and has its headquarters in Hoffman Estates, USA. As a Global Solution Extensions Partner of SAP SE, the company offers SAP-based IT solutions with specialization for the automotive, chemical, consumer goods, food, high-tech, manufacturing and pharmaceutical industries, as well as retail and wholesale, especially in the go-to-market sector. 

At the Subscription Leaders Summit in October 2019 in Frankfurt, more than 120 participants met to discuss the future of the subscription business in six keynotes, three panels and six deep dive sessions. Frank Frohmann led the Deep Dive Session on the topic of “Pricing”.

The video shows the highlights of the event.