Pricing model optimisation

Pricing model optimisation – best practice methods in the subscription business

Important facts about pricing model optimisation

• Digitalisation offers enormous opportunities for differentiation in pricing. Not via the price amount as such (numerator of the price formula). But rather via the pricing model (the “denominator” of the price).
  The object of price modelling is to answer the questions for what, when, by whom and on the basis of which parameters the price is formed.
• Innovative pricing models not only lead to a better monetization of the benefit, but are 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 just “value skimming” (monetization). Pricing can also contribute to value generation.
• Subscription models are of interest to many companies, but are only one of many pricing model options.

• Many B2C and B2B companies have differentiated themselves with “pay-per-use” approaches. Usage-based (such as “pay-per-use”) or benefit-based (“outcome-based”, “performance-based”) price models are based on fundamentally different objectives, prerequisites and success criteria than usage-independent price models (subscriptions).

• Even though subscription models are becoming increasingly important in many industries: Subscription models are no guarantee for profits if the higher-level business model is not sustainable. Numerous recent examples from the automotive, airline, ride-hailing, bike-sharing etc. sectors prove this.
• The selection of the optimal pricing model is a complex process that requires methodical support. The prerequisite for decision support logics for price model optimisation is a stringent differentiation (see article series on the differentiation of price models and revenue models).
• The introduction of new pricing models in the market should be carefully planned and prepared. The benefit argumentation for the customer is crucial. The chances of successfully introducing an innovative pricing model are all the greater
  • the better customer needs are addressed, which have not been taken into account so far;
  • the more differentiated the services on which pricing models are based
  • the stronger the market position of the company.

Success factor #Pricing

• Digital Pricing: The role of price management in the digital transformation
• Price optimization – The role of modern methods for market success
• Optimal pricing – The best methods for the pricing process
• Price determination – methods for optimal pricing decisions
• The right pricing strategy

The revenue model

The revenue model of a company or business unit answers the following questions:

• With which services do we want to generate turnover?
• Which revenues come from which sources?
• Can individual revenue sources be combined? Or do we want to offer and invoice products, services, software, digital services and content separately?
• At which levels of the value chain do we want to generate revenues?
• Who are our revenue partners? From whom do we obtain revenues?
• Is it possible to open up completely new revenue sources? How would our offering have to be changed in order to tap into new revenue potential?

The pricing model

A pricing model is based on the revenue model definition. It results from the logical linking of six essential pillars.

The six dimensions of a pricing model can be defined by asking the following questions:

1 What does the customer pay for? → Basis of assessment
2. How many components does the price include? What is the measuring unit? → Price metrics
3. How does the customer pay? → Form of payment
4. Who sets the price? → Degree of interaction
5. At what time is the price set? → Date of pricing
6. Are services bundled or is a single service charged for? → Bundling vs. individual pricing.

The following exemplary illustrations of the revenue model and the illustration to derive 4 pricing models for 4 revenue sources serve to precisely define and integrate the two challenges.

The right-hand illustration shows four revenue sources (software, hardware, training and hotline) for Google’s automotive division.

The four revenue components result in four different pricing models for the partial services of Google’s “autonomous driving” business model, as can be seen in the illustration on the right.

In this article, the Pillar 1 – assessment base – is described in more detail. For all details of price model optimisation, please refer to the following source: a) Book “Digital Pricing”, Frank Frohmann, Springer Gabler (2018), pp. 218-253. b) Whitepaper “Digital Transformation and Pricing” (2019), pages 23-33.

Assessment basis of a pricing model

The assessment basis of a pricing model is based on the question: For which service does the customer pay? Traditionally, customers pay for a product or service; price per product (household appliance, car or smartphone), price per service unit, etc. The customer makes a one-off payment. Input-based models promote price transparency in the market. A common denominator is established across different offers, to which the respective price amount (in the meter) refers. This promotes the comparability of prices of different competitors. Thus the intensity of price competition is increased.

Ultimately, however, the customer is concerned with the contribution a product makes to satisfying his needs. The customer’s needs (and thus his willingness to pay) are usually not directed towards the possession of a product. Customers are concerned with the use of services; or to put it another way: The fulfilment of needs. For B2B customers, but also for the B2C business, the following applies: In the end, a customer always pays only for the satisfaction of a need or the solution of a problem. The needs-based perspective generates a much broader basis for price modelling; it is the catalyst for creative pricing models that are more closely geared to the output of the company. These include, for example, pay-per-use or pay-as-you-go models in B2C business. Innovative pricing models focus more on the use (or benefit to the customer) rather than the ownership of a product. In creative approaches, the assessment basis is oriented towards the value drivers of a product. The ideal starting point for modelling is value driver analysis (see Article 5 Price Determination – Methods for optimal pricing decisions). The VDA enables the methodical derivation of the customer-relevant feature that differentiates the offer most strongly from the competition. This results in a direct reference to the superordinate business model and the definition of the value proposition.

A basic distinction is made between usage-based and usage-independent pricing models.

Usage-independent assessment bases

A variant of a usage-independent pricing model used especially in digital industries is the subscription. Subscription models are often implemented in the form of a flat rate. A flat rate (all-inclusive tariff) is a unit price independent of the actual use of the offer. A flat rate is a variant of non-linear pricing, since the price per unit decreases with increasing usage. Subscription models are popular in many industries. Subscription pricing has established itself especially for digital products: streaming platforms offer unlimited access to digital content in the areas of music and film. The two global market leaders Spotify (in the case of music) and Netflix (for films and series) are well-known examples. But it is not only in the case of information goods that subscription models are increasingly gaining acceptance. Flat-rate tariffs are also being used for market penetration in digital business models of traditional product sectors. The monthly subscription Access by BMW allows customers to switch between different car models at short notice. Bookings are made via App. BMW offers two rental packages with different prices. Porsche (with Porsche Passport) and Mercedes (with Me Flexperience) introduced similar flat rate programmes.

The advantages and disadvantages of a subscription model can be summarised as follows.

Advantages from the customer perspective:

• Full cost transparency
• Simplicity
• Budget control (due to the decoupling of consumption and payment)
• Convenience
• The average price per unit falls as the customer’s total usage increases. For frequent users, there are economic advantages compared to a usage-based tariff.

Advantages from the provider perspective:

The advantages of a subscription model for companies arise primarily from customer perception and from price-psychological findings:

• Many customers find it difficult to assess their actual usage correctly. Demanders very often overestimate their own consumer behaviour. The advantages of a flat rate are overestimated by few users. This “flat rate bias” benefits the providers.
• The option of unlimited use tends to be associated with a higher willingness to pay on the part of customers.
• The reduction in the price complexity of the provider is also rewarded by a higher willingness to pay on the part of the customer (“pay for ease”). The simplicity of the pricing model is a value driver and increases the maximum price of the user.
• Customers avoid both losses and risks (“loss aversion”). Flat rate tariffs address the users’ security awareness. This explains why some users choose flat rates even when an alternative pay-per-use tariff is objectively cheaper. From a psychological point of view, a flat rate has the effect of insuring against the risk of unplanned additional costs. The arguments in favour of a subscription apply in particular to frequently consumed consumer goods, including above all information goods. In the case of digital offers, the increasing data consumption of users favours the acceptance of flat rates. More and more customers prefer an unrestricted freedom from worries in the form of unlimited data volume at a guaranteed price. The differences in the usage behaviour of different customer segments form the economic basis for subscription models. The flat rate level is determined in a mixed calculation. Customers who make little use of the offer are more profitable for the company than average. They contribute to the financing of frequent users, whose profit contribution is negative due to their high use of company resources.

Disadvantages from the provider perspective:

Demanders differ in their preferences and price willingness. The better it is possible to reflect these differences in price and supply, the greater the market exploitation. The profit that can in principle be skimmed off is given away in two ways with unit prices:

• Loss of margin: Certain sales volumes that could be realised even at higher prices are only contracted at the unit price. Price willingness above the level of the flat rate cannot be skimmed off.
• Loss of volume: Potential customers whose willingness to pay below the flat rate level cannot be won with the flat rate offer. The disadvantages outlined above explain, among other things, why some subscription models have so far been more than difficult to attract in terms of profitability.

Case study music streaming: Spotify

The world market leader in music streaming has – at least so far – not been able to operate significantly profitably. And this despite the fact that Spotify has over 200 million users worldwide (including 100 million subscription customers (premium account)). The business model of the B2C platform (“content provider for music streaming”) is based on content that has to be purchased expensively by the rights holders (the music labels). A way out of the losses is hardly possible through economies of scale. This distinguishes Spotify from the other large digitised groups. Spotify’s costs grow with the number of users. In contrast, the video streaming service Netflix pays fixed prices (flat-rate fees) for third-party content. Netflix also produces a lot of content itself. The consequence of this: Netflix profits from economies of scale! The revenue-cost gap opens up as users grow and the streaming market leader is profitable. In the case of Spotify, the effect will never materialise – unless you start with the structures of the business model. As the cost structure is unlikely to be significantly influenced, Spotify has to focus on a second pillar of the profit model – the revenue streams. Within the framework of a “freemium model” Spotify is currently building on two main revenue sources: 1. advertising revenues and 2. paid content (via a simple subscription model) The question is whether profits can be realised in the future by tapping other revenue sources. The starting point and basic prerequisite for the redefinition of the revenue model is the analysis of the value creation processes. The analysis in the case of Spotify shows the following: The benefit for the end customer is very high. Compared to its strongest competitors Apple Music, Amazon and Youtube, the market leader offers a higher performance in terms of personalised offers and listening suggestions. This is demonstrated by the enormous growth figures and the relatively high proportion of paying subscription customers in the premium version. By mid-2019, the Swedish streaming pioneer already had over 100 million subscription users. This raises a crucial question: Who are the other participants in the value chain? Musicians, record companies (labels) and concert organisers. All parties involved can benefit from the huge data treasure of Spotify. With its unique knowledge of user preferences, Spotify could provide both labels and artists with direct access to fans. The following is one of many examples of new value creation opportunities: Artists’ tour plans can be tailored more precisely based on the extensive data analysis. Spotify has full transparency about which artists and titles are heard particularly often in which countries. This added value for the value-added partners can be monetised via corresponding revenue and pricing models. The revenue base would thus be significantly expanded. Spotify would be able to generate revenues with end users as well as artists, promoters and music labels.
One final sentence on Spotify’s main competitor, Apple Music. Unlike Spotify, music streaming is only one element of Apple’s business model. The digital service need not necessarily be profitable on its own.

Usage-based assessment bases

The basic idea of a usage-based pricing model can be described using a case study from the B2B sector. In mechanical engineering, pricing is traditionally based on units: the business customer pays for a machine or the purchase of certain components. The business customer is actually only indirectly interested in the product. The actual benefit results from the performance provided by the machine and the resulting end product. Therefore, an output-oriented reference basis for the pricing model is appropriate. The assessment basis is then no longer the machine, but its performance. The customer does not pay a fixed price for a machine. Invoicing is based on the service rendered (e.g. the products manufactured or the number of operating hours). In the course of increasing digitisation, usage-oriented pricing models are becoming more and more important, especially for information goods. They are replacing the traditional pricing model in more and more sectors. The customer no longer pays for the digital offer, but only for its actual use. Pay-per-use approaches exist in various forms. Selected examples of usage-based assessment bases are:

• Price per mileage (Michelin)
• Price per cubic meter of purified water (Enviro Falk)
• Price depending on the transported weight (Schindler)

All three examples demonstrate the enormous potential of digital technologies. The optimisation of products, the development of new services and the design of creative pricing models go hand in hand. In the case of innovations or significant product improvements, a variation of the pricing model is often the decisive lever for profit optimisation. One of many examples is Michelin’s “pay per mile” approach in the B2B segment (truck tyres). With the traditional pricing approach, Michelin would not have been able to implement a price increase in the significant double-digit percentage range despite the enormous performance improvement. The existing market prices as an anchor would not have allowed a significant price increase. The monetarisation of the technical lead could only take place in the course of objective proof of performance – in the sense of longer mileage. This required a completely new pricing model (from “price per tyre” to “price per kilometre”).

In the course of digitalisation, numerous variations of the pay-per-use model developed. Pay-per-click models ensure the billing of online advertising. The basis for payment is not the placement of advertising (as in classical print media). The basis of pricing is the success of the communication. Only the use of digital advertising (e.g. the clicking of advertisements by interested parties) leads to costs for the advertising customer.

Outcome based pricing

A special form of usage-based pricing is based on the revenue model of value sharing. The company bases its revenues on the economic benefit that the customer derives from the service. Billing is not based on a discrete unit (e.g. time or data volume). Payment by the customer is based on his economic return. This requires a quantification of the economic consequences of product use. Value sharing is thus by definition more likely to be used in B2B business. A successful example of a quantified distribution of added value between suppliers and customers is provided by the wind turbine manufacturer Enercon. Enercon only generates revenues if its turbines generate electricity for the customer. The higher the running capacity of the wind turbines and the resulting electricity generation, the higher the payment from the customer to Enercon. The basis for this is digitalised value-added processes, including the automated recording of the necessary process data and sophisticated measurement technology. The decisive measured variable is the running performance of each individual wind turbine recorded by sensors. With its creative pricing model, the manufacturer takes some of the risk off its business customers. Enercon earns correspondingly less at low running performance. Various pricing models are available for the revenue concept of value sharing. Various metrics are possible:

• One-dimensional: Fixed percentage of revenue
• Two-part tariff with basic fee and variable income component

Conclusion pricing model optimisation

The overriding decisions on the business model and competitive strategy have a direct impact on the possible options for price modelling. In the two extreme poles, pricing is either differentiated and complex or pricing models are simple and transparent. For established companies pursuing a premium strategy, complex models may be appropriate. These make direct comparisons difficult. They therefore simplify the skimming off of price willingness. In contrast, aggressive challengers may find it advantageous to address customers with very simple pricing. Increased transparency for the customer inevitably pays off for the cheapest provider. This explains why in many industries, newcomers in particular have used flat rates as a pricing model. Flat rates increase the financial planning security of users. Not only does this give the customer an incentive for higher usage – interestingly, a flat rate also increases the level of willingness to pay. This proves that the pricing model and price level cannot be seen independently of each other.

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. 

Whitepaper “Digital Transformation and Pricing” by Frank Frohmann