Digitalization has opened the door for new business models, additional sources of revenue, a stronger integration of the customer in pricing processes, creative pricing models, etc. It affects all aspects of price management and paves the way for innovation that transcends the individual steps in the pricing process.
However, as studies on “digital pricing” show: unfortunately, digital price management is often still limited to topics like “automated price setting” or “pricing for online channels.”
But that’s hardly sufficient, as a brief look at the increasingly dynamic corporate examples shows: the digital transformation of successful B2B and B2C firms is spurring innovations at all three interconnected levels: business models, revenue models, and the pricing process. Digital pricing addresses and encompasses all three dimensions. The initial basis for the three-dimensional optimization is the customer benefit defined in the business model (value to customer).
With the increasing digitalization of business life, these interconnections will become more and more important. This is just as true for major technology corporations (e.g. Amazon, Alphabet, Apple, Microsoft) as it is for start-ups (Mobike, Waymo, etc.). Industrial firms who are seeking to meet the challenges of tomorrow with innovative digital business models (e.g. Trumpf, Bosch and Siemens) also offer a wealth of practical examples. In this regard, let’s take a brief look at Hitachi: a few years ago, the firm changed its value-creation architecture (operating model) in a B2B business area. The latest sensor technologies were integrated into commuter train systems, greatly improving their punctuality (value to customer). The result: Hitachi soon changed its business model: instead of offering trains as its product, the firm began offering B2B customers (based on a “train-as-a-service” concept) the service “punctuality.” In other words: the business model shifted from “selling products” to “offering software-based services.” The revenue model changed from one-off payments to steady flows of payments. And the new pricing model that emerged is as follows: the better the punctuality, the higher the price. The Spanish train operator AVE has – based on the same operating model and revenue model – even gone one step further when it comes to pricing: AVE offers travelers a punctuality guarantee for trips within Spain. If it can’t deliver on that promise, travelers are entitled to a full refund. Both of these examples combine business modeling, revenue model design and price model optimization. In terms of the pricing model the key question isn’t how much money the customer pays, but what the reference is: what does the customer pay for, how, when, and in what form? Companies including Michelin (car tires; “price per kilometer”), Enercon (wind turbines; “price per output”), BASF (automotive coatings; “cost per unit”) and Schindler (elevators; “price per amount of transported weight”) have created innovative, output-oriented pricing models of their own. In B2C markets, when it comes to creativity – based on new technologies like AI – the possibilities are practically endless. The innovative “pay per smile” pricing model at a theater in Barcelona, Spain shows: new technologies facilitate pricing innovation. In turn, “smile to pay” refers to an idea (from Tencent in China) to completely digitalize the customer journey. Let’s bear the following in mind: new technologies (sensor technologies, IoT, cloud, AI, etc.) have provided the necessary basis for the 3-stage digital transformation outlined above. But it requires a concrete customer demand to turn this technological potential into a market opportunity that can be monetized.
The 7 Determinants of Pricing
Every strategic pricing measure has to take into account at least 7 key pieces of information, the “7 C” of pricing. In essence, they address the following questions:
- Customer: How much are customers willing to pay? How high is their price elasticity with regard to our products?
- Competition: How much are our competitors charging? How will they respond to our pricing measures?
- Costs: What are the individual elements of our costs?
- Capacity: What does the capacity situation in our sector look like? How high is the utilization of our production and service capacities?
- Cycle stage: Which phase of the product lifecycle is our product in?
- Company targets: What is our strategy? What are our goals?
- Compliance: Which legal aspects of pricing have to be kept in mind in our sector?
Further information on the respective determinants:
Customer: The acceptance of the price from the customer’s perspective is a central influencing factor on sales and profits.
Competition: The customer’s preference for a given product depends on the competition’s prices. There are numerous examples of firms in various sectors who have used a differentiation strategy to rise above price competition.
Costs: The size of the costs determines a given firm’s leeway in terms of pricing.
Capacity: The utilization of production facilities and/or service personnel has a direct effect on pricing. The intensity of price competition is a product of the balance between supply and demand. In the case of overcapacity, pricing is frequently used to steer utilization.
Cycle Stage: The variation in prices throughout the product lifecycle is one of the most important “levers” for corporate success. Pricing strategies and levels for the four phases (introduction, growth, maturity and decline) differ fundamentally. The degree of market penetration can be controlled by the firm; e.g. a lower introductory price can be used to accelerate the diffusion process. Digitalization has increased the speed of these market developments.
The price potential, which varies throughout the lifecycle, can be described using the concept of “pricing power”. Pricing power refers to the potential that a given firm can achieve by convincing customers to pay its desired prices.
A firm’s pricing power is one of the most important early indicators of its long-term success. The ability to demand certain prices varies in the course of the lifecycle. A high “pricing power” – and the corresponding profit potentials that can be achieved through price changes – tend to arise in the following situations:
- innovative products / services,
- high market share (dominant market position),
- high customer benefit,
- complex offers with low price transparency,
- tight capacity,
- superior brand image.
Among these criteria, market share enjoys a prominent position. In connection with the lifecycle phases, investing in market share is critical to success, especially for digital products and services. In many digital sectors, quickly achieving critical mass is a precondition for reaping the rewards in subsequent lifecycle phases, in the form of higher prices.
Company targets: The basic equation profits = quantity × price – costs illustrate the direct connection between price and profits. As a company target, profits encompass all of the consequences of a pricing decision.
Compliance: Especially in digitalized sectors, the opportunities and risks of Price Management are greatly determined by relevant legal details. By way of example: technology corporations like Amazon, which migrate to the financial sector, have to comply with the standard requirements for the banking sector. Legal restrictions are also important in the highly profitable cloud computing business. For example, Amazon is prohibited from analyzing the content of firms’ saved data. In other sectors, there are e.g. legal restrictions on digital price communication (e.g. filling stations) and on the extent of bundling (e.g. software).
Interim summary: all successful pricing strategies are based on a clear orientation on customer needs. Whenever price acceptance and customer feedback is ignored, problems are sure to arise. A few years ago, when Sixt experimented with an extra charge for longer routes within Germany, the result was a major outcry from its B2B customers. Sixt quickly abandoned the initiative. The reason for this negative feedback was quite simple: competitors like Deutsche Bahn offered price incentives for longer distances; accordingly, any break with this learned mechanism was rejected. In turn, Apple offers a more recent example of ignoring customer feedback: even though it had been apparent for some time that the luxury prices charged for the iPhone were finding less acceptance, the strategy was continued for the latest series of models (XS Max, XS and XR) introduced in September 2018. By using modern methods (“social listening,” “voice of customer” analytics), Apple could have easily recognized customers’ massive criticism with regard to the price-performance ratio and avoided the “negative surprise” of declining market share, volumes, turnover and profits end of 2018. The fact is: Apple’s extremely high “pricing power” initially suffered a serious blow at the beginning of the year 2019. The “Apple shock” is – though an extreme case – no exception. An interesting fact in this regard: 76 % of all newly introduced products fail. Simon-Kucher & Partners identified a similarly high failure rate in a study on digitalization activities. The cause in both cases: too little attention was paid to customer needs.
The three-level model of digital pricing
Professional price management for digital products must necessarily begin with the overarching business model (Level 1). Determining the prices for products does not suffice for profit optimization, in terms of digital pricing, integrating all aspects of the business model is critical to success. The revenue model (Level 2) defines the sources of revenue (i.e., the offerings that need to be priced) and the payer (revenue partner). In turn, this leads us to the core decisions within the pricing process (Level 3): on the strategy, pricing structures and models, up to concrete price levels, discounts, rebates etc.
In works on price management, revenue models and business definitions are often overlooked. Yet doing so ignores a major challenge in the context of profit optimization. After all, in terms of the much-discussed digital transformation, there are essentially three pricing-relevant challenges:
- defining new value propositions, new product architectures and digital services,
- innovative revenue models, and
- technology-driven changes in the price management process.
All three levels – defining the business, revenue model and pricing process – must be approached and optimized from the customer’s perspective. The main elements of the three-level digitalization system include the customer benefit, value-creation system, profit model, sources of revenue, the individual components of a pricing model, etc. The essential criterion in connection with the three-level mode of digitalization is consistency: the more customer-oriented the individual modules are, and the more sound the relations between the respective elements in the three-level system are, the higher the success on the market will be. The interplay between these three dimensions can be seen in the following example involving Amazon. One important component of Amazon’s business model is the digital assistant Alexa, which offers users a broad range of services. Used together with the digital loudspeaker Echo, it can answer their questions, place orders via the online portal, play music, and control household devices like the lights or heating system. This software solution allows Amazon to access various sources of revenue in the digital services area. When customers use the digital assistant to control their music system, coffeemaker, refrigerator or heating, corresponding data is constantly transmitted in the context of the Internet of Things. All of these networked devices have to be constantly ready for activation (“always on”). This produces a direct effect on pricing models and the price levels. Depending on the customer segment and details of use (time, place, application, context, etc.), the perceived benefits of these digital services can vary considerably. The task is to optimally monetize on customers’ resulting willingness to pay. The prerequisite for doing so is a professional analysis and optimization process, which consists of the following steps:
- Quantifying the customer benefit for individual applications
- Segment-specific design for the digital services
- Identifying the resultant sources of revenue
- Deciding on the pricing model and price level for the services.
In summary, and as a point of departure for the subsequent articles, we can say the following: when there is not sufficient willingness to pay on the market, or the overall business model isn’t profitable, not even the best algorithm can make up for it. Tools, methods and automatic pricing mechanisms, though important, are only necessary conditions. Successful “digital pricing” begins with orienting the business model on customer needs!